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Report to the Chairman, Committee on Banking, Housing, and Urban 
Affairs, U.S. Senate:

October 2004:

FINANCIAL REGULATION:

Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure:

GAO-05-61:

GAO Highlights:

Highlights of GAO-05-61, a report to the Chairman, Committee on 
Banking, Housing, and Urban Affairs, U.S. Senate: 

Why GAO Did This Study:

In light of the passage of the 1999 Gramm-Leach-Bliley Act and 
increased competition within the financial services industry at home 
and abroad, GAO was asked to report on the current state of the U.S. 
financial services regulatory structure. This report describes the 
changes to the financial services industry, focusing on banking, 
securities, futures, and insurance; the structure of the U.S. and other 
regulatory systems; changes in regulatory and supervisory approaches; 
efforts to foster communication and cooperation among U.S. and other 
regulators; and the strengths and weaknesses of the current regulatory 
structure. 

What GAO Found:

The financial services industry has changed significantly over the last 
several decades. Firms are now generally fewer and larger, provide more 
and varied services, offer similar products, and operate in 
increasingly global markets. These developments have both benefits and 
risks, both for individual institutions and for the regulatory system 
as a whole. Actions that are being taken to harmonize regulations 
across countries, especially the Basel Accords and European Union 
Financial Services Action Plan, are also affecting U.S. firms and 
regulators. While the financial services industry and the international 
regulatory framework have changed, the regulatory structure for 
overseeing the U.S. financial services industry has not. Specialized 
regulators still oversee separate functions—banking, securities, 
futures, and insurance—and while some regulators do oversee complex 
institutions at the holding company level, they generally rely on 
functional regulators for information about the activities of 
subsidiaries. In addition, no one agency or mechanism looks at risks 
that cross markets or industry segments or at the system and its risks 
as a whole. 

Although a number of proposals for changing the U.S. regulatory system 
have been put forth, the United States has chosen not to consolidate 
its regulatory structure. At the same time, some industrial countries—
notably the United Kingdom—have consolidated their financial regulatory 
structures, partly in response to industry changes. Absent fundamental 
change in the overall regulatory structure, U.S. regulators have 
initiated some changes in their regulatory approaches. For example, 
starting with large, complex institutions, bank regulators, in the 
1990s, sought to make their supervision more efficient and effective by 
focusing on the areas of highest risk. And partly in response to 
changes in European Union requirements, SEC has issued rules to provide 
consolidated supervision of certain internationally active securities 
firms on a voluntary basis. Regulators are also making efforts to 
communicate in national and multinational forums, but efforts to 
cooperate have not fully addressed the need to monitor risks across 
markets, industry segments, and national borders. And from time to time 
regulators engage in jurisdictional disputes that can distract them 
from focusing on their primary missions. 

GAO found that the U.S. regulatory structure worked well on some levels 
but not on others. The strength and vitality of the U.S. financial 
services industry demonstrate that the regulatory structure has not 
failed. But some have questioned whether a fragmented regulatory system 
is appropriate in today’s environment, particularly with large, complex 
firms managing their risks on a consolidated basis. While the structure 
of the agencies alone cannot ensure that regulators achieve their 
goals—agencies also need the right people, tools, and policies and 
procedures—it can hinder or facilitate their efforts to provide 
consistent, comprehensive regulation that protects consumers and 
enhances the delivery of financial services. 

What GAO Recommends:

While GAO is not recommending a specific alternative regulatory 
structure, Congress may wish to consider ways to improve the regulatory 
structure for financial services, especially the oversight of complex, 
internationally active firms. Options to consider include consolidating 
within regulatory areas and creating an entity primarily to oversee 
complex, internationally active firms, while leaving the rest of the 
regulatory structure in place. Federal financial regulators provided 
comments on these options.

www.gao.gov/cgi-bin/getrpt?GAO-05-61.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Thomas J. McCool at (202) 
512-8678 or mccoolt@gao.gov.

[End of section]

Contents:

Letter:

Executive Summary:

Purpose:

Background:

Results in Brief:

GAO's Analysis:

Matter for Congressional Consideration:

Agency Comments and Our Evaluation:

Chapter 1: Introduction: 

Traditionally, Financial Institutions Served as Intermediaries and 
Transferred Some Risks:

The Financial Services Industry Faces Risks at the Institutional Level 
and Systemwide:

U.S. Financial Services Regulation Has Multiple Goals:

U.S. Financial Regulatory System Includes a Variety of Regulatory 
Bodies:

The United States Participates in International Organizations Dealing 
with Regulatory Issues:

Objectives, Scope, and Methodology:

Chapter 2: The Financial Services Industry Has Undergone Dramatic 
Changes: 

Financial Services Have Played an Integral Part in Globalization:

Large Institutions Have Become Larger through Consolidation and 
Conglomeration:

Roles of Large Financial Services Firms Have Changed and Financial 
Products Have Converged, but Some Differences Remain:

As Financial Services Institutions Have Diversified, Introduced New 
Products, and Become More Complex, Risks Have Changed:

Chapter 3: While Some Countries Have Consolidated Regulatory 
Structures, the United States Has Chosen to Maintain Its Structure:

Some Countries and States Have Consolidated Their Regulatory 
Structures:

United States Has Chosen to Maintain the Federal Regulatory Structure, 
although Proposals Have Been Made to Change It:

Chapter 4: Regulators Are Adapting Regulatory and Supervisory 
Approaches in Response to Industry Changes:

New Basel II Structure and EU Requirements Will Likely Affect Oversight 
of U.S. Financial Institutions:

U.S. Regulators Have Made or Considered Some Other Changes to Their 
Regulatory and Supervisory Approaches in Response to Industry Changes:

Chapter 5: Regulators Communicate and Coordinate in Multiple Ways, but 
Concerns Remain: 

U.S. Financial Regulators Communicate and Coordinate with Other 
Regulators in Their Sectors, but Sometimes Find It Difficult to 
Cooperate:

Financial Services Regulators Also Communicate across Financial 
Sectors, but Do Not Effectively Identify Some Risks, Fraud, and Abuse 
That Cross Sectors:

Chapter 6: The U.S. Regulatory System Has Strengths, but Its Structure 
May Hinder Effective Regulation

U.S. Financial Services Regulatory System Has Generally Been Successful 
but Lacks Overall Direction:

Structure of U.S. Financial Services Regulatory System May Not 
Facilitate Oversight of Large, Complex Firms:

Structure of U.S. Financial Services Regulatory System May Not 
Facilitate Response to Increased Globalization:

Regulators Provide Some Other Benefits by Specializing in Particular 
Industry Segments or Geographic Units, but Specialization Has Costs As 
Well:

Chapter 7: Congress May Want to Consider Changes to the U.S. Regulatory 
Structure: 

Matter for Congressional Consideration:

Agency Comments and Our Evaluation:

Appendixes:

Appendix I: Comments from the Board of Governors of the Federal Reserve 
System:

Appendix II: Comments from the Federal Deposit Insurance Corporation:

Appendix III: Comments from the Office of the Comptroller of the 
Currency:

Appendix IV: Comments from the Office of Thrift Supervision:

Appendix V: Comments from the Securities and Exchange Commission:

Appendix VI: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Staff Acknowledgments:

Related GAO Products:

Table:

Table 1: Selected Retail Products by Financial Institution and 
Function:

Figures:

Figure 1: Traditional Role of Financial Intermediaries:

Figure 2: International Debt Securities, 1987-2004:

Figure 3: Share of Assets in Each Sector Controlled by 10 Largest 
Firms, 1996-2002:

Figure 4: Merger Activity among Banking Organizations, January 1990-
June 2004:

Figure 5: Number of Futures Contracts Traded, 1995-2003:

Figure 6: Structure of a Hypothetical Financial Holding Company:

Figure 7: The Three Pillars of Basel II:

Figure 8: United States--EU Regulatory Dialogue:

Figure 9: Regulators for a Hypothetical Financial Holding Company:

Abbreviations:

AFM: Netherlands Authority for the Financial Markets:

APRA: Australian Prudential Regulation Authority:

ASIC: Australian Securities and Investments Commission:

BaFin: German Federal Financial Supervisory Authority (Die 
Bundesanstalt für Finanzdienstleistungsaufsicht):

CESR: Committee of European Securities Regulators:

CFMA: Commodity Futures Modernization Act:

CFTC: Commodity Futures Trading Commission:

CRS: Congressional Research Service:

CSE: consolidated supervised entity:

EU: European Union:

FBIIC: Financial and Banking Information Infrastructure Committee:

FCM: futures commission merchant:

FDIC: Federal Deposit Insurance Corporation:

FFIEC: Federal Financial Institutions Examination Council:

FSF: Financial Stability Forum:

GLBA: Gramm-Leach-Bliley Act:

IAIS: International Association of Insurance Supervisors:

ILC: industrial loan companies:

IMF: International Monetary Fund:

IOSCO: International Organization of Securities Commissions:

ISG: Intermarket Surveillance Group:

Japan-FSA: Financial Services Authority of Japan:

LTCM: Long-Term Capital Management:

NAIC: National Association of Insurance Commissioners:

NASDAQ: Nasdaq Stock Market Inc.

NCUA: National Credit Union Administration:

NFA: National Futures Association:

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:

SIA: Securities Industry Association:

SIBHC: supervised investment bank holding company:

SRO: self-regulatory organization:

UK-FSA: Financial Services Authority of the United Kingdom:

Letter October 6, 2004:

The Honorable Richard C. Shelby: 
Chairman: 
Committee on Banking, Housing, and Urban Affairs: 
United States Senate:

Dear Mr. Chairman:

This report responds to your request that we analyze the present 
financial services regulatory structure. As you requested, this report 
(1) describes the changes in the financial services industry over 
recent decades, (2) describes changes that have occurred in the U.S. 
regulatory structure and those of other industrialized countries, (3) 
describes major changes in U.S. financial market regulation, (4) 
discusses efforts to communicate, coordinate, and cooperate across 
agencies in the present system, and (5) assesses the strengths and 
weaknesses of the present financial regulatory structure. This report 
includes a Matter for Congressional Consideration.

As agreed with your office, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
from its issue date. We will then send copies to the Ranking Minority 
Member of the Committee on Banking, Housing, and Urban Affairs; the 
Chairman and Ranking Minority Member of the House Committee on 
Financial Services; the Secretary of the Department of the Treasury; 
the Chairman of the Board of Governors of the Federal Reserve System; 
the Chairman of the Federal Deposit Insurance Corporation; the 
Comptroller of the Currency; the Director of the Office of Thrift 
Supervision; the Chairman of the Securities and Exchange Commission; 
the Chairman of the Commodity Futures Trading Commission; the President 
of the National Association of Insurance Commissioners; and other 
interested parties. Copies will also be made available to others upon 
request. In addition, this report will be available at no charge on the 
GAO Web site at [Hyperlink, http://www.gao.gov].

This report was prepared under the direction of James M. McDermott, 
Assistant Director. Please contact Mr. McDermott at (202) 512-5373 or 
me at (202) 512-8678 if you or your staff have any questions about this 
report. Major contributors to this report are listed in appendix VI.

Sincerely yours,

Signed by: 

Thomas J. McCool: 
Managing Director, Financial Markets and Community Investment:

[End of section]

Executive Summary:

Purpose:

It is 5 years since Congress passed the landmark Gramm-Leach-Bliley Act 
(GLBA). In some ways, this act recognized the blurring of distinctions 
among banking, securities, and insurance activities that had already 
happened in the marketplace and codified regulatory decisions that had 
been made to deal with these industry changes. While recognizing 
industry and regulatory changes, that act changed neither the number of 
regulatory agencies nor, in most cases, the primary objectives and 
responsibilities of the existing agencies. The result of the blurring 
of distinctions among the traditional financial services sectors, 
recognized by GLBA, has enlarged the number and types of competitors 
facing any firm, both domestically and internationally. Thus, what is 
happening abroad from a regulatory perspective could impact the 
competitive position of U.S. financial services institutions and the 
ability of U.S. regulators to achieve their objectives. On this front, 
many other industrialized countries are consolidating their financial 
regulatory structures, and international forums are nearing completion 
of important efforts to harmonize regulation across countries.

To better understand the effectiveness of the U.S. regulatory system in 
this changing environment, the Chairman of the Committee on Banking, 
Housing, and Urban Affairs requested an analysis of the present 
regulatory structure. In particular, this report:

* describes the changes in the financial services industry over recent 
decades;

* describes changes that have occurred in the U.S. regulatory structure 
and those of other industrialized countries;

* describes major changes in U.S. financial market regulation;

* discusses efforts to communicate, coordinate, and cooperate across 
agencies in the present system; and:

* assesses the strengths and weaknesses of the present financial 
regulatory structure.

To meet these objectives GAO drew on its past work, reviewed other 
relevant literature, conducted interviews with officials of federal and 
state regulatory agencies, financial services industry 
representatives, and other experts in the United States, the United 
Kingdom, Belgium, and Germany and collected and analyzed data on 
industry changes and regulatory activities. We conducted our work 
between June 2003 and July 2004 in accordance with generally accepted 
government auditing standards in Washington, D.C; Boston; Chicago; New 
York City; Brussels, Belgium; London; and Berlin, Bonn, and Frankfurt, 
Germany.

Background:

An efficient and effective financial services sector promotes economic 
growth through the optimum allocation of financial capital. Achieving 
that outcome rests primarily with the industry; however, in some cases 
the market may not produce the most desirable outcomes and some form of 
regulatory intervention is needed. In the United States, laws define 
the roles and missions of the various regulators, which, to some 
extent, are similar across the regulatory bodies. Regulators generally 
have three objectives: (1) ensuring that institutions do not take on 
excessive risk; (2) making sure that institutions conduct themselves in 
ways that limit opportunities for fraud and abuse and provide consumers 
and investors with accurate information and other protections that may 
not be provided by the market; and (3) promoting financial stability by 
limiting the opportunities for problems to spread from one institution 
to another. However, laws and regulatory agency policies can set a 
greater priority on some roles and missions than others. In addition, 
the goals and objectives of the regulatory agencies have developed 
somewhat differently over time, such that bank regulators generally 
focus on the safety and soundness of banks, securities and futures 
regulators focus on market integrity and investor protection, and 
insurance regulators focus on the ability of insurance firms to meet 
their commitments to the insured.

Generally, banking and securities activities are regulated at both the 
state and federal levels, while futures are regulated primarily at the 
federal level and insurance at the state level. For banking activities, 
the Federal Reserve System (Federal Reserve)--including the Board of 
Governors and the 12 Federal Reserve Banks--the Office of the 
Comptroller of the Currency (OCC), the Office of Thrift Supervision 
(OTS), the Federal Deposit Insurance Corporation (FDIC), and the 
National Credit Union Administration (NCUA) are the primary federal 
regulators. For securities activities, the Securities and Exchange 
Commission (SEC) is the primary federal regulator, and for futures 
products, the Commodity Futures Trading Commission (CFTC) is the 
primary regulator. In addition, self-regulatory organizations under SEC 
or CFTC jurisdiction provide oversight of securities and futures 
dealers and exchanges. State regulators also provide oversight of 
banking, securities, and insurance. For commercial and savings banks 
with state bank charters, state banking departments charter the entity 
and have supervisory responsibilities, while the Federal Reserve or 
FDIC serve as the primary federal supervisor for these banks.[Footnote 
1] For securities, states generally provide oversight to protect fraud 
and abuse against within their jurisdictions. In contrast to these 
products or activities, which are either regulated primarily at the 
federal level or through a dual system of state and federal regulation, 
insurance products are regulated primarily at the state level. 
Organizationally, some regulatory agencies (OCC and OTS) are part of 
the Department of the Treasury (Treasury), while the others are 
independent entities or commissions. While OCC and OTS are part of 
Treasury, their heads are appointed by the President and approved by 
the Congress for fixed terms to ensure their independence.

The U.S. regulatory system for financial services is described as 
"functional," so that financial products or activities are generally 
regulated according to their function, no matter who offers the product 
or participates in the activity. Broker-dealer activities, for 
instance, are generally subject to SEC's jurisdiction, whether the 
broker-dealer is a subsidiary of a bank holding company subject to 
Federal Reserve supervision or a subsidiary of an investment bank. The 
functional regulator approach is intended to provide consistency in 
regulation and avoid the potential need for regulatory agencies to 
develop expertise in all aspects of financial regulation.

Some firms engaged in the provision of banking, insurance, securities, 
or futures products and activities in the United States are also 
required by statute to be regulated at the holding company level. These 
include bank holding and financial holding companies that are regulated 
by the Federal Reserve, and thrift holding companies that are regulated 
by OTS. In addition, SEC has statutory authority to oversee investment 
bank holding companies, if they choose to be overseen in that way.

U.S. regulators conduct their activities within a broad array of 
international forums and agencies. Some, such as the Basel Committee on 
Banking Supervision (Basel Committee), International Organization of 
Securities Commissions, and International Association of Insurance 
Supervisors, are voluntary organizations of supervisors from a number 
of countries. In addition, activities in the European Union--a treaty-
based organization of European countries in which those countries cede 
some of their sovereignty so that decisions on specific matters of 
joint interest can be made democratically at the European level--often 
impact U.S. firms and regulators.

Results in Brief:

Over the last few decades, the environment in which the financial 
services industry operates and the industry itself have undergone 
dramatic changes that include globalization, consolidation within 
traditional sectors, conglomeration across sectors, and convergence of 
institutional roles and products. As a result of these changes, a 
relatively small number of very large, diversified financial companies 
now compete globally to meet a broad range of customer needs. Moreover, 
the complexity of these firms and the products and services they offer 
and use are changing the kinds and extent of risks in the financial 
services industry. With regard to some risk, such as credit risk, 
diversification across products, services, and markets might be 
expected to reduce the risk faced by an individual institution. 
However, it may not reduce the extent of risk in the system as a whole. 
The increased sophistication in and interconnections throughout the 
industry now make it difficult to determine the location and extent of 
that risk. In addition, the difficulty of managing these large, 
complex, globally active firms may expose them to greater operational 
risk in that it is more difficult to impose adequate controls to 
prevent fraud and abuse or some other operational problem at home or in 
some small far-flung subsidiary. While there are fewer financial 
services firms, the U.S. financial services industry retains a large 
number of smaller entities that compete in more traditional segmented 
markets, where they generally offer less complex or varied services 
than the large, consolidated firms and compete more locally against 
institutions in their sector.

For some time, the United States has chosen not to change its 
regulatory structure substantially; however, since the mid-1990s, 
several other industrialized countries and some U.S. states have 
consolidated their regulatory structures, partially in response to 
changes in the industry. Today, instead of an array of government 
agencies and self-regulatory bodies, the countries GAO studied have one 
or two supervisory agencies. Germany, Japan, and the United Kingdom 
each have merged their regulatory structures into a single agency, 
while Australia and the Netherlands have consolidated their regulatory 
structures by assigning two of the major objectives of regulation--the 
safety and soundness of institutions and conduct-of-business, which 
includes market conduct, market integrity, and some aspects of 
corporate governance--to different regulatory agencies. Within these 
structures, the attainment of the third major regulatory objective, 
financial stability, is shared with the central bank, which may also 
share regulatory responsibilities. Those countries that have 
consolidated their regulatory structures differ in some important 
respects from the United States in that their economies and financial 
sectors are smaller and generally less diverse. Several U.S. states 
have similarly consolidated their regulatory agencies to better deal 
with changes in the industry. Officials in the states GAO talked to 
said that they are better able to meet the needs of consumers and to 
cooperate across traditional industry lines; however, they report that 
they have also sought to maintain the specialized knowledge regulators 
brought from their respective agencies. Over the years, proposals have 
also been made to consolidate various aspects of the U.S. regulatory 
structure, but the United States has not chosen to adopt those changes 
in any substantive way.

While the U.S. financial services regulatory structure has changed 
little, regulators have modified their regulatory and supervisory 
approaches to respond to market changes. For example, during the 1990s, 
the bank regulatory agencies began risk-focused supervision of large, 
complex banks, focusing supervisory attention on management policies 
and procedures for areas believed to be the highest risk for the 
banking organizations rather than trying to cover all aspects of bank 
management; this risk-focused approach now applies to all banking 
organizations. Somewhat earlier, the National Association of Insurance 
Commissioners (NAIC) began to conduct groupwide financial analyses for 
nationally significant insurance companies--companies that are large or 
operate in several states. Some of the most pronounced changes in 
regulatory approach have or are coming about as a result of efforts to 
harmonize supervision across national boundaries. These efforts include 
the Basel Committee negotiations to update capital requirements for 
banks, generally referred to as Basel II,[Footnote 2] and the European 
Union's Financial Services Action Plan, especially the Financial 
Conglomerates Directive, which requires most large, complex firms doing 
business in European Union countries to apply Basel capital standards 
and become subject to consolidated supervision sometime in 2005. These 
activities are leading to changes in the regulation and supervision of 
some large or complex U.S. financial services firms that are active in 
Europe. For example, SEC has, for the first time, adopted rules to 
provide holding company oversight for certain large securities firms on 
a voluntary basis. These rules incorporate some of the Basel II 
framework for capital adequacy regulation.

Congress and the regulators themselves have recognized the need for 
regulators in the U.S. system to communicate and coordinate activities 
within and across the traditional financial services sectors. Several 
formal and informal mechanisms exist to facilitate communication, both 
within and across sectors, but problems remain. For example, at the 
federal level, bank regulators coordinate examination and supervisory 
policy, including many rule-making initiatives, through the Federal 
Financial Institutions Examination Council and communicate 
internationally through the Basel Committee. Officials serving in the 
regional offices of the various federal bank regulators also reported 
that they communicate formally and informally with each other and with 
the state banking regulators in their region on a regular basis. 
However, problems between OTS and FDIC and between OCC and FDIC 
hindered a coordinated supervisory approach in bank failures in 2001 
and 1999, respectively, and questions have arisen concerning the 
efficacy of having several U.S. bank regulators present different 
positions at Basel Committee negotiations. With regard to concerns 
about Basel II, the regulators say that the process was necessarily 
complex, they are required to air any disagreements through a 
transparent, public process and, in the end, all of the provisions the 
various U.S. bank regulators wanted were included in Basel II when it 
was adopted in June 2004. Similarly, securities regulators at the state 
and federal levels say they regularly coordinate enforcement actions, 
but in certain high-profile cases, some disagreements have emerged 
concerning the appropriateness and effectiveness of state and federal 
actions. With regard to coordination across sectors, regulators have 
taken some actions themselves, but have often been directed to 
coordinate by Congress or the President, especially in response to 
crises such as the stock market crash of 1987, the events of September 
11, 2001, and recent corporate scandals. In a number of reports 
evaluating these cross sector efforts, GAO has noted that no mechanism 
exists for the monitoring of cross market or cross industry risks and 
that information sharing has not been sufficient for identifying and 
heading off potential crises. For example, in our report issued in 2000 
on the President's Working Group, which includes the heads of the 
Federal Reserve, Treasury, SEC, and CFTC, GAO reported that although 
this group has served as a mechanism to share information during 
unfolding crises, its activities generally have not included such 
matters as routine surveillance of risks that cross markets or of 
information sharing that is specific enough to help identify potential 
crises.

Experts generally agree that the regulatory structure alone does not 
determine whether regulatory objectives are achieved. Having an 
adequate number of people with the right skills, clear objectives, 
appropriate policies and procedures, and independence are probably more 
important. However, the regulatory structure can often facilitate or 
hinder the attainment of regulatory objectives. U.S. regulators and 
financial market participants GAO spoke with generally emphasized that 
the current regulatory structure has contributed to the development of 
U.S. capital markets and overall economic growth and stability. 
Industry participants also noted that regulators are generally of a 
high quality. With the adoption of holding company supervision for a 
broader segment of firms, some regulators may be better able to 
understand and prepare for the risks that cut across functional areas 
within a given holding company. In addition, in conjunction with agency 
specific strategic planning activities, regulators may better monitor 
risks that cut across the industry segments they oversee. However, no 
agency or mechanism has the responsibility for monitoring risks that 
cut more broadly across functional areas. Further, no agency has the 
responsibility for analyzing the risks to the financial system as a 
whole or planning strategically to address those risks and problems 
that may develop in the future; there also is no mechanism for agencies 
to cooperate effectively to perform these tasks. Some characteristics 
of the U.S. regulatory structure--specialization of and competition 
among the agencies--facilitate the attainment of some regulatory 
objectives and hinder the attainment of others. On the positive side, 
specialization allows regulators to better understand the risks 
associated with particular activities or products and to better 
represent the views of all segments of the industry. And competition 
among regulators helps to account for regulatory innovation and 
vigilance, by providing businesses with a method to move to regulators 
whose approaches better match the businesses' operations. However, 
these very characteristics may hinder the effective and efficient 
oversight of large, complex, internationally active firms that compete 
across sectors and national boundaries. In addition, the specialized 
and differential oversight of holding companies in the different 
sectors has the potential to create competitive imbalances among firms 
in those sectors based on regulatory differences alone. Further, 
competition among the regulators may limit the ability to negotiate 
international agreements that would broadly be to the advantage of U.S. 
firms. Similarly, some legal experts and regulators note that because 
large, complex firms are managed centrally, regulators that specialize 
in understanding risks specific to their "functional" sector may not 
have the ability or authority to oversee the complex risks that span 
financial sectors or the risk management methodologies employed by 
these firms. Moreover, they note that competition among supervisory 
authorities poses the risk that financial firms may well engage in a 
form of regulatory arbitrage that involves the placement of particular 
financial services or products in that part of the financial 
conglomerate in which supervisory oversight is the least intrusive.

In this report, GAO recognizes that the specifics of a regulatory 
structure may not be the critical determinant in whether a regulatory 
system is successful because skilled regulators with the appropriate 
policies and procedures could potentially overcome any impediments of 
the structure through better communication and coordination across 
agencies. However, because the structure may hinder the attainment of 
certain regulatory goals, GAO suggests that Congress may want to 
consider ways to consolidate the regulatory structure to (1) better 
address the risks posed by large, complex firms and their consolidated 
risk management approaches, (2) promote competition domestically and 
internationally, and (3) contain systemic risk. Some of these ways may 
require that the lines that now define regulatory responsibility change 
to recognize the changed environment of financial services. This could 
be done in several ways, including making relatively small changes such 
as consolidating the bank regulators and, if Congress wishes to provide 
an optional federal charter for insurance, creating a federal insurance 
regulator, or making more dramatic changes such as creating a single 
regulatory agency. Alternatively, a small agency could be created to 
facilitate the oversight of all large, internationally active firms. 
Each alternative has potential benefits and costs. For example, 
consolidation could facilitate, but won't necessarily ensure, that 
regulators communicate and coordinate, provide for regulatory 
neutrality, and monitor risks across markets. However, larger 
regulatory agencies could be less accountable to consumers or the 
industry, possibly damaging the diversity that enriches our economy, or 
could lose expertise critical to overseeing certain aspects of the 
industry. In addition, change itself has certain costs, such as the 
costs of rewriting the various laws that support the current regulatory 
structure and any unintended consequences that could result during the 
movement from the current structure to a new structure.

GAO's Analysis:

The Financial Services Industry Has Undergone Dramatic Changes:

The environment in which the financial services industry operates and 
the industry itself have undergone dramatic changes. First, 
globalization has become a predominant characteristic of modern 
economic life and has affected and been affected by the financial 
services sector. Capital moves across national boundaries, and many 
financial services firms operate globally. For example, foreign firms 
increasingly own U.S. life insurers and many U.S. banks and securities 
firms are internationally active. In addition, Citigroup has a 
significant retail banking business in Germany, while ING, a Dutch 
firm, seeks to attract deposits in its U.S. thrift. Second, 
consolidation of firms within the "functional" areas of banking, 
securities, and insurance and conglomeration of firms across these 
areas have increasingly come to characterize the large players in the 
industry. Since 1995, 40 large banking organizations have merged or 
acquired each other to such an extent that today just 6 very large 
institutions remain. Similarly, the number of securities and futures 
firms and the number of insurance companies have also declined while 
generally the industry has grown. With regard to increased 
conglomeration, a research report by International Monetary Fund staff-
-based on a worldwide sample of the largest 500 financial services 
firms in terms of assets--shows that the percentage of U.S. financial 
institutions in the sample that were engaged to some significant degree 
in at least two of the functional sectors of banking, securities, and 
insurance increased from 42 percent in 1995 to 61.5 percent in 2000, 
and that these conglomerates held 73 percent of the assets of all of 
the U.S. firms included in the sample. Commonly, large firms will seek 
to use their size to meet a wider array of customer demand for 
different financial products and services and to diversify an 
individual firm's risk profile. Third, the roles of financial 
institutions and the products and services they offer have converged, 
so that many of these institutions are competing to offer similar 
services to customers. While these changes are occurring, the U.S. 
economy still has a large number of smaller entities that compete in 
more traditional segmented markets, where they generally offer less 
complex or varied services than the large, consolidated firms and 
compete more locally against institutions in their sector.

As a result of changes in the industry, as well as the development of 
complex financial products, the financial services industry has become 
more complex, and thus the kinds and extent of risks the industry faces 
are changing. It is generally agreed that banks can better withstand 
defaults by segments of their creditors, because they now serve a range 
of geographic markets and types of creditors. In addition, by 
securitizing assets, certain institutions have generally been able to 
reduce certain kinds of risks within an institution by passing them off 
to other financial institutions or investors. However, the overall risk 
to the industry may not have been reduced. Institutions that have 
purchased securitized assets, for instance, may not have risk 
management systems designed for the acquired risks. Further, the 
relationships between institutions that securitize assets and those 
buying these securitized assets range across regulatory and 
governmental jurisdictions. Changes in the industry, especially the 
growth of large institutions, have also affected the level and 
management of operational and reputation risk. Large, complex firms 
pose new risks for global financial stability because they can be 
brought down by fraud and abuse or some other operational problem in 
some small far-flung subsidiary. For example, the collapse of Barings, 
a British bank with global operations, demonstrates the potential 
vulnerability of firms to operational risk. In this case, management 
did not effectively supervise a trader in Singapore, and his actions 
brought down the whole bank.

While Some Countries Have Consolidated Regulatory Structures, the 
United States Has Chosen to Maintain Its Structure:

Partly in response to industry changes, since the mid-1990s several 
major industrial countries have consolidated their regulatory 
structures. Germany, Japan, and the United Kingdom have each 
consolidated their regulatory structures so that they rely primarily on 
a single agency. The United Kingdom's move from nine regulatory bodies, 
including self-regulatory organizations (SRO), to a single agency, the 
Financial Services Authority (UK-FSA), is the most dramatic. UK-FSA 
focuses strategically on achieving a small number of statutory 
objectives--maintaining confidence in the financial system, promoting 
public understanding of the financial system, securing the appropriate 
degree of protection for consumers, and reducing the potential for 
financial services firms to be used for a purpose connected with 
financial crime--across a broad range of financial institutions and 
activities. In pursuing these goals, UK-FSA is required to take account 
of additional obligations, including achieving its goals in the most 
efficient and effective way and not damaging the competitive position 
of the United Kingdom internationally. To achieve its objectives under 
these proscribed constraints, UK-FSA focuses on the largest firms and 
on the needs of retail consumers. In addition, UK-FSA has taken actions 
to break down the traditional industry silos and to ensure that large, 
complex firms are overseen in consistent ways. While UK-FSA has sole 
responsibility for the safety and soundness of financial institutions 
and conduct-of-business, a tripartite group that includes the central 
bank and Her Majesty's Treasury pursues the goal of financial 
stability. The German single regulator, which is still quite new, 
maintains the traditional silos of banking, securities, and insurance, 
adding crosscutting groups to handle conglomerate supervision and 
international issues. In addition, the new supervisory body shares some 
supervisory responsibilities with Germany's central bank. Because of 
persistent problems in the Japanese economy, especially in its banking 
sector, the Japanese experiment with a single regulator illustrates the 
point that a country's financial services regulatory structure alone is 
not the determining factor in promoting economic growth through the 
optimum allocation of financial capital.

GAO also reviewed documents for two other countries--Australia and the 
Netherlands--that have consolidated their regulatory structures into 
two agencies that have responsibility for a single regulatory 
objective. In each country, one agency is responsible for prudential 
regulation of all financial institutions and the other for ensuring 
that financial firms and markets conduct their businesses properly. 
These structures are based on the belief that government agencies 
should have a single focus, so that one objective will not take 
precedence over another. In the Netherlands, the Dutch central bank has 
become the prudential regulator, while in Australia, the prudential 
regulator is independent. In both cases, the central bank has the 
primary responsibility for achieving the objective of financial 
stability.

Some U.S. states have consolidated their structures in response to 
industry changes as well. The states GAO spoke with had created a 
single regulator structure, in part, because of the blurring of 
traditional boundaries in the industry. These states said they are 
better able to share information and cooperate across the sectors, but 
that maintaining expertise in the traditional sectors is still 
important. In addition, state officials said that while they did not 
consolidate to reduce the cost of regulation, consolidation had reduced 
costs.

The United States, which differs from the other countries that have 
consolidated their structures in significant ways, such as having a 
much larger and more diverse financial sector, has not consolidated its 
regulatory structure. While GLBA substantially removed many of the 
barriers that had previously separated commercial banking from 
investment banking and insurance underwriting, GLBA did not 
substantially change the U.S. regulatory structure. Over the years, 
however, many proposals have been made to change the U.S. regulatory 
structure, and these proposals continued to be made throughout the 
1990s and early 2000s. These include proposals to consolidate the bank 
regulators, merge SEC and CFTC, change the self-regulatory organization 
structure for securities, and create a federal insurance regulator to 
oversee those companies opting for the proposed federal insurance 
charter. Proposals have also been made that cut across sectors, 
including ones for a single federal regulator in each area, an 
oversight board, and a fully consolidated regulator.

Regulators Are Adapting Regulatory and Supervisory Approaches in 
Response to Industry Changes:

Partly as a response to efforts to harmonize regulation 
internationally, regulators are adapting regulatory and supervisory 
approaches to industry changes. The major international efforts include 
the culmination of negotiations at the Basel Committee to update the 
framework for capital adequacy requirements for banks and bank holding 
companies, resulting in the Basel II framework, and European Union 
implementation of the Financial Conglomerates Directive, which will 
require most internationally active U.S. financial firms be subject to 
consolidated supervision. U.S. regulators will be implementing the 
Basel II requirements for large banking organizations over the next 
several years. Basel II has three pillars: the first concerns setting 
of minimum capital requirements, the second focuses on supervisory 
review of and action in response to banks' capital adequacy, and the 
third requires banks to publicly disclose information about their risk 
profile, risk assessment processes, and the adequacy of their capital 
levels to foster greater market discipline. The Financial Conglomerates 
Directive requires that non-European financial conglomerates, certain 
securities firms, and bank and financial holding companies operating in 
the European Union have adequate consolidated supervision, which 
includes application of Basel capital standards. Under the directive, 
which is expected to go into effect in 2005, a non-European financial 
conglomerate, securities firm, or bank or financial holding company 
that is not considered to be supervised on a consolidated basis by an 
equivalent home country supervisor would be subject to additional 
supervision by regulators in European Union member states. As a result, 
some major U.S. companies will need to demonstrate that they have 
consolidated home country supervision. Some companies that own thrift 
institutions may seek to meet these requirements by choosing OTS, which 
has the authority to oversee thrift holding companies, as their home 
country consolidated supervisor. For others, SEC has adopted rules for 
voluntary oversight of certain holding companies with large broker-
dealers that are to be called Consolidated Supervised Entities. SEC is 
pursuing some changes to the Basel II standards that would make those 
requirements more relevant to securities activities undertaken by U.S. 
firms.

U.S. regulators have adapted other regulatory and supervisory 
approaches in response to industry changes. Beginning in the mid-1990s, 
OCC and the Federal Reserve adopted new supervisory protocols for 
large, complex institutions. Under this approach, examiners are 
assigned full time to a bank (and are often on-site) so that they can 
continually monitor and assess a banking organization's financial 
condition and risk management systems through the review of a variety 
of management reports and frequent meetings with key bank officials. 
Examiners focus examinations on a bank's internal control and risk-
management systems; this risk-based approach is now used for banks of 
all sizes. Securities regulators had repeatedly revised their 
supervision protocols and had taken other actions to better understand 
derivatives activities of securities firms. The Commodity Futures 
Modernization Act of 2000--which had the primary goals of addressing 
changes in market conditions, such as the introduction of a wider 
variety of products--revamped many of the processes and goals of CFTC. 
And, NAIC adopted risk-based capital requirements and began analyzing 
significant insurance companies that do business in several states to 
identify issues that could affect groups across state lines.

Regulators Communicate and Coordinate in Multiple Ways, but Concerns 
Remain:

Most of the communication among U.S. regulators takes place within a 
"functional" area. Within each of the four areas--banking, securities, 
insurance, and futures--federal regulators have established 
interagency groups to facilitate coordination and also communicate 
informally on a variety of issues. Generally, within sectors, these 
regulators communicate with each other, SROs, relevant state 
regulators, and their international counterparts. In insurance, NAIC is 
the primary vehicle for state regulators to communicate with each other 
and to coordinate with insurance regulators abroad. While regulators 
report frequent and regular meetings within their area, coordinated 
responses are not always reached on some major issues.

Bank regulators coordinate examination and supervisory policy, 
including many rule-making initiatives, through the Federal Financial 
Institutions Examination Council and communicate internationally 
through the Basel Committee. They also hold formal meetings at the 
national and regional levels and communicate informally on a regular 
basis.

Despite these practices, problems persist. In the 2001 failure of 
Superior Bank, FSB, problems between OTS, the primary supervisor, and 
FDIC hindered a coordinated supervisory approach, especially OTS's 
refusal to let FDIC participate in examinations. The failure resulted 
in a substantial loss to the deposit insurance fund. Similarly, 
problems between OCC and FDIC were identified in the failure of the 
First National Bank of Keystone (West Virginia), which failed in 1999. 
(Regulators note that subsequent changes in policies should avoid 
similar problems in the future.) On the international front, several 
U.S. regulators joined the Basel II negotiations or presented their 
views late in the process. Regulators said that this ensured that 
concerns from all industry sectors were addressed in the negotiations, 
that a transparent process was used, and that the United States 
regulators obtained all of the provisions they wanted in the 
international agreement, reached in June 2004. Critics complain that 
having multiple regulators, particularly at the latest stages of 
negotiations, needlessly complicated the process and could have 
affected the outcome.

While SEC and state securities regulators told us that they coordinate 
activities, including enforcement actions, some high-profile cases have 
resulted in disagreements. SEC and state securities regulators have 
brought several enforcement actions together; however, SEC and the 
states have sometimes disagreed on what is an appropriate role for 
each, and on how effective each has been. Similarly, in the insurance 
area, where NAIC is a highly structured forum for communication, some 
critics have noted that NAIC does not have the power to force state 
regulators to adopt similar positions, while other critics have noted 
that, as a quasigovernmental body, NAIC has too much power over state 
insurance regulation.

Regulators themselves have identified the need to communicate across 
sectors. For example, nine securities SROs created the Intermarket 
Surveillance Group in 1983, and since then, futures SROs and foreign 
exchanges have joined as affiliated members. The purpose of this group 
is to coordinate and develop programs and procedures designed to assist 
in identifying possible fraudulent and manipulative acts and practices 
across markets and to share information. SEC and CFTC also jointly 
developed regulations implementing portions of the Commodity Futures 
Modernization Act, which lifted the ban on securities futures, but the 
process was difficult. Prior to the passage of the act, staff of both 
regulators had at times claimed sole jurisdiction over single stock 
futures, necessitating development of a memorandum of understanding 
that clarified joint oversight responsibilities for these instruments.

Congress and the President have often seen the need to direct 
regulators to communicate across "functional" areas, sometimes in 
response to crises. On a number of occasions, Congress has directed 
regulators to communicate across "functional" areas. For example, in 
GLBA, Congress directed regulators to communicate to better oversee the 
risks of diversified holding companies; and following recent corporate 
and accounting scandals, Congress directed them to collectively draft 
guidance on complex structured finance transactions. Similarly, the 
President has issued executive orders directing regulators to form the 
President's Working Group and the Financial and Banking Information 
Infrastructure Committee. The former was created to address issues 
related to the 1987 stock market crash and was formally reactivated in 
1994 to consider other issues, including the 1997 market decline and 
threats to critical infrastructure. The latter was created after the 
events of September 11, 2001, to coordinate federal and state financial 
regulatory efforts to improve the reliability and security of the U.S. 
financial system.

In evaluating these and other efforts of financial regulators to 
communicate and coordinate, GAO has found that these ways do not allow 
for a satisfactory assessment of risks that cross traditional 
regulatory and industry boundaries and therefore may inhibit the 
ability to detect and contain certain financial crises. In addition, 
the existing ways regulators communicate and coordinate do not provide 
for the systematic sharing of information on enforcement actions across 
sectors, making it more difficult for regulators to identify potential 
fraud and abuse, and for consumers to identify the relevant regulator.

The U.S. Regulatory System Has Strengths, but Its Structure May Hinder 
Effective Regulation:

Financial markets exist to serve the needs of businesses, households, 
and government, and financial regulation is judged, in part, by how 
well markets meet the needs of these users. U.S. regulators and 
financial market participants GAO spoke with generally emphasized that 
the current regulatory structure has contributed to the development of 
U.S. capital markets and overall growth and stability in the U.S. 
economy. Industry participants also noted that regulators are generally 
of a high quality. With the adoption of holding company supervision for 
a broader segment of firms, some regulators may be better able to 
understand and prepare for the risks that cut across functional areas 
within a given holding company. In addition, in conjunction with agency 
specific strategic planning activities, regulators may better monitor 
risks that cut across the industry segments they oversee. However, no 
agency or mechanism has the responsibility for monitoring risks that 
cut more broadly across functional areas. Further, no agency has the 
responsibility for analyzing the risks to the financial system as a 
whole or planning strategically to address those risks and problems 
that may develop in the future; there also is no mechanism for agencies 
to cooperate effectively to perform these tasks. Agency structure alone 
does not determine whether regulators do their jobs efficiently and 
effectively, but it can facilitate or hinder achieving those goals. 
Experts outside the regulatory system and some foreign regulators have 
suggested that the U.S. regulatory system does not facilitate and may 
hinder the efficient and effective oversight of large, complex, 
internationally active firms. In particular, critics have noted that 
"functional" regulation--focusing the oversight of different 
regulators on specific activities within a financial services firm--is 
inconsistent with these firms' centralized risk management. U.S. firms 
and regulators are also likely to be affected by efforts to harmonize 
regulation internationally. Large, internationally active firms say 
these efforts are critical to providing financial services in a cost-
effective manner; however, the fragmented nature of the U.S. regulatory 
system may hinder these negotiations. In addition, the increasing need 
for a global perspective in the insurance industry where U.S. insurers 
are increasingly foreign-owned is difficult within the state insurance 
regulatory system.

While large U.S. firms compete across sectors, important differences 
remain among banking, insurance, securities, and futures businesses. In 
addition, many smaller firms operate only in a single sector or single 
local market. As a result, the regulatory system benefits from the 
specialized knowledge regulators acquire within their specialized 
agencies. Regulatory agencies, however, may become "captives" of the 
industries they are supposed to regulate and not be able to benefit 
from economies of scale and scope related to the need for skills that 
cut across regulatory agencies. In addition, the existence of 
specialized agencies affords firms the opportunity to conduct 
transactions in those parts of its organization with the least 
intrusive regulation.

Congress May Want to Consider Changes to the U.S. Regulatory Structure:

The financial services industry is critical to the health and vitality 
of the U.S. economy. While the industry itself bears primary 
responsibility to effectively manage its risks, the importance of the 
industry and the nature of those risks have created a need for 
government regulation as well. While the specifics of a regulatory 
structure, including the number of regulatory agencies and the roles 
assigned to each, may not be the critical determinant in whether a 
regulatory system is successful, the structure can facilitate or hinder 
the attainment of regulatory goals. The skills of the people working in 
the regulatory system, the clarity of its objectives, its independence, 
and its management systems are critical to the success of financial 
regulation.

Because our regulatory structure relies on having clear-cut boundaries 
between the "functional" areas, industry changes that have caused those 
boundaries to blur have placed strains on the regulatory framework. 
While diversification across activities and locations may have lowered 
the risks being faced by some large, complex, internationally active 
firms, understanding and overseeing them have also become a much more 
complex undertaking, requiring staff that can evaluate the risk 
portfolio of these institutions and their management systems and 
performance. Regulators must be able to ensure effective risk 
management without needlessly restraining risk taking, which would 
hinder economic growth. Similarly, because firms are taking on similar 
risks across "functional" areas, to understand the risks of a given 
institution or those that span institutions or industries, regulators 
need a more complete picture of the risk portfolio of the financial 
services industry both in the United States and abroad.

Recognizing that regulators could potentially overcome the impediments 
of a fragmented regulatory structure through better communication and 
coordination across agencies, Congress has created mechanisms for 
coordination and on a number of specific issues has directed agencies 
to coordinate their activities. In addition, GAO has repeatedly 
recommended that federal regulators improve communication and 
coordination. While GAO continues to support these recommendations, it 
recognizes that the sheer number of regulatory bodies, their underlying 
competitive nature, and differences in their regulatory philosophies 
will continue to make the sharing of information difficult and true 
coordination and cooperation in the most important or most visible 
areas problematic as well. Therefore, Congress might want to consider 
some changes to the U.S. financial services regulatory structure that 
address weaknesses and potential vulnerabilities in our current system, 
while maintaining its strengths.

Matter for Congressional Consideration:

While maintaining sector expertise and ensuring that financial 
institutions comply with the law, Congress may want to consider some 
consolidation or modification of the existing regulatory structure to 
(1) better address the risks posed by large, complex, internationally 
active firms and their consolidated risk management approaches; (2) 
promote competition domestically and internationally; and (3) contain 
systemic risk. If so, our work has identified several options that 
Congress may wish to consider:

* consolidating the regulatory structure within the "functional" areas;

* moving to a regulatory structure based on a regulation by objective 
or twin peaks model;

* combining all financial regulators into a single entity; or:

* creating or authorizing a single entity to oversee all large, 
complex, internationally active firms, while leaving the rest of the 
structure in place.

If Congress does wish to consider these or other options, it may want 
to ensure that legislative goals are clearly set out for any changed 
regulatory structure and that the agencies affected by any change are 
given clear direction on the priorities that should be set for 
achieving these goals. In addition, any change in the regulatory 
structure would entail changing laws that currently govern financial 
services oversight to conform to the new structure.

The first option would be to consolidate the regulatory structure 
within "functional" areas--banking, securities, insurance, and 
futures--so that at the federal level there would be a primary point of 
contact for each. The two major changes to accomplish this at the 
federal level would be consolidation of the bank regulators and, if 
Congress wishes to provide a federal charter option for insurance, the 
creation of an insurance regulatory entity. The bank regulatory 
consolidation could be achieved within an existing banking agency or 
with the creation of a new agency. In 1996, we recommended that the 
number of federal agencies with primary responsibilities for bank 
oversight be reduced. However, we noted that in the new structure, FDIC 
should have the necessary authority to protect the deposit insurance 
fund and that the Federal Reserve and Treasury should continue to be 
involved in bank oversight, with access to supervisory information, so 
that they could carry out their responsibilities for promoting 
financial stability. We have not studied the issue of an optional 
federal charter for insurers, but have through the years noted 
difficulties with efforts to harmonize insurance regulation across 
states through the NAIC-based structure. Having a primary federal 
entity for each of the functional sectors would likely improve 
communications and coordination across sectors because it would reduce 
the number of entities that would need to be consulted on any issue. 
Similarly, it would provide a central point of communication for issues 
within a sector. Fewer bank regulators might reduce the cost of 
regulation and the opportunities for regulatory arbitrage, choosing 
charters so that transactions have the least amount of oversight. In 
addition, issues related to the independence of a regulator from the 
firms they oversee with a given kind of charter would be alleviated. 
However, consolidating the banking regulators and establishing a 
federal insurance regulator would raise concerns as well. While 
improved communication and cooperation within sectors would help to 
achieve the objectives outlined above, it would not directly address 
many of them. In addition, some constituencies, such as thrifts, might 
feel they were not getting proper attention for their concerns; and 
opportunities for regulatory experimentation and the other positive 
aspects of competition in banking could be reduced. Further, while this 
option represents a more evolutionary change than some of the others, 
it might still entail some costs associated with change, including 
unintended consequences that would undoubtedly erupt as various banking 
agencies and their staff jockeyed for position within the new banking 
regulator. Similarly, the establishment of a federal insurance 
regulator might have unintended consequences for state regulatory 
bodies and for insurance firms as well.

Another option would be consolidating the regulatory structure using a 
regulation by objective, or twin peaks model. The twin peaks model 
would involve setting up one safety and soundness regulatory entity and 
one conduct-of-business regulatory entity. The former would oversee 
safety and soundness issues for insurers, banks, securities, and 
futures activities, while the latter would ensure compliance with the 
full range of conduct-of-business issues, including consumer and 
investor protection, disclosure, money laundering, and some governance 
issues. This could be accomplished by changing the tasks assigned to 
existing agencies or by restructuring the agencies or creating new 
ones. On the positive side, this option would directly address many of 
the regulatory objectives related to larger, more complex institutions, 
such as allowing for consolidated supervision, competitive neutrality, 
understanding of the linkages within the safety and soundness and 
conduct-of-business spheres, and regulatory independence. In addition, 
conduct-of-business issues would not become subservient to safety and 
soundness issues, as some fear. On the negative side, in addition to 
the issues raised by any change in the structure, this structure would 
not allow regulators to oversee the linkages between safety and 
soundness and conduct-of-business. As reputational risk has become more 
important, the linkages between these activities have become more 
evident. In addition, if the controls and processes for conduct-of-
business issues and safety and soundness issues are coming from the top 
of the organization, they are probably closely related. Finally, 
combining regulators into multifunctional units might not allow the 
regulatory system to maintain some of the advantages it now has, 
including specialized expertise and the benefits of regulatory 
competition and experimentation.

The most radical option would combine all financial regulators into a 
single entity, similar to UK-FSA. The benefits of the single regulator 
are that one body is accountable for all regulatory endeavors. It can 
more easily evaluate the linkages within and across firms, including 
those between conduct-of-business and safety and soundness 
considerations, plan strategically across sectors, and facilitate the 
allocation of resources to their highest priority use. However, 
achieving these goals would depend on having the right people and 
skills, clear regulatory objectives, effective tools, and appropriate 
policies and procedures. While the UK-FSA model is intriguing, this 
option raises some concerns for the United States. First, because of 
the size of the U.S. economy and the number of financial institutions, 
this entity would have to be very large and, thus, could be unwieldy 
and costly. UK-FSA has about 2,300 employees, while estimates of the 
number of regulators currently in the United States range from about 
30,000 to 40,000. In addition, officials at UK-FSA have commented about 
the difficulty of setting priorities when a large number of issues have 
to be dealt with. Prioritizing these issues for the United States would 
be particularly difficult. Further, an entity with this scope and size 
might have difficulty responding to smaller players and might therefore 
damage the diversity that has enriched the U.S. financial industry. 
Also, staff at such an entity might lose or not develop the specialized 
skills needed to understand both large and small companies and risks 
that are specific to the different "functional" sectors. And, without 
careful oversight, such a large and all-powerful entity might not be 
accountable to consumers or the industry.

A more evolutionary change would be to have a single entity with 
responsibility for the oversight of all large, complex, or 
internationally active financial services firms that manage risk 
centrally, compete with each other within and across sectors, and, by 
their size and presence in a wide range of markets, pose systemic 
risks. Having a single regulatory entity for large, complex, or 
internationally active firms could be accomplished by giving this 
responsibility to an existing regulator or by creating a new entity. A 
new entity might consist of a small staff that would rely on the 
expertise of staff at existing regulatory agencies to accomplish 
supervisory tasks.

Having a single regulatory entity for large, complex, or 
internationally active firms would have the advantage of addressing 
industry changes, while leaving much of the U.S. regulatory structure 
unchanged. A single regulatory entity for large, complex holding 
companies would have responsibilities that more closely align with the 
businesses' approach to risk than the current regulatory structure. In 
addition, this entity could promote competition between these firms by 
ensuring, to the greatest extent possible, that oversight is 
competitively neutral. A single regulatory entity for internationally 
active firms would also be better positioned to help coordinate the 
views of the United States in international forums, so that the U.S. 
firms are not competitively disadvantaged during negotiations. Finally, 
this entity would be better able to appraise the linkages across large, 
complex, internationally active firms and, thus, with the aid of the 
Federal Reserve and Treasury, could contribute to promoting financial 
stability. These potential improvements could be obtained without 
losing the advantages afforded by our current specialized regulators, 
who would continue to supervise the activities of regulated firms such 
as broker-dealers or banks. However, this option also has drawbacks. 
While the transition costs might be less than in some of the other 
options, the creation of a new entity or changing the role of an 
existing regulatory entity would still entail costs and likely some 
unintended consequences. It might also be difficult to maintain the 
appropriate balance between the interests of the large or 
internationally active firms and smaller, more-specialized entities. It 
also could involve creating one more regulatory agency in a system that 
already has many agencies.

Agency Comments and Our Evaluation:

We received written comments on a draft of this report from the 
Chairman of the Board of Governors of the Federal Reserve System, the 
Chairman of FDIC, the Comptroller of the Currency, and the Director of 
SEC's Division of Market Regulation. Their comments generally noted 
that the U.S. financial regulatory system had balanced effective 
regulation and market forces to promote a strong and innovative 
financial system. Where appropriate, we have changed the report to 
clarify this balance. In addition, the Chairman of the Federal Reserve 
Board of Governors and the Chairman of FDIC stressed the importance of 
the insured depository in the regulatory scheme. We provided a draft of 
the report to Treasury, CFTC, and NAIC, for possible comments, but no 
written comments were provided. All of the agencies provided technical 
comments that were incorporated, where appropriate.

The Director of the Office of Thrift Supervision provided comments on a 
draft of this report, saying that the report inadequately reflected 
OTS's authority to supervise thrift holding companies and OTS's 
international initiatives. While we have made some changes to the 
report to clarify these topics, we believe that the report does 
accurately discuss both topics. We also disagreed with the Director's 
request that we delete references to the failure of Superior Bank, FSB, 
which he thought did not reflect the causes of the failure or the 
significant costs to the insurance funds from other failures. We did 
change the report to make clear that this failure, and another 
commercial bank failure in 1999, were caused by actions of the banks 
themselves. However, these failures did highlight problems in 
coordinating actions by the primary federal bank regulators and FDIC, 
which also has authority to examine the banks it insures.

[End of section]

Chapter 1: Introduction:

The U.S. financial services industry has four sectors--banking, 
securities, insurance, and futures,[Footnote 3] which together had 5.8 
million employees and were responsible for almost one-tenth of the U.S. 
gross domestic product in 2001. Traditionally, the financial services 
industry promoted economic growth by intermediating between households, 
businesses, and governments seeking to increase their assets through 
savings and those interested in increasing their current spending 
through borrowing. Intermediation differed in specific ways across the 
major sectors. All financial services firms are exposed to a variety of 
risks, including credit and market risk, and the industry as a whole is 
exposed to systemic risk, which is generally defined as the risk that a 
disruption (at a firm, in a market segment, to a settlement system, 
etc.) could cause widespread difficulties at other firms, in other 
market segments, or in the financial system as a whole.

The U.S. regulatory structure is composed of several agencies that tend 
to specialize in given financial sectors and activities and has a 
tradition of both state and federal regulation of some sectors and 
activities. Generally, banking is regulated by several federal 
regulators and by state bank regulators; securities by the Securities 
and Exchange Commission (SEC), self-regulatory organizations (SROs), 
and state regulators; futures by the Commodity Futures Trading 
Commission (CFTC) and SROs; and insurance by state insurance 
departments. Federal agencies are charged with overseeing particular 
types of institutions and activities, and state agencies exercise a 
similar function for entities that are not regulated exclusively by the 
federal government. The federal agencies also operate within an 
international framework that includes a variety of entities.

Traditionally, Financial Institutions Served as Intermediaries and 
Transferred Some Risks:

Because those doing the saving in an economy and those doing the 
spending have not always had direct access to each other, financial 
services firms have traditionally served as intermediaries between 
them. Figure 1 illustrates how financial services firms perform this 
role. Different institutions--depositories, securities firms, 
insurance companies, and futures firms--facilitated intermediation 
differently, using different markets and products. In addition, some 
firms helped households and businesses manage risk.

Figure 1: Traditional Role of Financial Intermediaries:

[See PDF for image]

[End of figure]

By most measures, depositories--commercial banks, thrifts,[Footnote 4] 
credit unions,[Footnote 5] and industrial loan companies 
(ILCs)[Footnote 6]--make up the largest group of financial 
intermediaries. Traditionally, depositories used the funds they 
received as deposits to make loans directly to businesses and 
consumers, and various types of depositories were set up to serve 
different constituents. Today, their activities are considerably more 
diverse. For instance, banks and their affiliates are heavily involved 
in the OTC derivatives market, in which transactions involving 
financial derivatives are negotiated off exchanges. Depositories 
include commercial banks, with about 73 percent of domestic deposits at 
the end of 2003; thrifts, with about 14 percent of domestic deposits; 
credit unions, with about 9 percent of domestic deposits; and ILCS, 
with about 1 percent of domestic deposits. Although structural 
differences remain, most powers and services of depositories have 
converged over time, with few practical differences remaining in the 
activities they undertake. Thus, in this report we will generally refer 
to all depositories as banks.

Securities firms are second to banks in the amount of assets held and 
revenue generated. Securities firms facilitate the transfer of funds 
from savers to businesses or government through capital markets by 
underwriting corporate equity securities (stocks) and corporate and 
government debt securities (bonds). In addition, securities firms 
facilitate the buying and selling of existing securities so that funds 
move from all kinds of savers to all kinds of spenders. Several types 
of securities firms participate in this process. Brokers are 
intermediaries for those who buy and sell securities, and dealers are 
those who buy and sell securities for their own accounts. Investment 
banks underwrite new debt securities and equity securities and perform 
broker-dealer functions. Investment banks buy the new issues and, 
acting as wholesalers, sell them to institutional investors such as 
banks, mutual funds, and pension funds. Investment companies, such as 
mutual funds and hedge funds, gather funds from savers and collectively 
pass them to spenders by purchasing assets in capital markets. 
Investment advisers and transfer agents also play a role in this market 
but do not act directly as intermediaries. By offering savings products 
with varying risks and returns, securities firms also help savers 
manage risk.

Insurance companies, the third largest sector of the financial services 
industry, serve as intermediaries by taking the insurance premium 
payments of households and businesses in payment for insurance coverage 
and investing in corporate securities. The return on these investments 
is expected to fund insurance companies' future liabilities. Insurance 
premium payments come from the sale of products that usually fall into 
three categories: property-casualty, life and health, and reinsurance. 
Property-casualty insurance products cover business and household 
assets such as cars, houses, business structures, inventories, and 
goods in transit, as well as areas of liability such as product 
performance and professional misconduct. Life insurance products 
provide a tax-free sum to the beneficiary of the policyholder in the 
event of the policyholder's death or other insured event. Health 
insurance, which covers expenses associated with medical care and often 
any financial losses individuals incur from injuries or illness, is not 
directly relevant to this study. Insurance companies purchase 
reinsurance, among other things, to spread risk and protect against 
catastrophic events. Along with their role as financial intermediaries, 
insurance companies have helped households and businesses manage risk 
by allowing them to insure themselves against certain contingencies. 
Agents who are employed by the insurance companies or work 
independently generally distribute insurance products.

While firms that deal in exchange-traded futures (futures firms) 
facilitate the transfer of funds, the primary role of futures markets 
involves transferring risk and providing a mechanism for price 
discovery. Market participants include hedgers, who are managing risks, 
and speculators, who are taking a position on the direction of market 
movement in hopes of making a profit. Futures contracts protect sellers 
and purchasers of assets, such as physical commodities like pork 
bellies or financial commodities like currencies, from changes in value 
over time and provide opportunities for speculators to take varying 
positions on the future value of these commodities in hopes of making a 
profit. Several types of futures firms participate in this process. 
Futures firms that execute orders and hold retail customer accounts are 
futures commission merchants (FCMs). In addition, floor brokers make 
trades for others and, along with floor traders, also make trades for 
themselves. Commodity pool operators serve a function similar to that 
of investment companies in securities markets in that they pool funds 
for the purpose of trading futures contracts. Commodity trading 
advisers and others also participate in futures markets.[Footnote 7] 
The markets where exchange-traded futures contracts are traded are 
generally called boards of trade.

The Financial Services Industry Faces Risks at the Institutional Level 
and Systemwide:

To varying degrees, financial institutions are exposed to the following 
types of risks:[Footnote 8]

Credit risk--the potential for financial losses resulting from the 
failure of a borrower or counterparty to perform on an obligation.

Market risk--the potential for financial losses due to the increase or 
decrease in the value or price of an asset or liability resulting from 
broad movements in prices, such as interest rates, commodity prices, 
stock prices, or the relative value of currencies (foreign exchange).

Liquidity risk--the potential for financial losses due to the inability 
of a firm to meet its obligations because of an inability to liquidate 
assets or obtain adequate funding, such as might occur if most 
depositors or other creditors were to withdraw their funds from a firm.

Operational risk--the potential for unexpected financial losses due to 
inadequate information systems, operational problems, and breaches in 
internal controls, or fraud. These can include risks associated with 
clearing and settling transactions, either as a principal or as an 
agent, as well as risks associated with custodial functions (e.g., 
holding securities on behalf of others).

Reputational risk--the potential for financial losses that could result 
from negative publicity regarding an institution's business practices 
and subsequent decline in customers, costly litigation, or revenue 
reductions.

Legal risk--the potential for financial losses due to breaches of law 
or regulation that may result in heavy penalties or other costs.

Business/event risk--the potential for financial losses due to events 
not covered above, such as credit rating downgrades (which affect a 
firm's access to funding), or factors beyond the control of the firm, 
such as major shocks in the firm's markets.

Insurance/actuarial risk--the risk of financial losses that an 
insurance underwriter takes on in exchange for premiums, such as the 
risk of premature death.

In addition to these risks, the financial system as a whole may be 
vulnerable to systemic risk, which is generally defined as the risk 
that a disruption (at a firm, in a market segment, to a settlement 
system, etc.) could cause widespread difficulties at other firms, in 
other market segments, or in the financial system as a whole. The 
difficulties may be real in that institutions, markets, or settlement 
systems are linked by transactions or may result in customers panicking 
as a result of believing that failure at a given institution will 
affect similar institutions and taking actions such as removing 
deposits that precipitate systemic crises.

U.S. Financial Services Regulation Has Multiple Goals:

Generally, the United States relies on markets to promote the efficient 
allocation of capital throughout the economy so as to best fund the 
activities of households, business, and government. Financial services 
are subject to oversight for several reasons that relate to the 
inability of the market to ensure that the efficient allocation of 
capital will take place. Essentially, markets cannot ensure that 
certain kinds of misconduct, including fraud and abuse or market 
manipulation, will not occur and that consumers/investors will have 
adequate information to discipline institutions with regard to the 
amount of risk they take on. In addition, because of systemic linkages, 
the system as a whole may be prone to instability. While financial 
services firms are aware of systemic risk, they will not likely take 
steps to minimize it.

In the United States, laws define the roles and missions of the various 
regulators, and to some extent these are similar across the regulatory 
bodies. However, laws and regulatory agency policies can set a greater 
priority on some roles and missions than others. In addition, the goals 
and objectives of the regulatory agencies have developed somewhat 
differently over time, such that bank regulators generally focus on the 
safety and soundness of banks, securities and futures regulators focus 
on market integrity and investor protection, and insurance regulators 
focus on the ability of insurance firms to meet their commitments to 
the insured.

In general, regulators help protect consumers/investors who may not 
have the information or expertise necessary to protect themselves from 
fraud and other deceptive practices, such as predatory lending or 
insider trading, and that the marketplace may not necessarily provide. 
Through monitoring activities, examinations, and inspections, 
regulators oversee the conduct of institutions in an effort to ensure 
that they do not engage in fraudulent activity and do provide 
consumers/investors with the information they need to make appropriate 
decisions and ultimately discipline the behavior of financial 
institutions in the marketplace. However, in some areas providing 
information through disclosure and assuring compliance with laws are 
still not adequate to allow consumers/investors to influence firm 
behavior. In these cases, regulators oversee how risk is managed and 
seek to restrain excessive risk taking in order to promote the safety 
and soundness of institutions that engage in certain kinds of 
activities. In addition, by providing deposit insurance, overseeing 
other insurance or guarantee funds, or directly intervening in the 
marketplace, regulators take actions to ensure that the types of 
widespread financial instability that could seriously disrupt economic 
activity do not occur. However, with insurance or guarantee funds or 
the expectation that some firms are too big to fail, the normal 
disciplining of the market is disrupted, creating the "moral hazard" 
that institutions will take on more risk than they would in the absence 
of such insurance or expectations. As a result, the need for safety and 
soundness oversight is intensified.

U.S. Financial Regulatory System Includes a Variety of Regulatory 
Bodies:

The objectives of U.S. financial services regulation are pursued by a 
complex combination of federal and state government agencies and self-
regulatory organizations (SROs). Generally, regulators specialize in 
the oversight of financial entities in the various financial services 
sectors. This specialization stems largely from the laws that 
established these agencies and defined their missions. In addition, 
some regulators have responsibilities to regulate holding companies 
with subsidiaries that engage in various financial services activities. 
The Federal Reserve[Footnote 9] and the Department of the Treasury 
(Treasury) play a special role in maintaining financial stability.

Regulators Specialize in the Oversight of Financial Entities in Various 
Sectors:

Five federal agencies oversee banks, including those chartered and 
overseen by state regulatory agencies. The specific regulatory 
configuration depends on the type of charter the banking institution 
chooses. Banks may be regulated by the federal government alone, if 
they are chartered by a federal regulator such as the Office of the 
Comptroller of the Currency (OCC) or Office of Thrift Supervision 
(OTS), or by both federal and state governments, if they are state-
chartered institutions. Securities and futures firms are regulated at 
the federal level by the Securities and Exchange Commission (SEC) and 
Commodity Futures Trading Commission (CFTC), respectively, which, in 
turn, rely on SROs to assist with their oversight. State regulators 
also have oversight and enforcement responsibilities for securities. 
Insurance entities are overseen largely at the state level. There are 
also regulators for government sponsored enterprises and pension funds, 
which lie outside the scope of this report.

Multiple Regulators Oversee Banking Entities:

Banking institutions can generally determine their regulators by 
choosing a particular kind of charter--commercial bank, thrift, credit 
union, or industrial loan company. These charters may be obtained at 
the state level or the national level for all except industrial loan 
companies, which are chartered only at the state level. State 
regulators charter institutions and participate in the oversight of 
those institutions; however, all of these institutions have a primary 
federal regulator if they have federal deposit insurance. State-
chartered commercial banks that are members of the Federal Reserve are 
subject to supervision by that institution. Other state-chartered 
banks, such as nonmember state banks, state savings banks, and ILCs, 
with federally insured deposits are subject to Federal Deposit 
Insurance Corporation (FDIC) oversight, while OTS supervises state-
chartered savings associations that are members of the Savings 
Association Insurance Fund. Federally chartered institutions are 
subject to oversight by their chartering agencies. OCC supervises 
national banks, OTS supervises federally chartered thrifts, and the 
National Credit Union Administration (NCUA) supervises federally 
chartered credit unions. To the extent that OTC derivatives activities 
take place in these institutions, they are subject to oversight by the 
appropriate regulator. In addition, FDIC has backup supervisory 
authority for those banks that are members of the insurance funds it 
oversees and have a different primary supervisor.

The primary objectives of federal bank regulators include ensuring the 
safe and sound practices and operations of the institutions they 
oversee and the stability of financial markets. To achieve these goals, 
regulators establish capital requirements, conduct on-site 
examinations and off-site monitoring to assess a bank's financial 
condition, and monitor compliance with banking laws. Regulators also 
issue regulations, take enforcement actions, and close banks they 
determine to be insolvent. In addition, federal regulators oversee and 
take enforcement actions to ensure compliance with many consumer 
protection laws such as those requiring fair access to banking services 
and privacy protection.

The current bank regulatory structure evolved over time. OCC was 
created by the National Currency Act of 1863, which was rewritten as 
the National Bank Act of 1864. The Federal Reserve Act of 1913 created 
the Federal Reserve, partly in response to the financial panic of 1907. 
FDIC was established under the Banking Act of 1933. In 1933, Congress 
also authorized the federal chartering of savings and loans by the 
Federal Home Loan Bank Board, and, in 1934, the National Housing Act 
established the Federal Savings and Loan Insurance Corporation to 
provide for federal regulation of federally insured, state-chartered 
thrifts. In 1989, OTS replaced the Federal Home Loan Bank Board as the 
federal thrift institution regulator.[Footnote 10] Organizationally, 
OCC and OTS are within the Department of the Treasury; however, the 
Comptroller of the Currency and the Director of OTS are appointed by 
the President and confirmed by the Senate for fixed terms, an 
arrangement intended to help ensure the independence of these agencies. 
The Federal Reserve's Board of Governors and FDIC are independent 
federal agencies; the Comptroller of the Currency and Director of OTS 
sit on FDIC's five-person board of directors. The three other board 
members are appointed by the President for fixed terms with one 
appointed as Chairman and another as Vice Chairman. As with the 
Comptroller of the Currency and the Director of OTS, the Federal 
Reserve's Board of Governors are appointed by the President and 
confirmed by the Senate for fixed terms.

SROs Contribute to Security and Futures Regulation:

The Securities Exchange Act of 1934 established the regulatory 
structure of U.S. securities markets. These markets are regulated under 
a combination of self-regulation (subject to SEC oversight) and direct 
SEC regulation. This regulatory structure was intended to give SROs 
responsibility for administering their own operations, including most 
of the daily oversight of the securities markets and their 
participants. One of the SROs--NASD--is a national securities 
association that regulates registered securities broker-
dealers.[Footnote 11] Other SROs include national securities exchanges 
that operate the markets where securities are traded.[Footnote 12] 
These SROs are primarily responsible for establishing the standards 
under which their members conduct business; monitoring business 
conduct; and bringing disciplinary actions against their members for 
violating applicable federal statutes, SEC's rules, and their own 
rules. SEC oversees the SROs by inspecting their operations and 
reviewing their rule proposals and appeals of final disciplinary 
proceedings.

The Securities Exchange Act also created SEC as an independent agency 
to oversee the securities markets and their participants. SEC has a 
five-member commission headed by a chairman who is appointed by the 
President for a 5-year term. In overseeing the SROs' implementation and 
enforcement of rules, SEC may use its statutory authority to, among 
other things, review and approve SRO-proposed rule changes and abrogate 
(or annul) SRO rules.

The futures market's regulatory structure consists of federal oversight 
provided by CFTC and industry oversight provided by SROs--the futures 
exchanges and the National Futures Association (NFA). Futures SROs are 
responsible for establishing and enforcing rules governing member 
conduct and trading; providing for the prevention of market 
manipulation, including monitoring trading activity; ensuring that 
futures industry professionals meet qualifications; and examining 
members for financial strength and other regulatory purposes. Their 
operations are funded by the futures industry through transaction fees 
and other charges. In regulating the futures market, CFTC independently 
monitors, among other things, exchange trading activity, large trader 
positions, and certain market participants' financial condition. CFTC 
also investigates potential violations of the Commodity Exchange Act 
and CFTC regulations and prosecutes alleged violators. Additionally, 
CFTC oversees the SROs to ensure that each has an effective self-
regulatory program. In this regard, CFTC designates and supervises 
exchanges as contract markets and NFA as a registered futures 
association, audits SROs for compliance with their regulatory 
responsibilities, and reviews SRO rules and products that are traded on 
designated exchanges.

States Have Primary Responsibility for Regulating Insurance Entities:

Unlike other financial service sectors, the U.S. insurance industry is 
regulated primarily at the state level.[Footnote 13]To help coordinate 
their activities, state insurance regulators established a central 
structure, the National Association of Insurance Commissioners (NAIC), 
in 1871. Members of this organization are the heads of the insurance 
departments of 50 states, the District of Columbia, and 4 U.S. 
territories and possessions. NAIC's basic purpose is to encourage 
consistency and cooperation among the various states and territories as 
they individually regulate the insurance industry. To that end, NAIC 
promulgates model insurance laws and regulations for state 
consideration and provides a framework for multistate examinations of 
insurance companies. State insurance regulators have tended to stress 
safety and soundness issues, but have also taken action in the conduct-
of-business area, especially with regard to sales practices. The 
McCarren-Ferguson Act of 1945 generally asserted the view that 
insurance regulation should be undertaken by the states.

Some U.S. Regulators Engage in Holding Company Oversight:

Many of the largest financial legal entities are part of holding 
company structures--companies that hold stock in one or more 
subsidiaries. Many companies that own or control banks are regulated by 
the Federal Reserve as bank holding companies, and their nonbanking 
activities generally are limited to those that the Federal Reserve has 
determined to be closely related to banking. Under the Gramm-Leach-
Bliley Act (GLBA), bank holding companies can qualify as financial 
holding companies and thereby engage in a range of financial activities 
broader than those permitted for "traditional" bank holding companies. 
Savings and loan or thrift holding companies (thrift holding 
companies), which own or control one or more savings and loan 
companies, are subject to supervision by OTS and, depending upon the 
circumstances of the holding company structure, may not face the types 
of activities restrictions imposed on bank holding companies. 
Investment bank holding companies that have a substantial presence in 
the securities markets can elect to be supervised by SEC as a 
supervised investment bank holding company (SIBHC) if the holding 
company does not own or control certain types of banks. Holding 
companies that own large broker-dealers can elect to be supervised by 
SEC as consolidated supervised entities (CSE). SEC would provide 
groupwide oversight of these entities unless they are determined to 
already be subject to "comprehensive, consolidated supervision" by 
another principal regulator. While holding company supervisors oversee, 
to varying degrees, the holding company, the appropriate functional 
regulator, as described above, remains primarily responsible for 
supervising any functionally regulated subsidiary within the holding 
company.

Bank and Financial Holding Companies:

The Bank Holding Company Act of 1956, as amended, generally requires 
that holding companies with bank subsidiaries register with the Federal 
Reserve as bank holding companies.[Footnote 14] Among other things, the 
Bank Holding Company Act restricts the activities of bank holding 
companies to those the Federal Reserve determined, as of November 11, 
1999, to be closely related to banking. However, under amendments to 
the Bank Holding Company Act made in 1999 by GLBA, a bank holding 
company can qualify as a financial holding company that, under GLBA, 
may engage in a broad range of additional financial activities, such as 
securities and insurance underwriting. The Federal Reserve has primary 
authority to examine and supervise a bank holding company, financial 
holding company, and their respective nonbank affiliates, except for 
those that are "functionally regulated" by some other 
regulator.[Footnote 15] The Federal Reserve's authority to require 
reports from, examine, or impose capital requirements on a functionally 
regulated affiliate is limited. For example, the Federal Reserve has 
limited authority under GLBA to examine broker-dealer affiliates of 
bank and financial holding companies. These limitations were designed 
to lessen the regulatory burden on and provide for consistent 
regulation of a financial activity, such as securities, regardless of 
whether the entity conducting the activity is affiliated with a 
commercial bank. In this report, we sometimes refer to banks, bank 
holding companies, and financial holding companies as banking 
organizations.

Thrift Holding Companies:

Under the Home Owners' Loan Act of 1933, as amended, companies that own 
or control a savings association are subject to supervision by OTS. 
Historically, most thrift holding companies were designated as "exempt" 
and permitted to engage in a wide range of activities, including 
insurance, securities, and nonfinancial activities.[Footnote 16]GLBA 
expanded the activities authorized for nonexempt thrift holding 
companies to include those authorized for financial holding companies. 
However, GLBA curtailed the availability of exempt status to only those 
that meet all of the following criteria: the organization was a thrift 
holding company on May 4, 1999, or became a thrift holding company 
under an application pending with OTS on or before that date; the 
holding company meets and continues to meet the requirements for an 
exempt thrift holding company; and the thrift holding company continues 
to control at least one savings association (or successor savings 
association) that it controlled on May 4, 1999, or that it acquired 
under an application pending with OTS on or before that date. As a 
result, GLBA in effect redefined the requirements for an exempt thrift 
holding company.

SEC's Consolidated Supervision:

Beginning with the Market Reform Act of 1990, SEC has been undertaking 
supervisory activities aimed at assessing the safety and soundness of 
securities activities at a consolidated or holding company 
level.[Footnote 17] That act authorized SEC to collect information from 
registered broker-dealers about the activities and financial condition 
of their holding companies and material unregulated affiliates. In 
1992, SEC began receiving risk-assessment reports from firms that 
permitted it to assess the potential risks that affiliated 
organizations might have on broker-dealers. By June 2001, SEC was 
meeting monthly with major securities firms in connection with their 
risk reports. SEC rules regarding more complete oversight of the 
activities of some holding companies--SIBHC and CSE--became effective 
in August 2004.[Footnote 18] GLBA had amended the Securities Exchange 
Act of 1934 to permit an investment bank holding company that is not 
affiliated with certain types of banks and has a subsidiary broker-
dealer with a substantial presence in the securities markets to elect 
to become an SIBHC and be subject to SEC supervision on a groupwide 
basis. SEC established a similar set of rules for holding companies 
with the largest broker-dealers to voluntarily consent to consolidated 
supervision by becoming a CSE. Under the CSE rules, broker-dealers may 
apply to SEC for a conditional exemption from the application of the 
standard net capital calculation and, instead, use an alternative 
method of computing net capital that permits utilization of 
mathematical modeling methods. As a condition for granting the 
exemption, broker-dealers' ultimate holding companies must consent to 
capital requirements consistent with Basel standards and groupwide SEC 
supervision unless they are determined to already be subject to 
"comprehensive, consolidated supervision" by another principal 
regulator. For companies that choose to become SIBHCs or CSEs, SEC 
would have supervisory authority over OTC derivatives transactions 
undertaken in previously unregulated affiliates.

Federal Reserve and U.S. Treasury Play Roles in Maintaining Financial 
Stability:

As the U.S. central bank, the Federal Reserve also has responsibility 
for ensuring financial stability. In practice, this has entailed 
providing liquidity to financial markets during periods of crisis. For 
example, in the immediate aftermath of the September 11, 2001, attacks, 
the Federal Reserve provided about $323 billion to banks to overcome 
problems that resulted from the inability of a major bank to clear 
trades in government securities. In addition, the Federal Reserve is 
also both a provider and regulator of clearing and payment 
services.[Footnote 19]

The Department of the Treasury shares in the responsibility for 
maintaining financial stability and has other responsibilities related 
to financial institutions and markets as well. Treasury shares 
responsibility for managing systemic financial crises, coordinating 
financial market regulation, and representing the United States on 
international financial market issues. Treasury, in consultation with 
the President, may also approve special resolution options for 
insolvent financial institutions whose failure could threaten the 
stability of the financial system. Two-thirds of the members of the 
Federal Reserve's Board of Governors and of the FDIC Directors must 
approve any extraordinary coverage.

The United States Participates in International Organizations Dealing 
with Regulatory Issues:

U.S. regulators meet with regulators from other nations in a number of 
different forums:

* Basel Committee on Banking Supervision (Basel Committee). Agency 
principals from OCC, FDIC, and the Federal Reserve[Footnote 20] 
participate as members in the Basel Committee, along with central bank 
and regulatory officials of other industrialized countries.[Footnote 
21] The committee formulates broad supervisory standards and 
guidelines, including those for capital adequacy regulation, and 
recommends best practices in the expectation that individual 
authorities will take steps to implement them through detailed 
arrangements--statutory or otherwise--that are best suited for their 
own national systems. One of the objectives of the Basel Committee is 
to close gaps in international supervision coverage so that no 
internationally active banks escape supervision and supervision is 
adequate. The committee encourages convergence toward common approaches 
and common standards without attempting detailed harmonization of 
member country supervisory techniques.

* International Organization of Securities Commissions (IOSCO). IOSCO 
is the principal international organization of securities commissions, 
and is composed of securities regulators from over 105 countries. SEC 
is a member of IOSCO, and CFTC participates as an associate member. 
IOSCO develops principles and standards for improving cross-border 
securities regulation, reviews major securities regulatory issues, and 
coordinates practical responses to these concerns. Areas addressed by 
IOSCO include: multinational disclosure, accounting, auditing, 
regulation of the secondary markets, regulation of intermediaries, 
enforcement and the exchange of information, investment management, 
credit rating agencies, securities analysts' conflicts of interest, and 
securities activity on the Internet.

* International Association of Insurance Supervisors (IAIS). 
Established in 1994, IAIS represents insurance supervisory authorities 
of some 180 jurisdictions. It was formed to promote cooperation among 
insurance supervisors, set standards for insurance supervision and 
regulation, provide training for members, and coordinate work with 
regulators in the other financial sectors and international financial 
institutions. NAIC works with IAIS.

* Joint Forum. Established in early 1996 under the aegis of the Basel 
Committee, IAIS, and IOSCO, the Joint Forum publishes papers addressing 
supervisory issues that arise from the continuing emergence of 
financial conglomerates and the blurring of distinctions between the 
banking, securities, and insurance sectors.[Footnote 22] The Joint 
Forum comprises an equal number of senior insurance, bank, and 
securities supervisors representing 13 countries.[Footnote 23]

* Financial Stability Forum (FSF). Convened in April 1999, FSF brings 
together national authorities responsible for financial stability in 
significant international financial centers, international financial 
institutions, sector-specific international groupings of regulators 
and supervisors, and committees of central bank experts. FSF seeks to 
coordinate the efforts of these various bodies in order to promote 
international financial stability, improve the functioning of markets, 
and reduce systemic risk. The Federal Reserve, SEC, and Treasury 
participate in FSF.

The International Monetary Fund (IMF) also plays a role in promoting 
effective regulation of financial services. IMF is an organization of 
184 countries, working to foster global monetary cooperation, secure 
financial stability, facilitate international trade, promote high 
employment and sustainable economic growth, and reduce poverty. As part 
of its surveillance activities, IMF and the World Bank have taken a 
central role in developing, implementing, and assessing internationally 
recognized standards and codes in areas that are crucial for the 
efficient functioning of a modern economy, including central bank 
independence, financial sector regulation, corporate governance and 
policy transparency, and accountability. In response to banking crises 
in the 1990s, they created the Financial Sector Assessment Program to 
assess the strengths and weaknesses of countries' financial sectors. 
The staffs of these institutions also conduct research related to these 
activities.

These international institutions and forums have generally agreed on a 
set of principles or prerequisites for achieving the objectives of 
financial regulation. These generally include:

* formulating clear objectives for regulators;

* ensuring regulatory independence, but with appropriate 
accountability;

* providing regulators with adequate resources, including staff and 
funding;

* giving regulators effective enforcement powers; and:

* ensuring that regulation is cost efficient.

Objectives, Scope, and Methodology:

Our objectives were to describe changes over recent decades in (1) the 
financial services industry; (2) the U.S. regulatory structure and 
those of several other industrialized countries; and (3) U.S. financial 
market regulation, focusing on capital requirements, supervision, 
market discipline, and domestic and international coordination. Our 
objectives also included assessing (4) U.S. regulators' efforts to 
communicate, coordinate, and cooperate with each other and with 
regulators abroad, and (5) the strengths and weaknesses of the present 
U.S. financial regulatory system. While housing finance is often 
considered part of the financial services industry, this report does 
not include government-sponsored enterprises with a major role in 
housing finance or their regulators.[Footnote 24] In addition, because 
credit unions have only about 9 percent of domestic deposits and ILCs 
have only 1 percent of domestic deposits, this report does not discuss 
them in detail.[Footnote 25] Finally, we have not included pension 
funds or their regulator in this report. In addition, we do not discuss 
the role of the Federal Trade Commission or the impact of tax policy 
on the financial services industry.

To address the objectives of this report, we conducted interviews with 
senior supervisory and regulatory officials at the federal level, 
including the Federal Reserve, FDIC, OCC, OTS, SEC, and CFTC. At the 
state level, we interviewed supervisory and regulatory officials in 
Florida, Illinois, Massachusetts, Michigan, Minnesota, and New York as 
well as trade associations representing state regulators, including 
supervisors of the Conference of State Bank Supervisors, North American 
Securities Association of Administrators, and National Association of 
Insurance Commissioners. Finally, we spoke to a variety of SROs, 
including the New York Stock Exchange (NYSE), NASD (formerly the 
National Association of Securities Dealers), Municipal Securities 
Rulemaking Board, National Futures Association, Chicago Mercantile 
Exchange, Chicago Board of Trade, and Chicago Board Options Exchange. 
These agencies provided us with documents and statistics, including 
research studies, examination manuals, annual and strategic reports, 
performance plans, and financial and budgetary data. In addition to our 
interviews with supervisory and regulatory officials, we also met with 
officials representing financial services firms and exchanges and their 
trade associations, and academic experts. Information about depository 
institutions identified in this report was obtained from publicly 
available sources.

This report also draws on extensive work we have done in the past on 
the financial services regulatory structure and includes information 
gathered from many sources. These sources include studies of the 
history of the financial services industry; records from congressional 
hearings related to regulatory restructuring; and professional 
literature concerned with the industry structure and regulation. We 
also reviewed relevant banking, securities, insurance, and futures 
legislation at the federal level.

To address issues of international harmonization and to compare the 
U.S. regulatory regime with more consolidated structures abroad, we 
conducted fieldwork in Belgium, Germany, and the United Kingdom. During 
our field visit, we interviewed officials from the European Union (EU), 
European Central Bank, Financial Services Authority in the United 
Kingdom (UK-FSA), The Bank of England, Her Majesty's Treasury (HM-
Treasury), Federal Financial Supervisory Authority in Germany (BaFin), 
Deutsche Bundesbank (Bundesbank), and German Treasury. Many of the 
officials we interviewed provided us with documents and research 
studies on their regulatory processes and the reasons for implementing 
more consolidated structures. We also interviewed officials from 
financial services firms, including subsidiaries of U.S. firms as well 
as two firms headquartered in the countries we visited. In addition, we 
spoke with trade associations and other experts on the EU and 
regulatory consolidation within various countries. For those countries 
we did not visit (Australia, Japan, and the Netherlands), we reviewed 
documents and provided our findings for review by government officials 
from the relevant country or other recognized experts. We did not 
conduct a full legal review of the regulatory regimes for any of these 
countries.

To develop certain other information, we collected data from federal 
and state regulators and SROs on the resources they devoted to 
supervision from 1999 to 2003. We also collected information about 
ongoing regular communication these entities had with other regulatory 
bodies between January 2003 and March 2004. We did not use any 
nonpublic supervisory data in conducting our work for this report.

We provided a draft of this report to the Department of the Treasury, 
Board of Governors of the Federal Reserve System, CFTC, FDIC, NAIC, 
OCC, OTS, and SEC for review and comment. The written comments of the 
Board of Governors, FDIC, OCC, OTS, and SEC are printed in appendixes I 
through V and are discussed at the end of chapter 7. The staffs of 
these agencies also provided technical comments that have been 
incorporated, as appropriate. The Department of the Treasury, CFTC, and 
NAIC did not provide written comments, but their staffs provided 
technical comments that have been incorporated, as appropriate. We 
conducted our work between June 2003 and July 2004 in accordance with 
generally accepted government auditing standards in Washington, D.C; 
Boston; Chicago; New York City; Brussels, Belgium; London; and Berlin, 
Bonn, and Frankfurt, Germany.

[End of section]

Chapter 2: The Financial Services Industry Has Undergone Dramatic 
Changes:

The environment in which the financial services industry operates and 
the industry itself have undergone dramatic changes that include 
globalization, consolidation, conglomeration, and convergence. These 
forces have affected financial services firms, markets, and products. 
First, globalization that includes the financial services industry has 
become a characteristic of modern economic life. Second, consolidation 
(merging of firms in the same sector) and conglomeration (merging of 
firms in other sectors) have increasingly come to characterize the 
large players in the financial services industry. Third, the roles of 
financial institutions and the products and services they offer have 
converged so that institutions often offer customers similar services, 
although sectors still specialize to some extent. As a result of these 
changes, as well as the development of innovative financial products, 
the financial services industry has become more complex, and thus the 
kinds and extent of risks the industry faces have changed.

Financial Services Have Played an Integral Part in Globalization:

Globalization has had a major impact on a broad range of economic 
activities, including financial markets. Figure 2, which shows the 
ongoing growth of international corporate and sovereign debt, 
illustrates the linkages among financial markets around the globe.

Figure 2: International Debt Securities, 1987-2004:

[See PDF for image]

[End of figure]

The financial services industry--firms, markets, and products--have 
been an integral part of the globalization trend. At present, firms 
have a greater capacity and increased regulatory freedom to cross 
borders, creating markets that either eliminate or substantially reduce 
the effect of national boundaries. U.S.-owned financial services firms 
have increased their international activities, and a significant number 
of foreign-owned financial services companies are operating within the 
United States. In banking, for example, Citibank has substantial and 
growing retail banking activities in Germany and ING Direct, a Dutch-
owned company, has a large deposit base in the United States. In the 
securities sector, in 2003 U.S. investors held $2.5 trillion of foreign 
securities, and foreign holdings of U.S. securities other than U.S. 
Treasury securities rose to $3.4 trillion. In the insurance sector, a 
significant portion of U.S. insurers and the U.S. market are now 
foreign controlled. In 2001, 142 U.S. life insurers were foreign-owned, 
up from 69 in 1995. And, according to the International Insurance 
Institute, from 1991 to 1999, sales by foreign-owned property-casualty 
insurers doing business in the United States grew by 62.8 percent.

Deregulation and technological change have facilitated globalization. 
Barriers that once limited international financial transactions have 
been substantially reduced or removed, and greater computing power and 
better telecommunications networks have driven the technological 
revolution. These technological changes have had a major effect on 
wholesale securities and futures markets around the world. Many 
securities and futures products can be traded 24 hours a day from any 
place in the world. Electronic trading and other changes have made this 
transformation possible. Large U.S.-based institutional investors can 
now buy stock in publicly traded foreign companies by accessing foreign 
stock markets. Smaller retail investors can participate in the equity 
markets of foreign countries by buying mutual funds that specialize in 
developed or emerging foreign markets.

Large Institutions Have Become Larger through Consolidation and 
Conglomeration:

Generally, over the last several decades, large financial institutions 
have consolidated by merging with or acquiring other companies in the 
same line of business. Consolidation has occurred in all of the 
industry segments discussed in this report--banking, securities, 
futures, and insurance. While the number of firms declined, the 
percentage of industry assets concentrated in the largest 10 commercial 
banks, thrifts, life insurers, and property-casualty insurers rose 
between 1996 and 2002, as shown in figure 3. While the percentage of 
assets of the largest 10 securities firms has fallen somewhat, these 
firms still have more than 50 percent of the industry's assets. The 
same technological and improvements and deregulation that have driven 
globalization have also contributed to consolidation and 
conglomeration. While large firms have gotten larger and often account 
for an increasing share of each industry, there are still a large 
number of firms in each industry segment. Some observers believe that 
the financial services sectors will come to be characterized by a few 
large players and lots of small, niche-market players, with few in 
between.

Figure 3: Share of Assets in Each Sector Controlled by 10 Largest 
Firms, 1996-2002:

[See PDF for image]

[End of figure]

The change in the banking sector has been especially dramatic, as it 
has been driven by both technological change and significant 
deregulation. In the early 1980s, bank holding companies faced 
limitations on their ability to own banks located in different states. 
Some states did not allow banks to branch at all. With the advent of 
regional interstate compacts in the late 1980s, some banks began to 
merge regionally. Additionally, the Riegle-Neal Interstate Banking and 
Branching Efficiency Act of 1994 removed restrictions on bank holding 
companies' ability to acquire banks located in different states and 
permitted banks in different states to merge, subject to a process that 
permitted states to opt out of that authority.[Footnote 26] While the 
U.S. banking industry is still characterized by a large number of small 
banks and researchers have questioned whether economies of scale and 
scope exist, the larger banking organizations have grown significantly 
through mergers after 1995. As figure 4 shows, 40 large banking 
organizations operating in 1990 had consolidated into 6 banking 
organizations by August 2004. These six banking organizations had about 
40 percent of total bank assets in the United States.

Figure 4: Merger Activity among Banking Organizations, January 1990-
June 2004:

[See PDF for image]

[End of figure]

Many of the larger financial services firms are part of holding 
companies that operate in more than one of the traditional sectors. 
These firms are called conglomerates. A research study by IMF staff 
shows that based on a worldwide sample of the top 500 financial 
services firms in assets, the percentage of firms in the U.S. that are 
conglomerates--firms having substantial operations in more than one of 
the sectors (banking, securities, and insurance)--increased from 42 
percent of the U.S. firms in the sample in 1995 to 61.5 percent in 
2000; however, for the sample of U.S. firms, the percentage of assets 
controlled by conglomerates declined from 78.6 percent in 1995 to 73 
percent in 2000.[Footnote 27] The largest banks in the United States 
have brokerage operations, and many sell insurance and mutual fund 
products. While much of the conglomeration in the United States took 
place prior to GLBA, that important piece of legislation removed 
restrictions on the extent to which conglomerates could engage in 
banking and nonbanking financial activities, thus, for example, making 
it possible for financial conglomerates to purchase insurance companies 
and other financial institutions to purchase banks.

To facilitate and recognize the trend toward conglomeration, GLBA 
authorized new regulatory regimes. The act authorized bank holding 
companies to qualify as financial holding companies and provided for 
voluntary SEC supervision of investment bank holding companies. While 
rules for the latter were issued only in June 2004, financial holding 
companies grew from 477 in 2000 to 630 in March 2003. Metropolitan Life 
Insurance Company, one of the largest life insurance companies in the 
United States, and Charles Schwab & Co., a sizable securities firm, 
acquired or opened banks and became financial holding companies. In 
addition, several major insurance and commercial companies, including 
American International Group, General Electric, and American Express, 
have thrifts and Merrill-Lynch has chartered an ILC in addition to its 
commercial bank and thrift. As a result, a consumer can make deposits, 
obtain a mortgage or other loan, or purchase insurance products from 
the same company. Although some had expected that conglomeration would 
intensify after GLBA, as yet, this does not seem to have happened. The 
reasons vary: Many firms were already conglomerates before the passage 
of GLBA, the removal of some limitations on bank-affiliated broker-
dealers allowed banks to grow internally, banks did not see any 
synergies with insurance underwriting, and a general slowdown occurred 
in merger and acquisition activity across the economy in the early 
2000s. While merger and acquisition activity in banking has picked up, 
sizable mergers between firms in different sectors have not 
materialized so far. It may be that these mergers are not economically 
efficient, the regulatory structure set up under GLBA is not 
advantageous to these mergers, or it may simply be too soon to tell 
what the impact will be. In addition, some cross-sector mergers have 
been unwound. For example, Citigroup sold off the property-casualty 
unit of Travelers, which had been affiliated with Citibank since their 
merger in 1998.

Roles of Large Financial Services Firms Have Changed and Financial 
Products Have Converged, but Some Differences Remain:

Increasingly, financial intermediaries are relying on fee-based 
services, including asset management, for their profitability. Firms in 
all of the sectors are also increasingly involved in activities to 
manage their and their institutional customers' risks. In addition, 
product offerings by firms in different segments of the financial 
services industry have converged so that product offerings that might 
appear to be different are competing to meet similar customer needs, 
such as having access to liquid transaction accounts, saving for 
retirement, or insuring against the failure of a party to live up to 
the terms of a commercial contract.

Market Developments Have Forced Financial Services Firms to Adapt:

Generally, financial services firms, especially banks, have had to 
adapt to the ease with which corporations can now directly access 
capital markets for financing, rather than depending on loans. For 
example, with the emergence of the commercial paper market, many large 
firms with strong credit ratings that had been dependent on bank loans 
were able to access capital markets more directly. As a result, those 
large banks that had been major lenders to these firms have had to find 
new sources of revenue. Banks are now relying more on fee-based income 
that is generated by structuring and arranging borrowing facilities, 
providing risk management tools and products, and servicing the loans 
they have sold off to other institutions as well as from fees on 
deposit and credit card activity, including account holder fees, late 
fees, and transactions fees. Many large banking institutions have moved 
into investment banking activities, including arranging OTC derivative 
transactions for their corporate customers. These institutions also 
earn fees on their investment banking activities as well as from their 
sales of insurance and mutual fund products.

These role changes have been facilitated by the development of new 
products, such as securitized assets, that depend on sophisticated 
mathematical models and the technology needed to support them. In its 
simplest form, asset securitization is the transformation of generally 
illiquid assets into securities that can be traded in capital markets. 
The process includes several steps: the firm that issued the loans 
creates a legal entity (a "pool"), segregates loans or leases into 
groups that are relatively homogeneous with respect to their cash-flow 
characteristics and risk profiles, including both credit and market 
risks, and sells the group to the pool. The pool then issues securities 
and sells them to an underwriter, who prices them and sells them to 
investors. Securitized assets generally consist of mortgage-backed 
securities and other asset backed securities where loans for products 
such as credit cards or commercial loans are securitized and sold. 
Mortgage-backed securities[Footnote 28] grew from about $1,123 billion 
in 1990 to about $3,796 billion in 2003, while other asset-backed 
securities grew by a factor of 12 over that same period of time. 
Because the risk embedded in securitized assets can be structured and 
priced so that financial institutions and others may be better able to 
manage credit and interest rate risk with these instruments.

Because banks and insurance companies could reduce their capital 
requirements by securitizing assets and removing those assets from 
their balance sheets, securitization was also driven by changes in 
capital requirements implemented in these industries in the early 1990s 
that required firms to hold more capital for certain assets.[Footnote 
29]

Along with securitized assets, derivatives have been used increasingly 
by financial institutions to manage assets and risks for themselves and 
others or to take a position on the direction of market movements in 
hopes of making a profit. Derivatives are contracts that derive their 
value from a reference rate, index, or the value of an underlying 
asset, including stocks, bonds, commodities, interest rates, foreign 
currency exchange rates, and indexes that reflect the collective value 
of underlying financial products. There are several types of 
derivatives, including the following:

* Futures and forwards--contracts that obligate the holder to buy or 
sell a specific amount or value of an underlying asset, reference rate, 
or index (underlying) at a specified price on a specified future date. 
Futures and forwards are used to hedge against changes or to speculate 
by attempting to make money off of predicting future changes in the 
underlying. Futures are often traded on exchanges and forwards are 
traded as OTC transactions and generally result in delivery of an 
underlying. (See ch. 1.)

* Options--contracts that grant their purchasers the right but not the 
obligation to buy or sell a specific amount of the underlying at a 
particular price within a specified period. Options can allow their 
holders to protect themselves against certain price changes in the 
underlying or benefit from speculating that price changes in the 
underlying will be greater than generally expected.

* Swaps--agreements between counterparties to make periodic payments to 
each other for a specified period. Swaps are often used to hedge market 
risk or speculate on whether interest rates or currency values will 
change in a particular direction.

* Credit default swaps--a contract whereby the protection buyer agrees 
to make periodic payments to the protection seller for a specified 
period of time in exchange for a payment in the event of a credit event 
such as a default by a third party referenced in the swap. Credit 
default swaps allow market participants to keep loans or loan 
commitments on their books and essentially purchase insurance against 
borrower default.

Figure 5 shows the growth in the number of exchange-traded futures 
since 1995.[Footnote 30] In addition, Bank for International 
Settlements' estimates of the notional amounts of OTC derivatives 
outstanding increased globally by about 146 percent between 1998 and 
2003, going from about $80 trillion in 1998 to about $197 trillion in 
2003.

Figure 5: Number of Futures Contracts Traded, 1995-2003:

[See PDF for image]

[End of figure]

The growth of derivatives activity attests to the usefulness of these 
instruments to the participants, but there are concerns about the 
management of derivatives risk. The complexity of some of these 
instruments can make it difficult for the users to understand and 
estimate the potential value or loss; moreover, the reliance on a 
counterparty to make an expected flow of payments during future years 
means that the recipient is exposed to the credit risk that the 
counterparty might default in the meantime.

Product Offerings in Different Sectors Have Also Converged:

While convergence has taken place among firms using similar securitized 
products and derivatives to manage assets and risks, it has also taken 
place in product offerings by firms in different segments of the 
financial services industry. These firms are competing against each 
other to provide households, businesses, and governments with the same 
basic services. For example, table 1 illustrates how financial firms in 
the various sectors, regardless of whether they are affiliated with 
firms in other sectors, are offering functionally similar products to 
satisfy the same retail customer needs.

Table 1: Selected Retail Products by Financial Institution and 
Function[A]:

Financial institution: Banks; 
Transaction accounts: Checking, savings; 
Fixed return investments: Certificates of deposit, corporate bonds, 
municipal bonds, Treasuries; 
Variable return investments: Variable annuities; 
Risk management: Insurance distribution[B]; 
Raising money: Loans (all types).

Financial institution: Broker-dealers; 
Transaction accounts: Cash management account; 
Fixed return investments: Corporate bonds, municipal bonds, Treasuries; 
Variable return investments: Stocks, mutual funds, variable annuities; 
Risk management: Options; 
Raising money: Loans associated with margin accounts.

Financial institution: Investment companies; 
Transaction accounts: Money market mutual fund; 
Fixed return investments: Guaranteed investment; 
contracts; 
Variable return investments: Mutual funds, variable annuities.

Financial institution: Insurers; 
Fixed return investments: Fixed annuities, guaranteed investment 
contracts; 
Variable return investments: Variable annuities, mutual funds; 
Risk management: Property-casualty, life insurance. 

Financial institution: Futures firms; 
Risk management: Futures, options. 

Financial institution: Other financing companies; 
Variable return investments: Consumer loans. 

Source: GAO:

[A] While most of these products could be offered by any financial 
institution through its affiliates, the products are classified here 
according to whether a stand-alone financial institution would offer 
the product.

[B] Subject to a grandfathering provision, GLBA prohibits national 
banks from engaging in title insurance activities, except that national 
banks and their subsidiaries may act as agents to sell title insurance 
in states where state banks are permitted to engage in that activity. 
15 U.S.C. 6713 (2000 & Supp. 2004). Also, national banks may underwrite 
certain insurance products, such as credit insurance, where the 
activity is incidental to the business of banking, and may act as 
insurance agents directly only under certain circumstances, although 
they may engage fully as insurance agents through subsidiaries.

[End of table]

Similarly, firms in different sectors compete by offering products that 
have similar ability to meet some business needs. Issuance of 
commercial paper can provide financing similar to commercial loans, and 
catastrophe bonds and reinsurance provide similar protection, as do 
surety bonds and standby letters of credit.

Although financial services firms and products have converged in 
numerous ways, firms in the various sectors, especially smaller firms, 
continue to specialize in some traditional functions. Commercial banks 
still make commercial loans to businesses, especially those smaller 
businesses that may not be able to raise funds directly in capital 
markets; insurance firms still underwrite the risks involved in 
insuring a life or property or casualty; and investment banks still 
underwrite new securities and advise firms on mergers and acquisitions.

As Financial Services Institutions Have Diversified, Introduced New 
Products, and Become More Complex, Risks Have Changed:

Globalization, consolidation, conglomeration, and convergence of 
financial institutions have changed the risk profile of the 
institutions and the linkages among them. Today, a large modern 
financial firm may operate in a variety of product and geographic 
markets. Figure 6 illustrates how such a complex firm might be 
organized.

Figure 6: Structure of a Hypothetical Financial Holding Company:

[See PDF for image]

[End of figure]

Generally, diversification into new geographic and product markets 
would be expected to reduce risk, while securitized and derivative 
products have given firms new tools to manage risk. Because risks 
interact, however, the net result on the risk of an individual 
institution or the financial system cannot be definitively predicted. 
In addition, managing risks in an environment that crosses industry and 
geographic lines along with new products have increased the complexity 
of institutions and the industry. As a result of all of these factors, 
the risks facing the industry have changed in some ways.

Credit Risks Have Changed as a Result of Industry Changes:

Generally, diversification of borrowers will reduce the credit risk of 
a financial services firm, and many of the changes in the industry have 
done just that. U.S. banks have consolidated and spread across the 
country so that they are no longer operating in a single small town, 
city, or state. If a town or even a region falls on hard times and 
borrowers increasingly default on loans, the bank, or other institution 
that made the loans, may be less affected than they once would have 
been, because borrowers in other markets may be enjoying positive 
economic circumstances and defaults in those markets may be dropping. 
The same is true for firms diversifying their types of products and for 
those diversifying to other parts of the world. In addition, by 
securitizing loans and selling them off or by using credit derivative 
products, individual firms or sectors may also reduce credit risk. For 
example, in its Global Financial Stability Report issued in April 2004, 
the IMF reported that, for many years, banks have been transferring 
risk, especially credit risk, to other financial institutions, such as 
mutual funds, pension funds, insurers, and hedge funds.[Footnote 31]

Many of the same forces that may have reduced credit risk for some 
institutions, as well as other forces, may have increased risk as well. 
For example, while globalization allows for diversification, it also 
complicates the evaluation of credit risk. Because bankruptcy laws 
differ among countries, the assets of a failed household or corporate 
borrower in another country may be less available to U.S. creditors. In 
addition, little recourse exists when foreign governments default on 
their debt. Further, the extent to which diversification and new 
products reduce credit risk depends on how the firm to which the risk 
is passed understands, measures, and manages its new markets and 
products--as well as the combined risks of old and new exposures. If it 
does not manage them well, these normally credit reducing activities 
could actually increase credit or other kinds of risks.

The degree to which diversification and new products reduce credit risk 
will also depend on the linkages between markets, products, and firms, 
and the relationship or correlation among the risks. For example, 
securitized products and credit derivatives can allow one institution 
to pass on risk to another. Regulators and others have expressed 
concern that this risk can become concentrated in a few firms or be 
passed to buyers that may be less equipped to handle it. Some research 
has been conducted because regulators and others were concerned that 
the banking sector was passing credit risk to the insurance sector or 
ultimately to households and that these developments could have 
implications for overall financial stability.[Footnote 32] For example, 
IMF reported in April 2004 that on a global basis the transfer of 
credit risk from banks to life insurers might increase financial 
stability because life insurers generally hold longer-term liabilities. 
However, the report notes that in recent years, many insurers have 
changed their products in ways that have begun to shorten the duration 
of their liabilities, raising questions about their advantage in 
handling credit risk. And as insurers in some parts of the world take 
steps to manage their balance sheet risk, they would likely transfer 
that risk to others--including the household sector, which might be 
less able to manage the risk.

Because financial services firms are competing and cooperating with 
each other across traditional industry and geographic boundaries, there 
are increased linkages that may not be well understood. Thus, downturns 
somewhere in the world, such as those in Russia in 1998 or Mexico in 
1995, can have a large impact on all of the major financial 
institutions. In addition, if the large financial institutions are 
linked to each other as counterparties in various transactions, a major 
credit failure at one could send systemic shockwaves through the United 
States and even the world's economy.

Many of the concerns raised here were evident in the near collapse of 
Long-Term Capital Management (LTCM)--one of the largest U.S. hedge 
funds--in 1998 following the Russian downturn.[Footnote 33] 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 OTC derivatives. 
According to LTCM officials, LTCM was counterparty to over 20,000 
transactions and conducted business with over 75 counterparties. 
Further, the Bank for International Settlements reported that LTCM was 
"perhaps the world's single most active user of interest rate swaps."
[Footnote 34] In addition many of the financial institutions that LTCM 
dealt with failed to enforce their own risk management standards.

Comparing the largest U.S. financial firms today with some large 
failures resulting from credit risk that did not appear to have 
systemic implications in the past can help shed light on the potential 
for systemic disruptions today. Bank of New England, which failed, in 
part, because of bad real estate loans, had $19.1 billion in assets at 
the time of its failure. In comparison, the largest bank holding 
company today had bank subsidiaries with assets of $823 billion in 
March 2004. Similarly, in the insurance area, one of the largest U.S. 
insurers has assets of $678 billion, while the largest insurance 
failure on record is Mutual Benefit, which had assets of only $13.5 
billion. While the unwinding of Drexel, Burnham, Lambert Group is 
sometimes pointed to as evidence that the failure of a major securities 
firm would not necessarily raise concerns about systemic risk 
sufficient to warrant intervention, some experts suggest that four 
trends in the international financial system since that collapse 
suggest that the outcome for a future failure of a major securities 
firm might be different:[Footnote 35] (1) Leading securities firms have 
become increasingly international, operating in markets around the 
world and through a complex structure of affiliates in countries with 
differing bankruptcy regimes; (2) securities firms are increasingly 
parts of conglomerates that include banks, and thus the systemic 
concerns related to bank failures might extend to securities firms; (3) 
securities firms themselves have grown in size so that while they may 
be less likely to fail, any failure is more likely to have systemic 
implications; and (4) the largest securities firms have become 
increasingly involved in global trading activities, particularly OTC 
derivatives. An SEC staff member told us that while they believe that a 
gradual unwinding of one of the largest securities firms today could 
still be handled without systemic implications, the sudden failure of 
one of these firms would likely have major implications for a broad 
swath of markets and investors. Because of the sheer size of today's 
financial institutions, some question whether these firms are too big 
to be allowed to fail. This belief could skew the incentives facing 
managers and investors to manage risk effectively.

Other Risks Have Also Been Affected by Changes in the Industry:

Changes in the industry, especially the growth of large institutions 
that cross industry and national boundaries, have also affected the 
level and management of operational and reputation risk. An official at 
one of the large securities firms told us that opportunities for fraud 
or other violations of law or regulation in some part of the 
organization increase immediately after a merger of entities with 
different corporate cultures. And to the extent that a firm operates 
centrally and the public believes the parts are connected, the ability 
to isolate such problems in some part of an organization will be more 
difficult. The collapse of Barings, a British bank, demonstrates the 
potential vulnerability to operational risk of firms operating across a 
wide range of markets. In this case, management did not effectively 
supervise a trader in Singapore, and his actions brought down the 
bank.[Footnote 36] Further, a firm's reputation can be damaged by 
disreputable practices, such as happened when a major institution 
violated derivatives sales practices and when it was discovered that 
ownership of a U.S. bank in Washington, D.C., was tied to BCCI, a 
corrupt bank headquartered in Luxembourg. Regulators have recognized 
the increased importance of operational risks, including reputation 
risk, in the new capital standards adopted by the Basel Committee in 
June 2004. (See ch. 4.)

[End of section]

Chapter 3: While Some Countries Have Consolidated Regulatory 
Structures, the United States Has Chosen to Maintain Its Structure:

Since the mid-1990s, several major industrial countries, including 
Australia, Germany, Japan, the Netherlands, and the United Kingdom, 
have consolidated their regulatory structures, and some U.S. states 
have consolidated their structures as well. While proposals have been 
advanced that would change the U.S. regulatory structure, the United 
States, most notably with the passage of GLBA, has chosen not to adopt 
any substantial changes. Proposals to change the U.S. regulatory 
structure made throughout the 1990s and early 2000s included 
consolidating bank regulators, merging SEC and CFTC, changing the SRO 
structure for securities, and creating a federal regulator to oversee 
those companies opting for the proposed federal insurance charter. 
Proposals have also been made that would cut across sectors, including 
proposals for a single federal regulator in each area, an oversight 
board, and a fully consolidated federal regulator.

Some Countries and States Have Consolidated Their Regulatory 
Structures:

During the 1990s and early 2000s, some other countries consolidated 
their regulatory structure. According to a research report by World 
Bank staff,[Footnote 37] by 2002, 29 percent of the countries that 
supervise banking, securities, and insurance had consolidated their 
regulatory structure to include only a single regulator, and another 30 
percent of the countries had consolidated regulators across two of the 
three sectors. The remaining countries had multiple regulators, with a 
minimum of one for each of the sectors. Countries within the 
EU[Footnote 38] made changes that sometimes reflect steps to create an 
integrated financial market but not an EU-wide regulatory regime. 
Generally, these countries' industries and regulatory structures 
historically had differed from those in the United States, largely 
because banking, securities, and insurance activities had not been 
legally separated as they were in the United States under the Glass-
Steagall Act. The products and services that financial services firms 
in these countries offered had changed, however, reflecting the 
financial innovations that have also transformed the U.S. financial 
services industry. Some U.S. states have also consolidated their 
regulatory structure. In addition, many states have combined some 
aspects of their banking, insurance, and securities regulators, and 
some have chosen to combine all of their financial regulation in a 
single government agency.

The EU Has Taken Steps Designed to Create an Integrated Financial 
Market but Not an EU-Wide Regulatory Regime:

EU member states that have consolidated their regulatory structures 
have done so in the larger context of efforts to create an integrated 
financial market in the EU. Building on long-term actions to create a 
single financial market in Europe, the EU has taken several actions 
that are influencing regulatory frameworks in European countries. 
First, in 1998 the European Central Bank was established, and this has 
diminished the roles of the central banks in countries that began using 
the euro in 2002.[Footnote 39] Second, the European Commission proposed 
an extensive Financial Services Action Plan (Action Plan) in 1999 that 
it expects to fully implement by 2005. Under the Action Plan, the EU 
would not create any EU-wide financial services regulatory bodies, but 
would instead enact legislation that would be adopted by the individual 
countries and implemented by their regulators. Since under the EU 
charter, firms can do business in all EU countries if they are located 
in one of them (the so-called Single Passport), EU officials and others 
have said that convergence is necessary to prevent duplicative 
requirements and regulatory arbitrage. That is, companies should not 
have an incentive to choose their location based on the regulatory 
regime in a particular country and should not be able to pit one 
regulator against another to get favorable regulatory decisions. 
Finally, to streamline European lawmaking and stimulate regulatory and 
supervisory convergence, the EU has created a process under which 
committees of securities, banking, and insurance regulators from the 
individual member states now consult and coordinate their work at 
several stages in the process between adoption of more detailed rules. 
These supervisory committees are the Committee of European Securities 
Regulators (CESR), the Committee of European Banking Supervisors, and 
the Committee of European Insurance and Occupational Pensions 
Supervisors.

The United Kingdom, Germany, and Japan Have Adopted a Single Regulator 
Structure:

Along with other countries, the United Kingdom, Germany, and Japan have 
each adopted versions of the single regulator model. However, the 
regulatory organizations in these countries differ significantly. The 
United Kingdom's consolidation is the most notable in that, according 
to a research paper by IMF staff, it provided an enormous impetus for 
other countries to unify their supervisory agencies.

United Kingdom:

Beginning in 1997, the United Kingdom consolidated its financial 
services regulatory structure, combining nine different regulatory 
bodies, including SROs, into the Financial Services Authority (UK-FSA). 
While UK-FSA is the sole supervisor for all financial services, other 
government agencies, especially the Bank of England and Her Majesty's 
Treasury (HM-Treasury), still play some role in the regulation and 
supervision of financial services. Formal financial regulation and 
supervision are relatively new to the United Kingdom; before 1980, 
according to officials at the Bank of England, a "raised eyebrow" from 
the Head of the Bank of England was used to censure inappropriate 
behavior. Thus, most of the agencies and SROs that were replaced did 
not have long histories.

Government officials and experts cited important changes in the 
financial services industry as some of the reasons for consolidating 
the regulatory bodies that oversee banking, securities, and insurance 
activities. These included the blurring of the distinctions between 
different kinds of financial services businesses, and the growth of 
large conglomerate financial services firms that allocate capital and 
manage risk on a groupwide basis. Other reasons for consolidating 
included some recognition of regulatory weaknesses in certain areas and 
enhancing the United Kingdom's power in EU and other international 
deliberations.

U.K. officials have reported that the United Kingdom did not separate 
its regulators by objective--the twin peaks model, which usually 
includes a prudential or safety and soundness regulatory agency and a 
conduct-of-business or market conduct regulatory agency--because the 
same senior management and groupwide systems and controls that 
determine a firm's ability to manage financial risk effectively also 
determine a firm's approach to market conduct. Similarly, while British 
experts acknowledge that groupwide supervision could be managed with 
regulators who specialize in the regulation of specific sectors, they 
say that the need for communication, coordination, cooperation, and 
consistency across the specialist regulatory bodies would make it 
exceedingly difficult to operate within a multiple regulator system.

According to documents provided by UK-FSA officials, the agency's 
enabling legislation stipulated four goals:

* maintaining confidence in the financial system;

* promoting public understanding of the financial system;

* securing the appropriate degree of protection for consumers; and:

* reducing the potential for financial services firms to be used for a 
purpose connected with financial crime.

In pursuing these goals, UK-FSA is directed to take account of 
additional obligations, including achieving its goals in the most 
efficient and effective way; relying on senior management at financial 
services companies for most regulatory input; applying proportionality 
to regulatory decisions, including the costs and benefits of each act; 
not damaging the competitive position of the United Kingdom 
internationally; and avoiding any unnecessary distortions in or 
impediments to competition, including unnecessary regulatory barriers 
to entry or business expansion.

UK-FSA is organized as a private corporation with a chairman and chief 
executive officer and a 16-person board of directors. Eleven members of 
the board are independent, while the other five are UK-FSA officials. 
UK-FSA is ultimately answerable to HM-Treasury and the British 
Parliament. The statute provides for a Practitioner Panel and a 
Consumer Panel to oversee UK-FSA for their respective constituencies. 
In addition, there are requirements for consultation on rules and an 
appeals process for enforcement actions.

UK-FSA documents and officials present UK-FSA as an organization 
strategically focused on achieving its statutory objectives. It has 
adopted a risk analysis model that it believes allows it to allocate 
resources so as to minimize the chance that UK-FSA will fail to meet 
its goals. As a result of this analysis, it focuses on the largest 
firms--the ones most likely to pose significant costs of failure--and 
on the needs of retail consumers. To assure that UK-FSA accomplishes 
its goals efficiently, it is required to submit cost-benefit analyses 
for its proposals. In addition, UK-FSA must report annually on its 
costs relative to the costs of regulation in other countries and must 
provide its next fiscal year's budget for public comment three months 
prior to the end of the current fiscal year.

UK-FSA officials say that they have also taken actions, within the 
institution, to break down the barriers--often called stovepipes or 
silos--between those regulating the different industries. From the 
beginning, they forged a new common language across industry segments 
and traditional regulatory boundaries. Staff have to explain why a 
requirement imposed on one segment should differ from that imposed on 
other sectors. The current organizational structure is designed around 
retail and wholesale divisions. The structure also includes 
crosscutting teams looking at various issues, including asset 
management, financial crime, and financial stability as well as the 
traditional areas of banking, securities, and insurance.

Most of the representatives of firms we spoke to in the United Kingdom, 
including U.K. subsidiaries of U.S. companies, felt that UK-FSA was 
doing a good job, but some industry representatives have raised 
concerns. Much of UK-FSA's success is attributed to the caliber of the 
people working there. For example, we heard that the ability to pull 
off the creation of UK-FSA depended greatly on the caliber of the early 
leadership and that using high-quality bank supervisors to supervise in 
other areas has had benefits, even though these staff may not have 
expertise specific to a particular business. However, some industry 
participants were concerned about the future and about the lack of 
expertise in some areas such as insurance. In addition, the 
Practitioner Panel in its 2003 annual report expressed concerns about 
UK-FSA's cost-benefit analyses, saying that certain costs are often 
unrepresentative or not included at all, and that there is a disregard 
for the total cost of regulation and the industry's ability to absorb 
the incremental cost of rule changes. They also suggested that analyses 
should include potential areas of consumer disadvantage, such as a 
reduction in choice and the possibility of unintended consequences. 
However, a UK-FSA official said that while the agency is working to 
improve its cost-benefit analysis, one industry trade association 
working on the issue had noted that UK-FSA is a world leader in the 
area.

Since UK-FSA took over, a major crisis in the life insurance area has 
come to light. Equitable Life is a mutual insurer in the United Kingdom 
that inappropriately sold policies in the high interest rate 
environment in the 1970s and 1980s that are now coming due and failed 
to reserve appropriately for them. A major study of this problem, the 
Penrose report, was issued in March 2004. The report concluded that the 
crisis was due to the "light touch, reactive regulatory environment" 
that preceded UK-FSA and that UK-FSA's work since 1997 "has sought to 
anticipate many of the lessons that might be drawn by this inquiry and 
it should come as no surprise that it has largely succeeded." The 
report also concluded that the lack of coordination between safety and 
soundness and market conduct regulation in the past was unacceptable. 
HM-Treasury is now undertaking an extensive review of UK-FSA's 
authorizing legislation, in part, to determine the impact UK-FSA might 
be having on competition in the U.K. financial services sector.

While UK-FSA is the sole financial services supervisor, other 
government entities still play a role in regulating the financial 
services industry. A tripartite agreement lays out the roles of the 
Bank of England, HM-Treasury, and UK-FSA. While UK-FSA is responsible 
for supervision of financial entities, the Bank of England retains 
primary responsibility for the overall stability of the financial 
system. It retains the lender of last resort responsibilities but must 
consult with HM-Treasury if taxpayers are at risk. High-level 
representatives from the three agencies meet monthly to discuss issues 
of mutual concern. According to officials at the Bank of England, it is 
difficult to tell how well the system is working because it has not yet 
had to weather a significant banking crisis.

Germany:

In 2002, Germany combined its securities, banking, and insurance 
regulators into BaFin; however, the changes appear less dramatic than 
at UK-FSA. Although crosscutting groups have been added to handle 
conglomerate supervision, international issues, and other cross-
sectoral topics that concern all of the supervisory divisions, the new 
structure still maintains the old divisions related to banking, 
securities, and insurance. In addition, the insurance and banking 
divisions are housed in Bonn, while the securities markets regulators 
are in Frankfurt. Finally, BaFin shares supervisory responsibilities in 
the banking area with the Bundesbank, Germany's central bank.

Organizationally, BaFin is a federal agency overseen by the treasury 
that must follow civil service laws. BaFin has an administrative board 
composed of the ministers of Finance, Economics, and Justice, members 
of Parliament, officials of the Bundesbank, and representatives of the 
banking, insurance, and securities industries. The Advisory Council 
made up of industry, union, and consumer representatives also advises 
BaFin.

BaFin's statutory mandate is to take supervisory or enforcement actions 
to counteract developments that may:

* endanger the safety and soundness of the assets entrusted to 
institutions in the banking, insurance, and other financial services 
sectors;

* impair the proper conduct of banking, insurance, and securities 
business or provision of financial services; or:

* involve serious disadvantages to the German economy.

Much of the immediate impetus for the creation of BaFin came from 
developments in the EU. However, the new organization also recognizes 
the blurring of industry lines and the need for reducing the costs of 
supervision to the government. Specifically German government officials 
cited the following reasons for the creation of a consolidated 
regulator:

* Financial institutions that are taking on similar risks must be 
treated the same.

* Conglomerates need effective oversight.

* The cost of regulation could be reduced through greater efficiency 
and by providing for industry funding of BaFin's operations.

* The role of the Bundesbank, in light of the creation of the European 
Central Bank, would be clarified.

* International standing and clout could be increased.

Like the United States, Germany has a state system of financial 
institutions and regulators as well as the federal system. The banking 
system consists of private banks and state banks, or Sparkassen, that 
are owned by a city or other government entity. The fragmentation of 
the banking industry has impacted the commercial banking industry in 
that private banks have difficulty expanding their retail banking 
operations. In addition, securities exchanges, as well as some 
insurance activities, are overseen at the state level.

Statutes and agreements lay out the complex relationship between BaFin 
and the Bundesbank. When we last reviewed the German bank regulatory 
system in 1995, we noted that while the Bundesbank played a role in the 
oversight of banks, this role was not then spelled out statutorily. 
With creation of the European Central Bank, the role of the Bundesbank 
in the supervision of credit institutions was also clarified. While 
BaFin conducts its own document analyses and, if required, its own 
investigations of troubled institutions and institutions of relevance 
to the system, BaFin is required to consult with the Bundesbank on new 
rules, and the Bundesbank is responsible for most of the ongoing 
monitoring of institutions. Officials at one of the German subsidiaries 
of a U.S. investment bank we spoke with said that most of their 
dealings are with the Bundesbank.

Japan:

Japan consolidated and modified its financial services regulatory 
structure in response to persistent problems in that sector. Japan's 
financial markets sector had certain similarities to that of the United 
States. Most notably, until 1996, Japan maintained legal separations 
between commercial banking, investment banking, and insurance. Japanese 
law, however, did allow cross ownership of financial services and 
commercial firms, permitting development of industrial groups or 
keiretsu that dominated the Japanese economy. These groups generally 
included a major or lead bank that was owned by other members of the 
group and that provided financial services to the members.

Problems in Japan's financial sector are generally accorded some 
responsibility for the persistent stagnation of its economy through the 
1990s. The Financial Reform Act of 1992 allowed the Ministry of Finance 
to impose capital requirements for banks and banks to own securities 
affiliates and created the Securities Exchange and Surveillance 
Commission. According to one author, while these laws were designed to 
reduce the Ministry of Finance's control over the financial sector, the 
ministry retained its role. In 1998, the Financial Supervisory Agency, 
renamed the Financial Services Agency (Japan-FSA) in 2000, was created, 
with functions and staff transferred from the Ministry of Finance. The 
Securities Exchange and Surveillance Commission was also moved into 
that organization. Japan-FSA has overseen the mergers of several large 
banks and reports progress in addressing the issue of nonperforming 
loans held by Japanese banks. In the review of Japan-FSA issued in 
2003, however, IMF raised questions about the independence and 
enforcement powers of the agency.

The Netherlands and Australia Have Consolidated Their Regulatory 
Structure Using the Twin Peaks Model:

Both the Netherlands and Australia consolidated their regulatory 
structure, but they did not adopt the single regulator structure. 
Instead, they adopted a structure that separates the regulators by 
objective,[Footnote 40] such that one regulatory body is responsible 
for prudential regulation and another for conduct-of-business 
regulation--often referred to as the twin peaks model.

In 2001, when the Netherlands Ministry of Finance proposed a 
restructuring of the financial regulatory structure, the country had 
three regulatory bodies--the Dutch Central Bank regulated banks, the 
Pensions and Insurance Supervisor regulated insurance, and the 
Securities Board regulated securities. Both the Central Bank and the 
Insurance Supervisor had some responsibility for financial stability. 
Since 1999, the Council of Financial Supervisors had helped to 
coordinate regulatory activities between the three agencies, but has 
received less attention as the country moves to the new structure.

The Netherlands is now in the final stages of consolidating its 
regulatory system and separating it into prudential and market conduct 
activities. The Pensions and Insurance Supervisor is merging with the 
Dutch Central Bank so that all prudential supervision will be done 
within the central bank, and in 2003, the Securities Board became the 
Netherlands Authority for the Financial Markets (AFM), the body 
responsible for market conduct in all segments of financial services.

As with the other countries, several factors contributed to the 
Netherlands' decision to change its regulatory structure. The 
Netherlands is the home of several of the largest, most globally active 
conglomerates. Supervision of these conglomerates had been divided 
among the three regulatory bodies and was not always consistent. As 
with the other central banks of other countries that adopted the Euro, 
the Dutch Central Bank no longer has primary responsibility for 
monetary policy or for the nation's currency. Like Germany, the 
Netherlands needed to clarify the role of its central bank after the 
formation of the European Central Bank.

With regard to its regulatory and supervisory roles, the Dutch Central 
Bank operates as an autonomous administrative authority. After the 
merger with the Pensions and Insurance Supervisor, its main objective 
is to ensure that banks, insurance companies, pension funds, and other 
financial service providers are sound businesses that can meet their 
liabilities to others now and in the future. The supervision focuses on 
protecting as well as possible the interests of consumers of financial 
services, whether they are individuals or businesses.

A three-person executive board, subject to oversight by a five-person 
supervisory board appointed by the Minister of Finance, manages AFM. 
According to its 2003 Annual Report, this authority's objectives are 
to:

* promote access to financial markets;

* promote the efficient, fair, and orderly operation of financial 
markets; and:

* ensure confidence in financial markets.

AFM is not organized around traditional industry sectors, but around 
three clusters of activities: Supervision Preparation, Supervision 
Implementation, and Business Operations.

In 1998, Australia's regulatory reforms provided for the establishment 
of the Australian Prudential Regulation Authority (APRA) to regulate 
the safety and soundness of financial institutions and the Australian 
Securities and Investments Commission (ASIC) to regulate corporations, 
market conduct, and consumer protection in relation to financial 
products and services. These changes followed a major study of 
Australia's regulatory regime--called the Financial System Inquiry or 
Wallis Report--that reported to the Australian Government in March 
1997. This report identified the following reasons for recommending 
reform:

* to achieve a more competitive and efficient financial system while 
maintaining financial market stability, prudence, integrity, and 
fairness;

* to design a regulatory framework that is adaptable to future 
financial innovations and other market developments; and:

* to ensure that the regulation of similar financial functions, 
products, or services is consistent between different types of 
institutions.

APRA, the safety and soundness regulator, provides prudential 
regulation for deposit-taking institutions, insurers, and pension 
funds. APRA consolidated prudential regulation responsibilities at the 
national level, taking on the responsibilities of nine regulatory 
agencies (the Reserve Bank of Australia, the Insurance Superannuation 
Commission and seven state-based regulators). It is an independent 
authority that is overseen by a three-person executive group. Its 
structure includes a risk management and audit committee and has four 
major divisions--diversified institutions, specialized institutions, 
supervisory support and policy, research and statistics.

ASIC is an independent commonwealth government body that has 
responsibility for regulating financial markets and corporations as 
well as consumer protection in relation to the provision of financial 
products and services, including securities, derivatives, pensions, 
insurance, and deposit taking. As one ASIC official put it, ASIC looks 
after consumers as individual customers, ensuring they receive proper 
disclosure, are dealt with fairly by qualified people, and continue to 
receive useful information about their investments. ASIC replaced the 
Australian Securities Commission, which had replaced the National 
Companies and Securities Commission at the federal level and the 
Corporate Affairs offices of the states and territories in 1991.

Along with APRA and ASIC, the Wallis report recommended that a Council 
of Financial Supervisors, initially composed of representatives of 
APRA, ASIC, and the central bank, be formed to deal with issues of 
coordination and cooperation. The council comprises high-level 
executives from each group and meets at least quarterly to discuss 
issues of mutual interest. As part of regulatory reforms flowing from a 
recent significant failure of an insurer, representatives of the 
treasury have also been included on the council.

Some U.S. States Have Also Consolidated Their Regulatory Structures 
Largely in Response to Industry Conglomeration and Product Convergence:

According to information provided by the Conference of State Bank 
Supervisors, in July 2004, 23 states supervise banking and either 
insurance or securities in one department. That information also shows 
that 14 states have consolidated financial regulatory structures, 
combining banking, securities, and insurance regulation into one 
department.[Footnote 41] We interviewed officials in large states--
Florida, Michigan, and Minnesota--that had consolidated their 
regulatory structures. Regulatory officials from each of these states 
told us they consolidated in response to industry changes that were 
blurring the traditional demarcations between banking, securities, and 
insurance activities. In all three states, officials said that although 
consolidation was not designed to conserve resources, they believed 
there had been cost savings due to consolidation.

State officials from Florida, Michigan, and Minnesota told us that 
consolidation had improved information sharing across different 
financial services sectors, specifically in the areas of licensing and 
customer complaints. Michigan has consolidated licensing of all sales 
agents, including mortgage, insurance, and securities. Now that all 
financial licensing is housed in one division, the state can more 
easily detect and discipline fraudulent behavior. For instance, 
individuals who have recently lost their license to sell securities due 
to fraudulent or other criminal acts cannot apply for a license to sell 
insurance or mortgages. Consolidation of customer complaints call 
centers has enabled Florida, Michigan, and Minnesota to downsize 
personnel and provide better services to consumers of financial 
products, according to officials from those states.

United States Has Chosen to Maintain the Federal Regulatory Structure, 
although Proposals Have Been Made to Change It:

While GLBA removed restrictions against affiliations among financial 
services providers across sectors, it did not change the financial 
services regulatory structure. Over the years, many proposals had been 
made to change the U.S. regulatory structure. Many of the proposals, 
including one we made in 1996, have concerned reducing the number of 
federal bank regulators. Suggestions have also been made to combine SEC 
and CFTC, and to consolidate the securities SRO structure. In addition, 
proposals for an optional federal charter for insurance companies are 
currently being considered. Finally, some proposals for consolidating 
across sectors were made in the discussions leading up to the passage 
of GLBA, and that law did not end calls for regulatory restructuring 
across sectors.

GLBA Permitted Affiliations across Areas without Changing the 
Regulatory Structure:

While GLBA removed many of the barriers that had restricted firms from 
engaging in banking, securities, and insurance activities, thus 
allowing many financial services firms to offer a wider array of 
services, it did not change the regulatory structure. By allowing 
banking organizations, securities firms, and insurance companies to 
affiliate with each other through a financial holding company 
structure, GLBA addressed several regulatory developments that had 
already permitted the affiliation of depository institutions with 
providers of nonbanking financial services. In 1998, the Federal 
Reserve had permitted Citicorp, at the time the largest bank holding 
company in the United States, to become affiliated with Travelers 
Group, a diversified financial services firm engaged in insurance and 
securities activities.[Footnote 42] Without the adoption of GLBA, the 
combined entity would have been subject to a requirement to divest or 
otherwise restructure many of its securities and insurance activities. 
In addition, OCC had promulgated regulations permitting national bank 
subsidiaries to engage in activities that were not permissible for the 
banks themselves.[Footnote 43] Moreover, as discussed earlier, most 
thrift holding companies were not subject to activities restrictions. 
GLBA codified regulatory developments that had already allowed expanded 
services within a holding company or from a national bank subsidiary.

After GLBA, banking, securities, and insurance activities continued for 
the most part to be regulated by the same primary federal regulator 
that had regulated them when only separate firms could participate in 
each activity. For instance, SEC primarily regulates securities 
activities regardless of where they occur within a financial holding 
company structure.[Footnote 44] Similarly, states continue to be 
responsible for regulation of insurance underwriting and other 
insurance-related activities undertaken by insurance 
companies.[Footnote 45] However, because the blurring of distinctions 
that once separated the financial products and services of banks, 
securities firms, and insurances companies also could blur the 
regulatory responsibilities of their respective regulators, GLBA 
contains provisions designed to enhance regulatory consultation and 
coordination. For example, with respect to insurance activities by 
insurance companies that are part of a financial holding company, the 
act calls for consultation, coordination, and information sharing among 
federal financial regulators and state insurance regulators.[Footnote 
46] In addition, although GLBA established the Federal Reserve as the 
umbrella regulator of financial holding companies, the act requires the 
Federal Reserve generally to coordinate with and defer to the 
"functional" regulators with respect to the institutions they 
regulate.[Footnote 47] Federal Reserve supervision of holding companies 
is to focus primarily on the consolidated risk position of the entire 
holding company, the risks the holding company system may pose to the 
safety and soundness of any of its depository institution subsidiaries, 
and compliance with consumer protection laws it is charged with 
enforcing.[Footnote 48] GLBA also retained OTS responsibility for 
supervising thrift holding companies, although it did limit the ability 
of nonfinancial companies to obtain thrift charters after May 4, 1999. 
In addition to establishing the scheme for the regulation of 
consolidated financial organizations involving a bank or thrift, GLBA 
provided for a program allowing for consolidated supervision by the SEC 
of investment bank holding companies.

One area for which GLBA discussed a potential new regulatory agency was 
insurance. As an incentive for states to modernize and achieve 
uniformity in insurance regulation, GLBA provided for a federal 
licensing agency, the National Association of Registered Agents and 
Brokers, that was to come into existence three years after the 
enactment of GLBA, if a majority of states failed to enact legislation 
for state uniformity or reciprocity.[Footnote 49] However, that agency 
has not come into existence because a majority of the states adopted 
the types of laws and regulations called for in the section.

Since 1990, Various Proposals Have Sought to Simplify the Bank 
Regulatory Structure and Reduce the Number of Regulators:

According to FDIC, many regulatory restructuring proposals concerned 
the restructuring of the multiagency system for federal oversight of 
banking institutions in the United States have been made since the 
1930s, when federal deposit insurance was introduced. Since 1990 
several additional proposals have been made, including the following 
three made between 1993 and 1994:

* 1994 Treasury proposal.[Footnote 50] This proposal would have 
realigned the federal banking agencies by core policy functions--that 
is, bank supervision and regulation function, central bank function, 
and deposit insurance function. Generally, this proposal would have 
combined OCC, OTS, and certain functions of the Federal Reserve and 
FDIC into a new independent agency, the Federal Banking Commission, 
that would have been responsible for bank supervision and regulation. 
FDIC would have continued to be responsible for administering federal 
deposit insurance, and the Federal Reserve would have retained central 
bank responsibilities for monetary policy, liquidity lending, and the 
payments system. Although FDIC and the Federal Reserve would have lost 
most bank supervisory rule-making powers, each would have been allowed 
access to all information of the new agency as well as limited 
secondary or backup enforcement authority. In addition, the Federal 
Reserve would be authorized to examine a cross section of large and 
small banking organizations jointly with the new agency. FDIC would 
have continued to oversee activities of state banks and thrifts that 
could pose risks to the insurance funds and to resolve failures of 
insured banks.

* H.R. 1227 (1993).[Footnote 51] This proposal would have consolidated 
OCC and OTS in an independent Federal Bank Agency and aligned 
responsibilities among the new and the other existing agencies. It also 
would have reduced the multiplicity of regulators to which a single 
banking organization could be subject, while avoiding the concentration 
of regulatory power of a single federal agency. The role of the Federal 
Financial Institution Examination Council would have been strengthened; 
it would have seen to the uniformity of examinations, regulation, and 
supervision among the three remaining supervisors. According to a 
Congressional Research Service (CRS) analysis, this proposal would have 
put the Federal Reserve in charge of more than 40 percent of banking 
organization assets, with the rest divided between the new agency and a 
reorganized FDIC.[Footnote 52]

* 1994 LaWare proposal.[Footnote 53] The LaWare proposal was outlined 
in congressional testimony, but never presented as a formal legislative 
proposal, according to Federal Reserve officials. It called for a 
division of responsibilities defined by charter class and a merging of 
OCC and OTS responsibilities. The two primary agencies under the 
proposal would have been an independent Federal Banking Commission and 
the Federal Reserve, which would have supervised all independent state 
banks and all depository institutions in any holding company whose lead 
institution was a state-chartered bank. The new agency would have 
supervised all independent national banks and thrifts and all 
depository institutions in any banking organization whose lead 
institution was a national bank or thrift. FDIC would not have examined 
financially healthy institutions, but would have been authorized to 
join in examination of problem banking institutions. Based on estimates 
of assets of commercial banks and thrifts performed by CRS, the LaWare 
proposal would have put the new agency in charge of somewhat more 
commercial bank assets than the Federal Reserve.

In 1996, we also recommended ways to simplify bank oversight in the 
United States in accord with four principles for effective supervision:

* consolidated and comprehensive oversight of entire banking 
organizations, with coordinated functional regulation and supervision 
of individual components;

* independence from undue political pressure, balanced by appropriate 
accountability and adequate congressional oversight;

* consistent rules, consistently applied for similar activities; and:

* enhanced efficiency and as low a regulatory burden as possible 
consistent with maintaining safety and soundness.

We recommended consolidating the primary supervisory responsibilities 
of OTS, OCC, and FDIC into a new, independent federal banking agency or 
commission. This new agency, together with the Federal Reserve, would 
be assigned responsibility for consolidated, comprehensive supervision 
of those banking organizations under its purview, with appropriate 
functional supervision of individual components. We also recommended 
that in order to carry out its primary responsibilities effectively, 
the Federal Reserve should have direct access to supervisory 
information as well as influence over supervisory decision making and 
the banking industry. In addition, we recommended that Treasury have 
access to supervisory information, including information on the safety 
and soundness of banking institutions that could affect the stability 
of the financial system. Furthermore, we recommended that under any 
restructuring, FDIC should have an explicit backup supervisory 
authority to enable it to effectively discharge its responsibility for 
protecting the deposit insurance funds. In coordination with other 
regulators, such authority should allow FDIC to go into any problem 
institution on its own without the prior approval of any other 
regulatory agency.

Partly in Response to Market Convergence, Proposals Have Been Made to 
Consolidate Securities and Futures Regulators:

Over the years, proposals have been made to consolidate SEC and CFTC, 
partly in response to increasing convergence in new financial 
instruments and trading strategies of the securities and futures 
markets. For instance, according to a 1990 CRS study, futures contracts 
based on financial instruments such as stock indexes are used by 
securities firms and large institutional investors simultaneously and 
are sometimes interchangeable with certain securities products. 
However, these transactions are regulated separately by CFTC and SEC. 
Prior to the passage of the Commodity Futures Modernization Act (CFMA) 
in 2000, the two agencies had disagreed on the jurisdiction of certain 
derivatives. In addition, new trading strategies involving both 
securities and futures transactions that have significant potential 
impacts on price movements have called for the need for better 
monitoring. Treasury also proposed three options to address these 
industry changes: (1) merging SEC and CFTC, (2) giving SEC regulatory 
authority over all financial futures, or (3) transferring regulation of 
stock index futures from CFTC to SEC.

In 1995, Members of Congress introduced the Markets and Trading 
Reorganization and Reform Act, which was intended to improve the 
effectiveness and efficiency of financial services regulation by 
merging SEC and CFTC. In testimony before the House Committee on 
Banking and Financial Services, we presented the major benefits and 
risks of merging SEC and CFTC, as well as specific issues related to 
this bill, to be considered in merging the two agencies. The 
anticipated benefits of a merger would have included reduced regulatory 
uncertainty concerning the two agencies' regulatory jurisdictions over 
particular financial products, a clarification that would likely have 
enhanced market efficiency and innovation. Another potential benefit we 
identified was greater ease in conducting international regulatory 
negotiations. We also identified some risks involved in such a merger, 
including (1) a potential for over-regulation that might have resulted 
in decreased market innovation and (2) a potential dominance of one 
market and regulatory perspective to the detriment of the other. In 
addition, we noted some operational risk that might arise during the 
transition to a single government agency, such as differences in 
institutional cultures and histories. Finally, we cautioned those 
considering the merger about the difficulty of quantifying both 
potential benefits and risks, and noted further that a merger might 
yield only small budgetary cost savings.

Efforts Have Been Made to Change the SRO Structure for Securities:

In 2002, NASD completed the sale of its subsidiary Nasdaq Stock Market 
Inc. (NASDAQ), in recognition of the inherent conflicts of interest 
that exist when SROs are both market operators and regulators. These 
conflicts had become evident in the mid-1990s when NASD was under 
scrutiny for price fixing. Concerns about conflicts of interest and 
regulatory inefficiencies also prompted proposals to simplify the SRO 
structure for securities. In January 2000, the Securities Industry 
Association (SIA) detailed the following three possibilities for 
changing the SRO structure.[Footnote 54]

* Hybrid SRO model. Under this model, a single consolidated entity 
unaffiliated with any market would have assumed responsibility for 
broker-dealer self-regulation and cross-market issues, such as those 
related to sales practices, industry admissions, financial 
responsibility, and cross-market trading. Individual SROs would have 
remained responsible for market-specific rules, such as those related 
to listings, governance, and market-specific trading. The majority of 
SIA members believed that the hybrid SRO model would reduce member-
related conflicts of interest and SRO inefficiencies. Eliminating 
duplicative SRO examinations, in their view, would have reduced 
inefficiencies in areas such as rule making, examinations, and 
staffing. SEC officials agreed that consolidating member regulation 
into one SRO could be an advantage of the hybrid SRO model. They noted 
that the industry was moving toward a hybrid model as NASDAQ separated 
from NASD and NASD contracted to provide regulatory services to more 
SROs.

* Single SRO model. Under this model, a single SRO would have been 
vested with responsibility for all regulatory functions currently 
performed by the SROs, including market-specific and broker-dealer 
regulation. According to SIA, the single SRO model could have 
eliminated the conflicts of interest and regulatory inefficiencies 
associated with multiple SROs, including those that would remain under 
the hybrid SRO model. However, SIA did not endorse this alternative, 
primarily because of the risk that self-regulation would have become 
too far removed from the functioning of the markets. In May 2002, we 
reported that, according to SEC officials, it might not be appropriate 
or feasible to give a single SRO responsibility for surveilling all of 
the markets, such as NASDAQ and NYSE, which have different rules that 
reflect differences in the way trades are executed.[Footnote 55]

* SEC-only model. Under this model, SEC would have assumed all of the 
regulatory functions currently performed by SROs. SIA did not endorse 
the SEC-only model because doing so would have eliminated self-
regulation of the securities industry, taking with it the expertise 
that market participants contribute. SIA also expected the SEC-only 
model would have been more expensive and bureaucratic, because 
implementing it would have required additional SEC staff and mechanisms 
to replace SRO regulatory staff and processes. In addition, according 
to SIA's report and SEC, a previous SEC attempt at direct regulation 
was not successful, owing to its high cost and low quality (relative to 
self-regulation), and this convinced SEC and other market participants 
that it was not a feasible regulatory approach.[Footnote 56]

We reported in 2002 that at that time, none of the models appeared to 
have the support from market participants that would be needed for 
implementation. However, since that time the governance structures of 
SROs have been under greater scrutiny.

Proposals Have Been Made for an Optional Federal Insurance Charter:

While proposals to regulate insurance at the federal level have been 
made from time to time, since 2000 this idea has been gathering steam. 
Several trade associations have made proposals for some federal 
regulation of insurance, and bills have been introduced in Congress. 
According to a CRS study, two bills introduced in the 107th Congress--
the National Insurance Chartering and Supervision Act and the Insurance 
Industry Modernization and Consumer Protection Act--included an 
optional federal charter for insurance companies that would be similar 
to a national bank charter. The proposals would have required the 
creation of a federal insurance regulator. These proposals suggested 
creating a new federal agency (similar to OCC and OTS) in Treasury. A 
bill introduced in July 2003, the Insurance Consumer Protection Act, 
would create a federal commission within the Department of Commerce to 
regulate the interstate business of property-casualty and life 
insurance and require federal regulation of all interstate insurers. It 
thus would pre-empt most current state regulation of insurance. 
Generally, these proposals differed in whether a federal charter would 
include insurance agencies, brokers, or agents and where a federal 
regulator would be housed.

Supporters of an optional federal charter include members of trade 
associations that generally represent the interests of larger life and 
property-casualty insurers--the American Council of Life Insurers, the 
American Bankers Insurance Association, and the American Insurance 
Association. These and other supporters have argued that an optional 
federal charter had benefited the banking sector by encouraging 
competition, regulatory efficiency, and product expansion and would 
benefit insurers by (1) removing the disadvantage large insurers have 
in competing with other financial service providers because large 
insurers have to comply with multiple state insurance standards; (2) 
allowing for more innovation among insurers because they would no 
longer have to secure product approval from different state regulators; 
(3) better representing the industry in federal policy and 
international trade negotiations through a single federal regulator; 
and (4) allowing consumers to have more product choices and more 
uniform protections across states.

Opponents of an optional federal charter, including some smaller life 
insurers, property-casualty insurers specializing in local services 
such as auto and homeowners insurance, and consumer groups, have argued 
that creating a new federal regulator would (1) create competition over 
industry charters between the federal regulator and state regulators 
and hence cause deterioration in the state regulatory system and 
industry regulatory standards; (2) lead to the loss of regulatory 
innovation and the testing and emergence of better policies because the 
current state system allows for regulatory innovation; and (3) be more 
costly than supporting NAIC's current efforts to achieve uniformity in 
the state system; and (4) be less responsive to consumer needs.

Proposals Made Before and After GLBA Cut across Functional Areas:

Prior to the passage of GLBA, some proposals to restructure the U.S. 
regulatory system concerned regulators across the financial services 
sectors. For example, in the early 1990s the Chicago Mercantile 
Exchange proposed that all federal financial regulation, including that 
of OCC, OTS, FDIC, CFTC, SEC, and certain functions of the Federal 
Reserve, be consolidated into "a single cabinet level department within 
the executive branch" to, among other things, facilitate regulatory 
coordination and allow for equal regulation of similar products, 
services and markets. In 1997, a congressional proposal included a 
National Financial Services Oversight Committee with representatives 
from Treasury, each of the federal bank regulators, SEC, and CFTC that 
would, among other things, establish uniform examination and 
supervision standards for financial services providers and identify 
providers that require "special supervisory attention." Following the 
passage in 1999 of GLBA, which did not change the regulatory structure, 
calls for regulatory restructuring across sectors continued, including 
a recommendation in 2002, by the Chairman of FDIC, for a single bank 
regulator, securities regulator, and insurance regulator at the federal 
level.

[End of section]

Chapter 4: Regulators Are Adapting Regulatory and Supervisory 
Approaches in Response to Industry Changes:

Although the U.S. regulatory structure has not changed in response to 
the industry changes we have identified--globalization, consolidation, 
conglomeration, and convergence--some U.S. regulators have adapted 
their regulatory and supervisory approaches to these changes. Some of 
these adaptations, especially those related to large, internationally 
active firms, have been made as part of or in response to efforts to 
achieve some degree of harmonization across the major industrial 
nations and within the EU. Some U.S. regulatory agencies have also made 
or considered other changes in response to the industry changes that we 
have identified.

New Basel II Structure and EU Requirements Will Likely Affect Oversight 
of U.S. Financial Institutions:

As part of the evidence of continuing globalization and increased 
complexity of financial institutions, the Basel Committee adopted a new 
set of standards (Basel II) in June 2004 that member and nonmember 
countries may adopt.[Footnote 57] These Basel II requirements are 
designed to address some of the shortcomings of the Basel I standards, 
and include supervision and market discipline requirements as well as 
standards for minimum capital levels. U.S. bank regulators are in the 
process of determining how to apply these standards for large, 
internationally active firms. Because the EU is requiring securities 
firms and other firms with significant insurance operations operating 
in the EU to adopt Basel standards as part of its Action Plan, 
international harmonization efforts are also having an impact on other 
U.S. regulators that oversee large, internationally active firms.

While U.S. Regulators Applied Basel I Standards to All Banks, They 
Propose to Require Only Large, Internationally Active Banks to Adopt 
Basel II Standards:

In 1988, the Basel Committee adopted the Basel Accord for international 
convergence of capital standards (now referred to as Basel I) to 
provide uniform risk-based capital requirements with the objectives of 
strengthening the soundness and stability of the international banking 
system and diminishing a source of competitive inequality among 
international banks. These risk-based capital requirements, which were 
available for implementation in the Basel Committee members' countries 
between 1990 and 1992, focused on limiting credit risk by requiring 
certain firms to hold capital equal to at least 8 percent of the total 
value of their risk-weighted on-balance sheet assets and off-balance 
sheet items, after adjusting the value of the assets according to 
certain rules intended to reflect their relative risk.[Footnote 58] 
U.S. bank regulators applied these standards to banks and bank holding 
companies. Basel I was amended in 1996 to include capital requirements 
for market risks for those banks or bank holding companies with a 
certain amount of securities and derivatives trading activity or, if 
deemed necessary by the regulator for safety and soundness purposes. 
Although Basel I generally is credited with improving the regulatory 
capital levels of most banks and reducing competitive inequities among 
international banks, it did not fully address changes and risks arising 
from increasingly complex financial markets. For instance, Basel I did 
not account for the internal credit risk mitigation activities of 
large, internationally active banks. Also, the limited number of risk-
weighted categories under Basel I meant that the standards had limited 
risk sensitivity. This has, among other outcomes, allowed banks to take 
on higher risk assets within each category without having to hold more 
capital for regulatory purposes. Moreover, Basel I did not explicitly 
account for operational risks, such as poor management or security and 
process failures.

Basel II, which is available for implementation in banking 
organizations in 2006 or 2007, is intended to address the shortcomings 
of Basel I. As illustrated in figure 7, Basel II has three pillars: (1) 
minimum capital requirements, (2) supervision of capital adequacy, and 
(3) market discipline in the form of increased disclosure.

Figure 7: The Three Pillars of Basel II:

[See PDF for image]

[End of figure]

Under the first pillar of Basel II--the definition of capital--the 
treatment of market risk and the minimum capital requirement of 8 
percent of risk-weighted assets remain the same as that in Basel I. 
With regard to credit and operational risk, however, Basel II allows 
firms with sophisticated risk management systems--generally large or 
internationally active firms--to use their internal risk assessment 
models and techniques to determine the appropriate amount of regulatory 
capital, with certain restrictions. These advanced approaches will not 
be available for implementation until the end of 2007.

The second pillar of Basel II focuses on supervisory review of and 
action in response to banks' capital adequacy. Supervisory review is 
expected to capture potential risks, including those that are external 
to banks, that are not fully captured under Pillar I and to assess 
banks' compliance with minimum standards and disclosure requirements of 
the more advanced capital calculation options being used by some firms. 
Supervisors are to evaluate banks' assessment, monitoring, and 
maintenance of their capital adequacy relative to their risk profile, 
including compliance with regulatory capital ratios. Supervisory review 
can involve on-site examinations or inspections, off-site review, 
discussions with bank management, review of work done by external 
auditors, and periodic reporting. Basel II calls for supervisors to 
intervene at an early stage to prevent capital from falling below 
minimum levels and to require remedial action if capital is not 
maintained or restored.

The third pillar of Basel II--market discipline--calls for banks to 
disclose information about their risk profile, risk assessment 
processes, and adequacy of their capital levels. The rationale is that 
a bank's borrowing and capital costs will rise if market participants 
perceive a bank to be risky, and banks will thus have an incentive to 
refrain from excessive risk taking. Members of the Basel Committee note 
that market discipline will become more important once banks are using 
their internal models and techniques to make capital decisions.

In recognition that large, internationally active banks pose different 
risks and use different risk management techniques than smaller, less 
internationally active banks, U.S. regulators are proposing to require 
that only a number of large, internationally active institutions comply 
with capital standards that are consistent with Basel II. Federal 
regulators expect that fewer than 10 large, internationally active 
banking organizations will be required to operate under rules 
consistent with Basel II by the end of 2007. Under current proposals, 
other U.S. banks that satisfy certain requirements will have the option 
of implementing the Basel II framework, and federal regulators expect 
roughly another 10 large banking organizations to adopt capital 
standards consistent with Basel II requirements.

EU Financial Conglomerates Directive Is Requiring Some Securities and 
Insurance Firms to Have Consolidated Supervision and Apply Basel 
Capital Standards:

Certain directives in the EU Action Plan, especially the Financial 
Conglomerates Directive, will impact some internationally active firms 
in the United States, especially those that have not been subject to 
bank or financial holding company oversight by the Federal Reserve 
because they do not own commercial banks. In recognition of the risks 
posed by financial conglomerates and other financial firms that do not 
have consolidated supervision, the directive specifies minimum 
requirements for consolidated supervision of such firms conducting 
business in the EU. The directive defines a financial conglomerate as a 
firm with insurance operations that also engages in banking or 
securities activities. In addition, the directive requires that non-
European conglomerates, banks, and securities firms have adequate 
consolidated supervision, which would generally include application of 
Basel standards.[Footnote 59] Under the directive, which goes into 
effect at the beginning of 2005, a non-European financial conglomerate 
or group that has a banking presence in the EU that is not considered 
to be supervised on a consolidated basis by an equivalent home country 
supervisor would be subject to additional requirements by EU 
regulators, which could include additional direct supervision.

U.S. regulators that provide or might provide consolidated oversight--
the Federal Reserve, OTS, and SEC, among others--responded to EU 
requests for information about their activities as holding company 
supervisors. This information was used to develop EU guidance for EU 
country regulators in determining whether U.S. firms doing business in 
EU countries have consolidated supervision that is equivalent to that 
required to be in place in EU host countries. According to EU 
officials, specific regulators in EU countries will use this guidance 
to determine whether a specific U.S. company operating in Europe has 
adequate consolidated supervision.

Officials at the Federal Reserve say that they do not expect to have to 
make any changes in the way they oversee bank or financial holding 
companies to be deemed an equivalent home country supervisor for 
affected companies under their supervision. However, because U.S. 
securities firms that are not owned by a bank or financial holding 
company are currently not supervised on a consolidated basis the way 
bank and financial holding companies are,to comply with the directive, 
these securities firms that conduct business in the EU will need to 
have a consolidated supervisor sometime in 2005.[Footnote 60] Some of 
these firms requested that SEC develop a program to provide them with 
consolidated supervision, and SEC responded with its CSE proposal. 
Firms opting to become CSEs will be subject to capital requirements 
that are consistent with Basel standards,[Footnote 61] which are 
described by the rules governing CSEs as an alternative to the net 
capital requirements generally required for broker dealers.[Footnote 
62] Because the requirements of Basel II were not established with U.S. 
securities firms in mind, SEC staff notes that it is participating in a 
joint working group established by IOSCO and the Basel Committee to 
address issues relating to the treatment of positions held in the 
trading book. One issue of interest to holding companies with broker-
dealer subsidiaries is the development of a more risk-based approach to 
capital requirements for securities activities. For example, since the 
Basel II standards were developed with the expectation of long-term 
credit exposures that are common for banks, securities firms believe 
that credit risk in their trading books that have much shorter 
exposures is overstated using Basel II requirements. IOSCO and the 
Basel Committee have had several meetings to discuss this and other 
issues.

With regard to required examination and disclosure requirements at the 
consolidated level, SEC says it expects to better monitor the financial 
condition, risk management, and activities of a broker-dealer's 
affiliates that could impair the financial and operational stability of 
the broker-dealer or CSE.SEC will examine regulated affiliates of CSE's 
that do not have a principal U.S. regulator, but will defer to the UK-
FSA (or another EU regulator) to examine affiliates in EU countries. 
For the ultimate holding company, SEC will examine the holding company 
unless it determines that it is already subject to "comprehensive, 
consolidated supervision" by another principal regulator. Thus, bank or 
financial holding companies generally would be exempt from SEC 
examination. In the case of holding companies, SEC believes the 
disclosure requirements that are part of Basel II are not consistent 
with those required by SEC.[Footnote 63] However, SEC staff said that 
they would apply Basel II disclosure standards while working to make 
them more consistent. SEC says that data being collected by the Basel 
Committee to measure the impact of Basel II will include data from the 
large securities firms that will register as CSEs, and this may allow 
the standards to better reflect the risks of these firms over time.

In response to the Financial Conglomerates Directive, U.S. and other 
firms with insurance and banking operations in the EU will need to 
choose a consolidated regulator and comply with Basel II. OTS is 
responsible for the consolidated supervision of Thrift Holding 
Companies, including a number of firms that are conglomerates under the 
EU directive. Some of the largest such firms may choose OTS as their 
consolidated supervisor for purposes of the directive. These firms 
qualify as thrift holding companies because they own a thrift under the 
exemption provided before May 1999 or have obtained a thrift charter 
since then. Officials at OTS say that 40 companies with insurance 
operations are now thrift holding companies, but not all of these are 
operating in EU countries or would be deemed conglomerates. These 
companies may not qualify as financial holding companies because they 
do not own a commercial bank and the scope of their activities, which 
may include commercial enterprises, make doing so impractical. 
Furthermore, they may not qualify for SEC oversight because they do not 
have a broker-dealer affiliate with a substantial presence in the 
securities markets. OTS expects its level of supervisory coordination 
with foreign regulators to increase as a result of the EU directive.

U.S. Regulators Have Made or Considered Some Other Changes to Their 
Regulatory and Supervisory Approaches in Response to Industry Changes:

Because of the increased size and complexity of some banks, U.S. bank 
regulators had adopted risk-focused examination procedures that tailor 
reviews to key characteristics of each bank, including its asset size, 
products offered, markets in which it competes, and its tolerance for 
risk. In recognition of the increased size of the largest banks and the 
possibility that shareholders and creditors believe that these banks 
are too big for regulators to allow them to fail, regulators have 
considered requiring banks to issue subordinated debt as a mechanism to 
enhance market discipline of banking institutions. However, regulators 
have not adopted this requirement, because evidence of its potential 
effectiveness is limited. Bank regulators also have adjusted their 
approaches in response to what appears to be heightened concern about 
reputational risk. SEC had made some changes related to the increased 
size and complexity of securities firms prior to adopting its 
consolidated supervision rules in response to the EU financial 
conglomerates directive. These changes affected the collection of 
information related to risk management from the parents and affiliates 
of broker-dealers. While CFTC and state insurance regulators will not 
adopt Basel II requirements, they have made other changes that 
acknowledge how the industry is changing. CFMA acknowledges the 
increasingly global nature of the futures industry and the increasing 
importance of new financial products. As a result of property-casualty 
failures in the 1980s and recognition of changes in the insurance 
industry, NAIC adopted a new Solvency Policy Agenda that included risk-
based capital and the creation of a Financial Analysis Unit that 
analyzes the behavior of insurers that operate across state lines.

U.S. Bank Regulators Adopted Risk-Focused Supervision for Large, 
Complex Firms and Made or Considered Other Changes:

In response to the development of large, complex banking organizations 
with diverse and changing risks and sophisticated risk management 
systems, U.S. bank regulators have generally placed greater emphasis on 
examining an institution's internal control systems and on the way it 
manages and controls its risks, rather than on assessing a bank's 
condition at a specific point in time. The federal bank regulators 
generally apply risk-focused examinations. We reported in 2000 that 
since the mid-1990s, the Federal Reserve and OCC have developed and 
refined their on-site examination policies and procedures for large, 
complex banks to focus on risk assessments along business lines, which 
often cross bank charters within the banking organization.[Footnote 64] 
Under the risk-focused approach, Federal Reserve and OCC examiners are 
to continually monitor and assess an institution's financial condition 
and risk management systems through the review of a variety of 
management reports and frequent meetings with key bank officials, 
documenting the areas they select for review, including their rationale 
for selecting those areas. Federal Reserve officials noted that 
detecting fraud remains a difficult task under the risk-focused 
approach, but that the approach was designed to detect the areas of a 
bank's (or bank holding company's) activities that posed the greatest 
risk to the safety and soundness of the institution.

In 2002, FDIC adopted an agreement with OTS, OCC, and the Federal 
Reserve that allows FDIC to examine insured depository institutions 
that pose a greater than normal risk to the deposit insurance funds. 
According to FDIC's annual report, under the agreement FDIC has 
assigned dedicated examiners to each of the eight largest insured 
banking institutions to monitor their financial condition and risk 
management processes and obtain timely information on the potential 
risks of these institutions. As FDIC is not the primary regulator of 
these institutions, it will rely on supervisory information provided by 
the primary regulators. In 2003, FDIC established a Risk Analysis 
Center to analyze information generated from the dedicated examiner 
program, among other tasks.

One change that has been discussed but not made in response to the 
growing size of banks is whether banks should be required to issue 
subordinated debt as a market discipline tool. The usual disclosure 
requirements for publicly traded companies may not be sufficient for 
large banks because shareholders may believe that the banks are too big 
for regulators to allow them to fail. Because subordinated creditors 
are especially sensitive to risks that a bank may fail, mandatory 
issuance of subordinated debt has been proposed as a means of enhancing 
market discipline to inhibit risk-taking activities and limit losses to 
the insurance funds when excessive risk taking damages a bank. 
Requiring banks to issue subordinated debt has been discussed in 
relation to the market discipline pillar of Basel II, but no such 
requirement appears in the standards adopted in June 2004. Similar 
proposals have not been adopted in the United States. GLBA directed the 
Federal Reserve and Treasury to study the feasibility of requiring 
depository institutions that pose significant systemic risk and their 
holding companies to maintain some portion of their capital in the form 
of subordinated debt. The Federal Reserve and Treasury supported the 
use of subordinated debt as a way of enhancing market discipline but 
said that more evidence would be needed to make such a policy 
mandatory. According to the report, almost all of the largest banking 
organizations had voluntarily issued and had subordinated debt 
outstanding in excess of 1 percent of their assets, providing some 
degree of direct market discipline and transparency. The Federal 
Reserve, OCC, and OTS agreed to continue to use various data and 
supervision to evaluate the use of subordinated debt.

U.S. bank regulators are also charged with ensuring that banks comply 
with various consumer protection laws and laws concerning money 
laundering and corporate governance issues. In addition to safety and 
soundness examinations, banks are also subject to examinations that 
evaluate their performance in meeting the needs of their communities 
under the Community Reinvestment Act and their compliance with anti-
money laundering rules under the Bank Secrecy Act and the USA PATRIOT 
Act. The regulatory agencies recently announced new examination 
procedures for banks' customer identification programs, for instance; 
this program was required under section 326 of the USA PATRIOT 
Act.[Footnote 65] Regulators also note that failure to comply with 
consumer protection and anti-money laundering laws and regulations can 
endanger a bank's safety and soundness because they may affect the 
bank's reputation. For example, OCC asserts that predatory lending 
practices in national banks could damage the reputations and thus the 
safety and soundness of those institutions. Furthermore, recent money 
laundering activities at some banks--which could affect the reputation 
of those banks--appear to have heightened regulatory efforts to prevent 
such activity.

SEC Had Made Changes Related to Size and Complexity of Firms Prior to 
Becoming a Consolidated Regulator:

With regard to adopting consolidated regulations for CSEs and SIBHCs, 
SEC officials said that what appear to be significant changes in their 
regulatory and supervisory approach are merely continuations of 
previously ongoing trends that recognized the increased size and 
complexity of many securities firms. Further, SEC officials recognize 
that because of the size of the parent firms, the sudden failure of a 
large securities firm that has broker-dealer affiliates could have a 
major impact on markets and investors.

SEC says that in setting capital requirements, it has been concerned 
with the safety and soundness of broker-dealers for some time. Since 
1975, the net capital rule has required that broker-dealers maintain a 
minimum level of net capital sufficient to satisfy all obligations to 
customers and other market participants and to provide a cushion of 
liquid assets to cover potential credit, market, and other risks. SEC 
amended its net capital rule in early 1997 to allow broker-dealers to 
use statistical models to calculate required capital charges for 
exchange-traded financial instruments to better reflect market risk. In 
1999, SEC adopted an optional regulatory framework that includes 
alternative net capital requirements for OTC derivatives dealers. Under 
this framework, OTC derivatives dealers may be permitted to use 
statistical models to calculate capital charges for market risk and to 
take alternative charges for credit risk. SEC rules also require firms 
to integrate their statistical models into their daily risk management 
processes and establish a system of internal controls to monitor and 
manage the risks associated with their business activities, including 
market, credit, leverage, liquidity, legal, and operational risks. With 
regard to supervision of risk management of securities firms, SEC 
officials say that they have long sought more information on the 
parents and affiliates of broker-dealers. Since 1992, SEC has collected 
risk assessment information from securities firms that own large 
broker-dealers. And, beginning in 1999, SEC has held monthly 
discussions regarding these risk assessments.

Much of SEC's examination program is related to ensuring that SROs, 
broker-dealers, and investment advisers comply with federal securities 
laws and rules, including having adequate systems and procedures in 
place to ensure compliance. SEC's examination procedures have evolved 
over time. In the mid-1990s, SEC's examination office began conducting 
fewer full scope examinations, which review all aspects of operations, 
and more frequent risk-focused examinations, which focus on specific 
areas or issues. We noted in a 2002 report[Footnote 66] that although 
SEC officials said they had been able to maintain their examination 
schedules and workload with their existing staff levels, some officials 
were concerned that the cycle for certain types of reviews could 
stretch beyond the planned time frames. In that report, we noted SEC 
officials also said that newly implemented rules would add time and 
complexity to the reviews. Overall, SEC officials said their 
examination office had lost a lot of experienced staff at the junior 
level and that new staff requires constant training.

With the corporate governance and accounting scandals that came to 
light beginning in 2002 and with the 2003 revelation of market timing 
and late trading abuses in mutual funds, SEC has made additional 
changes in its compliance exams and developed rules to improve 
corporate governance. We have reported that SEC did not identify the 
abusive practices in mutual funds for several reasons, including the 
inherent difficulty of detecting fraud and the focus of examinations on 
operations of mutual funds rather than on trading in the funds 
themselves.[Footnote 67] In response to late trading and other abuses 
in the mutual fund industry, SEC says that it is reassessing its 
supervision of investment companies.

We also reported that anticipating and identifying problems in a timely 
manner is a continuing problem for SEC:

One of the challenges SEC faces is being able to anticipate potential 
problems and identify the extent to which they exist. Historically, 
limited resources have forced the SEC to be largely reactive, focusing 
on the most critical events of the day. In this mode, the agency lacked 
the institutional structure and capability to systematically anticipate 
risks and align agencywide resources against those risks. In an 
environment like this, it is perhaps not surprising that SEC was not 
able to identify the widespread misconduct and trading abuses in the 
mutual fund industry. Increasing SEC's effectiveness would require it 
to become more proactive by thinking strategically, identifying and 
prioritizing emerging issues, and marshaling resources from across the 
organization to answer its most pressing needs.[Footnote 68] SEC is in 
the process of staffing a new risk assessment office that may lead to 
more proactive risk-based policies in the future.

Futures and Insurance Regulators Have Not Adopted Basel Standards, but 
Have Made Changes in Their Regulatory and Supervisory Approaches:

Many of the changes being made in CFTC's regulatory and supervisory 
approaches have come as a result of the passage of CFMA in 2000. The 
primary goal of that legislation was to address changes in market 
conditions such as the introduction of a wider variety of products, 
including contracts based on individual stocks. CFMA replaced "one-
size-fits-all" regulation with broad, flexible core 
principles.[Footnote 69] Generally, the new rules recognize the speed 
with which these markets change by laying out core principles for 
participants and markets, rather than by specifying prescriptive 
rules.[Footnote 70] For example, a CFTC regulation requires that 
certain entities-derivatives transaction execution facilities and 
contract markets-provide authorities and the public with trading 
information such as trading practices and contract conditions and 
prices, and that they enforce rules to minimize conflicts of interest 
in the decision making process, but it does not require specific 
measures for carrying out the principles.[Footnote 71]

CFTC has also changed its net capital rules for FCMs to better reflect 
changes in the commodity business. To modernize capital requirements 
for FCMs, CFTC adopted rules in August 2004 that replace the net 
capital requirement based on segregated customer funds with minimum 
risk-based capital requirements. The new rules attempt to reflect an 
FCM's complete exposure to commodity positions carried for both 
customers and noncustomers. According to CFTC's 2003 annual report, the 
rules are expected to ensure that a firm's capital requirement reflects 
the risks of the futures and options positions it carries.

In addition to the self-regulatory programs administered by the 
exchanges and NFA, CFTC oversees the compliance activities of SROs 
through audits and financial surveillance to ensure that SRO member 
firms are properly capitalized, maintain appropriate risk management 
capabilities, and segregate customer funds. According to CFTC's 2003 
annual report, to meet CFMA objectives, in the early 2000s CFTC 
modified its oversight process for SROs, moving from compliance-based 
examinations to risk-focused programs that respond to regulatory core 
principles. These exams were to focus on an institution's exposure to, 
and internal controls for, managing underlying risks.These programs 
were first implemented in 2003 in an SRO oversight examination of the 
Chicago Mercantile Exchange covering "financial capacity, customer 
protection, risk management, market move surveillance and stress 
testing, and operational capability." According to its 2003 annual 
report, CFTC is also developing a risk management tool that uses data 
received from firm financial filings and large trader reports to 
proactively monitor firm risk exposure and assess trader losses from 
risky positions that may cause firms to become undercapitalized.

According to an NAIC official, during the mid-to the late 1980s, a high 
number of failures among property-casualty insurers as well as a 
collective recognition on the part of the insurance regulatory 
community that the industry was becoming more complex, in part, because 
of technological advances, globalization, and capital market 
innovations, led NAIC to adopt its Solvency Policy Agenda. The agenda 
was composed of a number of initiatives, including risk-based capital 
and the Financial Analysis Unit.

According to NAIC, by 1990 a number of states were experimenting with 
risk-based capital formulas, and NAIC approved risk-based capital 
standards for life insurance companies in 1992 and for property-
casualty insurers in 1993. NAIC developed and recommended that states 
adopt the Risk-Based Capital for Insurers Model Act, which gave state 
insurance regulators the authority to act on the results generated by 
the risk-based capital formulas. For life insurers, companies are 
required to hold minimum percentages of various assets and liabilities 
as capital, with these percentages based on the historical variability 
of the value of those assets and liabilities. Risk factors are to be 
applied, usually as multipliers, to selected assets, liabilities, or 
other specific company financial data to establish the minimum capital 
needed to bear the risk arising from that item (similar to risk-weights 
in banking).In addition, the risk-based capital formula requires the 
performance of sensitivity tests to indicate how sensitive the formula 
is to changes in certain risk factors.

NAIC's Solvency Policy Agenda also led to the setting up of the 
Financial Analysis Unit. This unit's mission is to assist insurance 
regulators in achieving their objective of identifying, at the earliest 
possible stage, insurance companies that may be financially troubled. 
In pursuit of this mission, the Unit performs financial analysis of 
insurance companies under the direction of an NAIC working group. The 
working group was formed to identify nationally significant insurance 
companies--large firms or firms operating in a number of states--that 
are, or may become, financially troubled, and to determine whether 
appropriate regulatory action is being taken with regard to these 
firms.

[End of section]

Chapter 5: Regulators Communicate and Coordinate in Multiple Ways, but 
Concerns Remain:

In a system with multiple financial services regulators, communication 
and coordination are essential to preventing duplication in agency 
oversight, while ensuring that all regulatory areas are effectively 
covered. U.S. federal financial services regulators communicate and 
coordinate with other federal, state, and foreign regulators within 
their sector, and state insurance regulators communicate and coordinate 
across states and with insurance regulators in other countries; 
however, in each sector concerns remain. To a lesser extent, financial 
services regulators communicate and coordinate across sectors with 
U.S., state, and foreign regulators, but coordinating regulatory 
activities and sharing information continue to be sources of concern. 
Agencies have had problems systematically sharing information across 
sectors, making it more difficult for regulators to identify potential 
crises, fraud, and abuse, and for consumers to identify the relevant 
regulators. In addition, regulators do not routinely assess risks that 
cross traditional regulatory and industry boundaries.

U.S. Financial Regulators Communicate and Coordinate with Other 
Regulators in Their Sectors, but Sometimes Find It Difficult to 
Cooperate:

Within each of the four sectors, federal regulators have established 
interagency groups to facilitate coordination and also communicate 
informally on a variety of issues. Within sectors the federal 
regulators generally communicate with each other, with SROs, with 
relevant state regulators, and with their international counterparts. 
In insurance, NAIC is the primary vehicle for state regulators to 
communicate with each other and to coordinate with insurance regulators 
in other countries.

Federal Banking Regulators Coordinate Their Activities, but Bank 
Failures and International Negotiations Have Been Problematic:

The Financial Institutions Regulatory and Interest Rate Control Act of 
1978[Footnote 72] established the Federal Financial Institutions 
Examination Council (FFIEC) in 1979 as a vehicle through which bank 
regulators could communicate formally. FFIEC is empowered to prescribe 
uniform standards and principles and to devise report forms for member 
agencies' examinations of financial institutions. FFIEC makes 
recommendations to promote uniformity in the supervision of financial 
institutions, conducts schools for examiners, and has also established 
interagency task forces on consumer compliance, examiner education, 
information sharing, supervision, reports, and surveillance systems. 
Finally, it serves as a forum for dialogue between federal and state 
bank supervisory agencies.

A joint evaluation by the Offices of the Inspector General from three 
federal banking regulators found that FFIEC was accomplishing its 
legislative mission of prescribing uniform principles, standards, and 
report forms.[Footnote 73] Some officials criticized it for not 
accomplishing its mission more effectively and taking too long to 
complete interagency projects, however. FFIEC is discussing 
improvements to its effectiveness by developing annual goals, 
objectives, and work priorities. In response to questions about whether 
FFIEC should have a broadened role in coordinating banking, insurance, 
and securities regulators as a result of GLBA, most officials 
interviewed were not in favor of broadening FFIEC to include regulatory 
representatives from the insurance and securities industries. Most 
officials also did not see the need for a separate coordinating entity 
under GLBA modeled after FFIEC. Officials indicated that coordination 
under GLBA was occurring as needed and on an ad hoc basis and through 
periodic cross-sector meetings hosted by the Federal Reserve. Banking 
industry and professional associations said that FFIEC could be more 
proactive in communicating with the banking industry, however.

The 1994 Riegle Community Development and Regulatory Improvement Act 
mandated improvements to the coordination of examinations and 
supervision of institutions that are subject to multiple bank 
regulators. A set of basic principles, issued by the regulators in 
1993, said that the agencies place a high priority on working together 
to identify and reduce the regulatory burden and on coordinating 
supervisory activities with each other as well as with state 
supervisors, securities and insurance regulators, and foreign 
supervisors.[Footnote 74] Their objective is to minimize disruption and 
avoid duplicative examination efforts and information requests by:

* coordinating the planning, timing, and scope of examinations and 
inspections of federally insured depository institutions and their 
holding companies;

* conducting joint interagency examinations or inspections;

* coordinating and conducting joint meetings between bank or bank 
holding company management and regulators;

* coordinating information requests; and:

* coordinating enforcement actions.

The Federal Reserve, FDIC, and OCC have additional mechanisms to 
communicate and coordinate. Under the Shared National Credit Program, 
for example, they jointly review large syndicated loans that involve 
several banks to ensure that loans are reviewed consistently and to 
reduce regulatory burden on financial institutions. Program reports 
also include information on the level of credit risk in banks overall 
and by type of bank as well as credit exposures to certain industries. 
Similarly, representatives from the agencies meet regularly as the 
Interagency Country Exposure Review Committee to jointly determine the 
level of risk for credit exposures to various countries.

U.S. bank regulators also communicate regularly with bank regulators in 
other countries, both bilaterally and through multicountry 
organizations that specialize in bank issues. U.S. bank regulators 
overseeing U.S. subsidiaries of foreign banks work with the host-
country regulators in overseeing those institutions. U.S. bank 
regulators and UK-FSA explained how they coordinate examinations of 
U.K. institutions with U.S. operations such as HSBC and U.S. banks with 
U.K. subsidiaries such as MBNA. Similarly, some U.S. regulators 
coordinate with BaFin in overseeing Citigroup's activities in Germany 
and Deutsche-Bank Securities' activities in the United States. The 
Federal Reserve, FDIC, and OCC are members of the Basel 
Committee[Footnote 75] and a Federal Reserve Official chaired that 
committee during much of the Basel II discussions.

Throughout our meetings with banking agencies, officials told us they 
communicate regularly on both a formal and informal basis. They 
explained that officials in different agencies, both at the federal and 
regional level, know each other well and have each other's personal 
cell phone numbers so they can easily contact each other in case of a 
crisis. At the regional level, officials and staff from the Federal 
Reserve, OCC, FDIC, OTS, and state bank regulatory agencies regularly 
meet formally and talk often. Communication across these agencies, 
according to several officials, is facilitated by staff often moving 
between agencies and by long-standing working relationships.

In some cases, however, interagency cooperation between bank regulators 
has been hindered when two or more agencies share responsibility for 
supervising a bank. The Superior Bank and the First National Bank of 
Keystone (West Virginia) episodes illustrate this problem. Superior 
Bank, FSB, a federally chartered savings bank located outside Chicago 
failed in 2001. The failure was caused by Superior's strategy of 
originating and securitizing large volumes of high-risk loans and the 
failure of its management to properly value and account for the 
interest that Superior retained in pooled home mortgages. Shortly after 
the bank's closure, FDIC projected that the failure of Superior Bank 
would result in a substantial loss to the deposit insurance fund. We 
found that federal regulators had not identified and acted on the 
problems at Superior Bank early enough to prevent a material loss to 
the deposit insurance fund. Problems between OTS, Superior's primary 
supervisor, and FDIC hindered a coordinated supervisory approach; OTS 
refused to let FDIC participate in at least one examination.[Footnote 
76] Similarly, disagreements between OCC and FDIC contributed to the 
1999 failure of Keystone Bank, which was caused by the bank's 
maintaining loans that it did not own on its balance sheet; these 
overstated assets were attributed to alleged fraud. FDIC subsequently 
announced that it had reached agreement with the other banking 
regulators to establish a better process for determining when FDIC will 
examine an insured institution where FDIC is not the primary federal 
regulator.

Over the last couple of years, bank regulators have expressed differing 
views concerning the complex Basel Committee negotiations over Basel II 
(see ch. 4). However, it is unclear whether the differing views of the 
regulators improved the process, as the regulators claim, or 
unnecessarily complicated the process and possibly disadvantaged U.S. 
companies, as others have claimed. Bank regulators who sit on the Basel 
Committee told us that the outcome of the Basel II negotiations is 
better than it would have been with a single U.S. representative 
because of the contributions of regulators who represent the 
perspectives and expertise of their varied agencies. Regulators note 
that they have communicated regularly, but still have the 
responsibility of representing their agencies' differing objectives 
publicly. U.S. Basel Committee members said that this requirement to 
discuss differences in an open and transparent manner, rather than 
privately, is a strength of the system. The regulators also noted that 
some of the concerns raised by others about the timeliness of U.S. 
agencies' involvement in the negotiations might stem primarily from the 
long public comment period mandated in U.S. law, rather than the 
involvement of multiple agencies. This public comment period, they 
noted, would be a requirement even if fewer agencies were involved.

However, the lack of a single contact or negotiating position has 
raised questions about these negotiations. Since each of the agencies 
on the Basel Committee is charged with representing the objectives of 
its agency or the firms it oversees, the negotiations may not represent 
the interests of those who are not at the table. For example, OTS--
which oversees some firms that will likely have to comply with Basel 
II, due, in part, to the EU Action Plan--does not have a permanent seat 
on the Basel Committee. Since the large firms overseen by OTS differ in 
some important ways from those overseen by the other agencies, their 
positions may not be adequately represented in these negotiations. 
However, OTS officials say that they have a temporary seat on the Basel 
Committee, while that body considers their request for membership. OTS 
also noted that they are active members of two Basel capital 
implementation groups. In addition, the sometimes-conflicting views 
being expressed by U.S. regulators made it difficult for other 
countries to understand our position. Finally, in November 2003 members 
of the House Financial Services Committee warned in a letter to the 
bank regulatory agencies that the discord surrounding Basel II had 
weakened the negotiating position of the United States and resulted in 
an agreement that was less than favorable to U.S. financial 
institutions.[Footnote 77] H.R. 2042 would establish a committee of 
financial regulators chaired by the Secretary of the Treasury to ensure 
that there is a unified U.S. position in Basel Committee negotiations.

Federal Securities Regulators Often Communicate and Coordinate 
Activities with State Regulators, Securities' SROs, and Foreign 
Securities Regulators, but Problems Persist:

Federal securities regulators communicate and coordinate with SROs and 
state securities regulators. State securities regulators, including 
those in New York and Massachusetts, told us that for the most part 
they coordinate enforcement activities with SEC. One difficulty they 
pointed to was that privacy issues prevent them from discussing a case 
before they are ready to bring charges. However, they note that state 
regulators, SEC, and some SROs have jointly pursued securities law 
violators.

In addition to overseeing the securities SROs, SEC communicates 
regularly with them about various issues. For example, SEC and the SROs 
have taken steps to coordinate their examinations. In 2002, we reported 
that, according to SEC and SRO officials, representatives of SEC, all 
SROs, and the states attend annual summits to discuss examination 
coordination, review examination results from the prior year, and 
develop plans for coordinating examinations for the coming year. In 
addition, regional SEC staff and SRO compliance staff are to meet 
quarterly to discuss and plan examination coordination, and SRO 
examiners are to meet monthly to plan specific examinations of common 
members. At these latter meetings, examiners are expected, among other 
things, to collaborate on fieldwork dates, document requests, and 
broker-dealer entrance and closeout meetings. SROs also are to share 
their prior examination reports before beginning fieldwork. We noted, 
however, that SEC officials told us that some broker-dealers that have 
tried the coordinated examination program have concluded that it is 
more efficient for them to have two separate examinations.[Footnote 78] 
Additionally, SEC met with NYSE to discuss registrations of private 
foreign issuers.

Securities SROs also communicate regularly with each other. Ten of 
them, the major U.S. securities exchanges, are full members of the 
Intermarket Surveillance Group (ISG), a group they created in 1983 to 
share information across jurisdictions. The purpose of ISG is to share 
information and to coordinate and develop procedures designed to assist 
in identifying possible fraudulent and manipulative acts and practices 
across markets, particularly, between markets that trade the same or 
related securities and between markets that trade equity securities and 
options on an index in which such securities are included.

Internationally, SEC communicates and coordinates with international 
securities regulators through IOSCO and has worked with the EU's CESR 
to help harmonize activities between the EU and United States. SEC 
staff notes that it is participating in a joint working group 
established by IOSCO and the Basel Committee to address issues relating 
to the treatment of security positions held in the trading book, which 
includes securities held for dealing or proprietary trading. One issue 
is the development of a risk-based approach to capital requirements for 
securities activities, an issue of interest to holding companies with 
broker-dealer subsidiaries. And CESR officials told us that their 
communications with SEC have been fruitful in easing certain concerns, 
such as those associated with European companies' U.S. operations 
having to adopt Sarbanes-Oxley requirements. In May 2004, SEC and CESR 
announced their intentions to increase their cooperation and 
collaboration aimed at two primary objectives, namely to:

* identify emerging risks in the U.S. and EU securities markets to 
address potential regulatory problems at an early stage; and:

* engage in early discussion of potential regulatory projects in the 
interest of facilitating converged, or at least compatible, ways of 
addressing common issues.

For the rest of 2004 and 2005, SEC and CESR proposed considering issues 
related to market structure, mutual fund regulation, accounting 
convergence, and credit rating agencies.

Despite efforts of SEC and state securities regulators to communicate 
and coordinate their activities, some well-publicized disagreements 
developed following the corporate, accounting, and mutual fund 
scandals. After a settlement with one of the major U.S. securities 
firms concerning the use of research and during investigations of 
mutual fund irregularities, SEC and state regulators sometimes 
disagreed on what is an appropriate role for each, and on how effective 
each has been. For example, the Attorney General of New York, 
testifying before Congress concerning analyst conflicts of interest, 
said that while the issues had been widely reported in the press for 
years, SEC had issued no meaningful new regulations and had taken no 
serious enforcement actions prior to New York's investigation. Some 
securities industry officials told us that state officials should leave 
securities issues to federal officials and noted that unilateral 
actions by states have led to differing state securities laws. In 
addition, an official at one of the SROs told us that communication 
often takes place in a crisis situation, but that there is little or no 
time for strategic thinking.

NAIC Is the Coordinating Body for State Insurance Commissioners, but 
States Often Pursue Their Own Course:

NAIC is the long-standing structure for communication and coordination 
among state insurance commissioners. NAIC's meetings of all state 
regulators occur four times a year and interstate working groups meet 
regularly in various locations or by teleconference or videoconference 
to consider almost every aspect of insurance. Through its development 
of model laws such as those concerning risk-based capital standards and 
its accreditation program, NAIC has been a mechanism for achieving some 
harmonization in state securities regulation. In addition, NAIC 
officials and individual state insurance commissioners have coordinated 
with insurance regulators from other countries through IAIS and other 
forums. IAIS has developed core principles of insurance supervision and 
is working on developing a regulatory framework.

Because each state ultimately determines what actions it will take, 
NAIC cannot ensure uniform regulation. One tool NAIC has used to 
attempt to achieve a consistent state-based system of solvency 
regulation throughout the country is its accreditation program. 
However, we have reported that the accreditation program has 
weaknesses. In our review of the program in 2001, we noted that while 
the accreditation program had improved over the 10 years of its 
existence, and 47 state insurance departments had been accredited by 
NAIC, it still had weaknesses that raised questions about NAIC's 
accreditation reviews.[Footnote 79] For example, Mississippi and 
Tennessee received accreditation during and after a $200 million theft 
that involved four failed insurance companies in those states as well 
as two others. In addition, because New York will not adopt the risk-
based capital model law, what is usually considered one of the 
strongest state regulatory bodies is not accredited. As a result of 
NAIC's inability to force states to adopt certain rules and 
regulations, some critics think the voluntary aspect of NAIC reduces it 
effectiveness. Other critics argue that because NAIC operates as a 
quasi-governmental entity, it exercises too much power over individual 
state regulators.

CFTC Coordinates Activities with SROs and Futures Regulators in Other 
Countries:

According to CFTC, it coordinates with futures SROs and foreign 
financial services regulators. CFTC says it coordinates with exchanges 
in monitoring of daily trading activities, looking at the positions of 
large traders, and reviewing products listed by exchanges. CFTC's 
coordination with futures regulators in other countries--for example, 
UK-FSA and BaFin--takes place partially through CFTC's participation in 
the activities of IOSCO. CFTC participates in IOSCO working groups on 
secondary markets and market intermediaries, enforcement and 
information sharing, and investment management. CFTC also participates 
on IOSCO task forces covering issues such as implementation of IOSCO 
objectives and principles of securities regulation, and payment and 
settlement systems. While CFTC participates in working groups and task 
forces, it does not have the same status at IOSCO that SEC has; CFTC is 
an associate member of that organization, rather than a ordinary 
member.

Financial Services Regulators Also Communicate across Financial 
Sectors, but Do Not Effectively Identify Some Risks, Fraud, and Abuse 
That Cross Sectors:

Federal financial regulators also communicate and coordinate their 
activities across "functional" areas. Federal Reserve officials note 
that, as directed by GLBA, they rely on information that is shared by 
functional regulators, including SEC, in the Federal Reserve's 
supervision of bank and financial holding companies. Channels for 
communication and coordination have been set up by the regulators or at 
the direction of the President or Congress, often in response to a 
crisis. However, regulators do not always share information or monitor 
risks across sectors.

Federal Reserve Reports That It Relies on Functional Regulators in 
Supervision of Bank and Financial Holding Companies:

GLBA directed the Federal Reserve to rely on functional regulators in 
its supervision of nonbanking activities in bank and financial holding 
companies. For example, broker-dealer subsidiaries of bank or financial 
holding companies are subject to oversight by SEC, NASD, and, 
potentially, other SROs. In its 2001 strategic plan, the Federal 
Reserve reported that it is coordinating with other regulators to 
fulfill its role as the holding company supervisor. Federal Reserve 
officials told us that this coordination is a key component in their 
supervision of bank and financial holding companies, and that 
information has been readily provided by functional regulators as part 
of that process.

Regulators and SROs Have Created Mechanisms for Communicating across 
Sectors:

SEC and CFTC have jointly developed regulations implementing portions 
of CFMA that lifted the ban on certain types of securities-based 
futures, but the process was difficult. Before CFMA was enacted, SEC 
and CFTC competed over regulation of single-stock futures for nearly 
two decades. SEC claimed jurisdiction because single-stock futures 
behave like the underlying individual stocks and bonds; CFTC claimed 
jurisdiction because single-stock futures behave like futures. As a 
result of this stalemate, Congress banned the trading of single-stock 
futures. CFMA lifted the prohibition on trading single-stock futures 
and narrow-based stock index futures and allows these futures to be 
traded under a system of joint regulation by SEC and CFTC. However, 
according to CFTC and SEC officials, the market for single-stock 
futures has been slow to develop. In addition, a CFTC official told us 
that it had long had routine, if informal, contacts with SEC concerning 
financial integrity and on how certain firm assets and liabilities 
should be treated in calculating net capital. SEC staff told us that 
they agree with this statement. Similarly, CFTC coordinates its efforts 
with SEC on enforcement cases with jurisdiction in several different 
geographic areas.

Since its creation in 1983, ISG has expanded to include futures and 
foreign exchanges as affiliate members. According to CFTC, the purpose 
of ISG today is to provide a framework for the sharing of information 
and the coordination of regulatory efforts among exchanges trading 
securities and related products to address potential intermarket 
manipulation and trading abuses. ISG plays a crucial role in 
information sharing among markets that trade securities, options on 
securities, security futures products, and futures and options on 
broad-based security indexes. ISG also provides a forum for discussing 
common regulatory concerns, thus enhancing members' ability to fulfill 
efficiently their regulatory responsibilities.

Internationally, regulators from multiple sectors have established 
forums to facilitate multinational communication across sectors. The 
Joint Forum and FSF are two such forums. The Basel Committee, IOSCO, 
and IAIS established the Joint Forum in 1996 to examine cross-sectoral 
supervisory issues related to financial conglomerates such as risk 
assessment and disclosure. The Federal Reserve, Treasury, and SEC serve 
on FSF, which was initiated in 1999 in response to the Asian financial 
crisis. FSF brings together, on a regular basis, representatives of 
governments, international financial institutions, and others to 
promote international financial stability through information exchange 
and international cooperation in financial supervision and 
surveillance.

Congress and the President Have Directed Regulators to Communicate 
across Sectors, Especially after Crises:

By executive order in March 1988, the President established the 
President's Working Group on Financial Markets, which is composed of 
the heads of the Federal Reserve, SEC, and CFTC and chaired by 
Treasury, to address issues related to the 1987 stock market crash. As 
we reported in 2000,[Footnote 80] the President's Working Group was 
established in response to a crisis and, as the need had arisen, had 
continued to function as such. The President's Working Group was 
formally reactivated in 1994 and since then has considered several 
issues, including the 1997 market decline, hedge funds and excessive 
leverage, year 2000 preparedness issues, the rapid growth of the OTC 
derivatives market, and threats to critical infrastructure.[Footnote 
81] The group meets on a bimonthly basis at the staff level and has 
sent letters to Congress with common positions on issues such as energy 
derivatives legislation and mutual fund reform.

After the events of September 11, 2001, the President issued an 
executive order to create the Financial and Banking Information 
Infrastructure Committee (FBIIC), which is charged with coordinating 
federal and state financial regulatory efforts to improve the 
reliability and security of the U.S. financial system. Chaired by 
Treasury's Assistant Secretary for Financial Institutions, FBIIC 
includes representatives from federal and state financial regulatory 
agencies, including CFTC, the Conference of State Bank Supervisors, 
FDIC, the Federal Housing Finance Board, the Federal Reserve, NAIC, 
NCUA, OCC, the Office of Cyberspace Security, the Office of Federal 
Housing Enterprise Oversight, the Office of Homeland Security, OTS, and 
SEC.

In passing GLBA, Congress recognized the need for regulators engaged in 
supervising parts of holding companies to communicate and coordinate 
across "functional" areas. For example, the Federal Reserve and state 
insurance regulators must coordinate efforts to supervise companies 
that control both a bank and a company engaged in insurance activities; 
similarly, OTS and state insurance regulators have to coordinate 
activities as well. The Federal Reserve, FDIC, OCC, and OTS have signed 
regulatory cooperation agreements with almost all insurance 
jurisdictions; NAIC and the bank regulators say the remainder of the 
insurance jurisdictions have state laws that prohibit them from sharing 
information. GLBA also established the National Association of 
Registered Agents and Brokers, subject to NAIC's oversight, and 
stipulated that the association coordinate with NASD in order to ease 
the administrative burden on those who are members of both 
organizations--that is, agents and brokers that deal both in insurance 
and securities.

Other congressionally directed communication includes directing the 
Federal Reserve, OCC, and SEC to form an interagency group to draft 
guidance on complex structured finance transactions following the 
corporate and accounting scandals of the late 1990s. At the invitation 
of these agencies, FDIC and OTS joined the interagency group. On May 
19, 2004, the agencies issued that guidance for comment. More recently, 
Congress has created the Financial Literacy and Education Commission to 
coordinate federal efforts and develop a national strategy to promote 
financial literacy.[Footnote 82] The commission, which is chaired by 
the Secretary of the Treasury, consists of 20 federal agencies, 
including all of the federal financial regulators.

In light of the major changes being made in the EU as a result of the 
Action Plan as well as other factors, Treasury and EU officials agreed 
in early 2002 to establish an informal dialogue on financial market 
issues. As part of that dialogue, U.S. and EU financial services 
policymakers, including officials from the Federal Reserve and SEC, 
meet regularly (1) to foster a mutual understanding of each other's 
approach to the regulation of financial markets, (2) to identify any 
potential conflicts in approaches as early in the regulatory process as 
possible, and (3) to discuss regulatory issues of mutual interest. Some 
of the issues that have been considered in the dialogue are Sarbanes-
Oxley, the Financial Conglomerates Directive, accounting standards, and 
allowing the placement of foreign electronic trading screens in the 
United States absent registration of either the exchange or its listed 
securities. As figure 8 shows, regulators and others are talking to 
their EU counterparts in a number of separate venues.

Figure 8: United States--EU Regulatory Dialogue:

[See PDF for image]

[End of figure]

Cross-Sector Communication Has Not Facilitated Sharing of Important 
Information or Monitoring of Risks:

In evaluating some of the means by which U.S. regulators communicate 
across sectors, we have found that these generally do not provide for 
the systematic sharing of information, making it more difficult for 
regulators to identify potential fraud and abuse, and for consumers to 
identify the relevant regulator. In addition, these means do not allow 
for a satisfactory assessment of risks that cross traditional 
regulatory and industry boundaries and therefore may inhibit the 
ability to detect and contain certain financial crises, as can be seen 
in the following.

* With regard to the President's Working Group, we reported in 2000 
that although it has served as a mechanism to share information during 
unfolding crises, its 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.[Footnote 83]

* In reviewing the near collapse of LTCM--one of the largest U.S. hedge 
funds--in 1998, we reported that regulators continued to focus on 
individual firms and markets but failed to address interrelationships 
across industries. Thus, federal financial regulators did not identify 
the extent of weaknesses in bank, securities, and futures firm risk 
management practices until after LTCM's near collapse and had not 
sufficiently considered the systemic threats that can arise from 
unregulated entities.[Footnote 84]

* Our reviews of financial crises showed that almost never did a single 
federal financial services regulator have the necessary authority, 
jurisdiction, or resources to contain the crisis. Several officials 
told us that this dispersion had sometimes limited the federal 
government's ability to identify incipient financial crises or to 
monitor a crisis once it had occurred.[Footnote 85]

* In reviewing responses to the events of September 11, 2001, we 
reported that the multiorganization nature of U.S. financial services 
regulation has slowed the development of a strategy that would ensure 
continuity of business for financial markets in the event of a 
terrorist attack.[Footnote 86]

* In a recent review of interagency communication regarding enforcement 
actions taken by the regulatory agencies against individuals and firms, 
we reported that while information sharing among financial regulators 
is a key defense against fraud and market abuses, the regulators do not 
have ready access to all relevant data related to regulatory 
enforcement actions taken against individuals or firms. We also 
reported that many financial regulators do not share relevant consumer 
complaint data among themselves on certain hybrid products such as 
variable annuities (products that contain characteristics of both 
securities and insurance products) in a routine, systematic fashion, 
compounding the problem that consumers may have in identifying the 
relevant regulator.[Footnote 87] Determining the relevant regulator for 
variable annuities has been a source of regulatory disagreement for 
some time. After years of court battles, it was determined that 
variable annuities would be regulated as securities by the federal 
government but also fall under the authority of state insurance and 
securities regulators. At the federal level, SEC regulates the 
registration of variable annuity products. Under federal law, variable 
annuity products registered with SEC are generally exempt from 
registration with state securities regulators. As with other securities 
products, NASD regulates the sale of variable annuity products through 
broker-dealers. At the state level, the insurance companies that offer 
variable annuities generally fall under the jurisdiction of insurance 
regulators, though sales of such products can also fall under the 
jurisdiction of state securities regulators, or some combination of 
both regulators, depending on the state. Some state securities 
regulators told us they are making an effort to amend the Uniform 
Securities Act to place the oversight of variable annuities sales under 
the jurisdiction of state securities departments.

While financial regulators generally supported better sharing of 
regulatory information, they cited some barriers to sharing. Those 
barriers generally centered on the need for individual agencies to meet 
their statutory objectives, including protecting confidential 
regulatory information from public disclosure. Officials at one banking 
agency, additionally, noted that they are sometimes reluctant to 
discuss some issues with SEC because of concern that the discussion 
would immediately trigger an investigation, while the banking officials 
are working to resolve the issue in a manner that does not compromise 
safety and soundness. However, officials at that agency also note that 
if the agency becomes aware of a securities law violation, they make an 
immediate referral to SEC.

Officials at several of these regulatory agencies noted that their 
responsibilities are outlined in law. For example, with regard to 
airing differences on Basel II, bank regulators noted that they are 
required to put documents out for public comment and respond to those 
comments. In other cases, agencies note that they were created as 
independent agencies rather than as components of executive agencies 
and departments to avoid interfering with these responsibilities. 
Officials at one agency, for instance, noted that while Treasury would 
have a role in coordinating the efforts of executive agencies prior to 
or during international negotiations, their agency would have to ensure 
that any such coordinating role did not interfere with their statutory 
responsibilities. We have also reported that banking and securities 
regulators have said that NAIC's status as a nonregulatory entity was a 
barrier to information sharing, even when NAIC was acting on behalf of 
its member agencies. In some cases, current state statutes may also 
hinder information sharing.

[End of section]

Chapter 6: The U.S. Regulatory System Has Strengths, but Its Structure 
May Hinder Effective Regulation:

While structure is not the determining factor in the success of efforts 
to provide efficient and effective regulation, it can facilitate or 
hinder regulators' efforts. Some U.S. regulators and financial market 
participants we spoke with cited the contribution of the current 
regulatory structure to the development of U.S. capital markets, and 
the U.S. economy overall--for example, for encouraging competition and 
promoting stability. However, the regulatory system does not facilitate 
the monitoring of risks across firms and markets and does not provide 
for a proactive, strategic approach to systemwide issues. In addition, 
some outside the U.S. regulatory system, including foreign regulators, 
have criticized the U.S. regulatory system for hindering effective 
oversight of large, complex firms. We also found that dividing 
supervision of large, complex firms among U.S. regulators can result in 
inconsistent supervision. In addition, the U.S. regulatory system is 
not well structured for dealing with issues in a world where financial 
firms and markets operate globally.

While the demarcations between the "functional" areas have blurred and 
large firms have diversified across sectors, differences among the 
sectors are still important. Thus, the system benefits from having 
regulators that specialize in the "functional" areas. However, 
"functional" specialization has drawbacks as well, including the 
inability to take advantage of economies of scale and scope, the danger 
of becoming a voice for certain interests, and the possibility that 
firms may seek supervision from the least intrusive regulators.

U.S. Financial Services Regulatory System Has Generally Been Successful 
but Lacks Overall Direction:

The U.S regulatory system has allowed financial intermediaries and 
markets to contribute broadly to the U.S. economy. Corporations have a 
range of financing options to choose from--including bank lending and 
securities issuance--that have generally allowed the economy to grow 
and consumers have a range of options to choose from that allow them to 
make purchases and save for retirement. In addition, new products have 
been developed that allow financial institutions to manage risk. Some 
of the people we spoke with wondered why anyone would want to change a 
regulatory system that has generally supported these aspects of our 
economy. Officials at one trade association told us that because our 
system is so successful, some other countries are trying to replicate 
aspects of it. In addition, at least one academic researcher has 
commented that European countries tried to create SEC-type regulatory 
agencies where the focus, in part, is on protecting consumers.

U.S. financial institutions are generally characterized as dynamic and 
innovative and some aspects of the regulatory system have these 
characteristics as well. In chapter 4 of this report, we showed how 
some regulatory approaches have evolved over time to better address 
changes in the industry. The U.S. financial system is dynamic and 
innovative because it is populated by a large number of firms and 
different industries that compete with each other in an environment 
where no one sector or firm has gained the market power that would 
stifle innovation. Similarly, the regulatory system is characterized by 
a large number of regulators that must often compete with each other to 
provide more innovative or vigilant regulation. Competition among the 
banking regulators, especially the Federal Reserve and OCC, is given 
credit for changes in regulation including the modernization that 
removed prohibitions against securities firms, banks, and insurance 
companies operating in a single holding company structure, and 
increased regulatory attention to the provision of loans in certain 
minority areas. Similarly actions by some state attorneys general and 
other securities officials helped prod the Justice Department and SEC 
to take more aggressive action and may have helped to highlight a need 
for increased resources at SEC.

Having multiple regulators also allows for regulatory experimentation. 
An insurance regulator in Illinois can allow the market to set 
insurance rates, while insurance regulators in Massachusetts must 
approve rate increases. Similarly, for depository institutions, Utah 
offers certain advantages to ILCs that obtain charters in that state. 
The movement of CFTC to a principles-based approach while SEC stays 
with a rules-based approach to regulation is another example of how 
regulators can be innovative in experimenting with different approaches 
to regulation.

One of the international criteria for a successful regulatory system is 
to have adequate resources, and the success of the U.S. regulatory 
system is often attributed to the overall quality of U.S. regulators. 
Many of the industry officials we talked with felt that their 
regulators had the needed skills to provide effective supervision. 
Whether the U.S. regulatory structure facilitates the hiring of a 
sufficient number of quality staff across all of the regulatory 
agencies is an open question. Officials at UK-FSA said they felt they 
were better able to attract good staff in a consolidated regulatory 
structure because they had better visibility in the marketplace, could 
offer better career paths, and in some cases, were able to pay higher 
salaries than the agencies that existed before consolidation. However, 
that organization still has only about 2,300 staff members. Because 
several of the U.S. regulators are this large, have visibility in the 
marketplace, and are able to offer competitive salaries, they are well 
positioned to hire good staff. However, some of the federal regulators 
and state insurance regulatory agencies are relatively small and could 
face difficulties in attracting qualified staff due to the substantial 
demand by other government agencies and the private sector for the best 
personnel.

The regulatory system is also credited with helping to foster financial 
stability and maintain continuity. The system has allowed for creative 
solutions to potentially destabilizing events. For example, between 
January and September 1998, LTCM lost almost 90 percent of its capital. 
In September 1998, the Federal Reserve determined that rapid 
deterioration of LTCM's trading positions and the related positions of 
some other market participants might pose a significant threat to 
global financial markets that were already unsettled with Russia's 
default on its debt. As a result, the Federal Reserve facilitated a 
privately funded recapitalization to prevent LTCM's total 
collapse.[Footnote 88] While some experts believe that the market would 
have handled this crisis, the Federal Reserve Bank of New York is 
credited by many with facilitating the resolution of a major liquidity 
crisis with potential systemic repercussions. Again, when the events of 
September 11, 2001, led to unsettled government securities trades and 
other financial market disruptions, the Federal Reserve provided needed 
liquidity to financial markets. Federal bank regulators also provided 
guidance to banks on maintaining business relations with their 
customers that had been affected by the attacks and issued a joint 
statement advising banks that any temporary drops in bank capital would 
be evaluated in light of a bank's overall financial condition. SEC took 
similar actions to facilitate the successful reopening of stock 
markets, including providing temporary relief from some regulatory 
requirements.[Footnote 89]

Through its supervision of bank and financial holding companies, the 
Federal Reserve does have oversight responsibility for a substantial 
share of the financial services industry. The scope of its oversight, 
however, is limited to bank and financial holding companies. However, 
no government agency is charged with looking at the financial system as 
a whole, and the ability of regulators to meet their objectives on an 
ongoing basis. We have repeatedly noted that regulators do not share 
information or monitor risks across markets or "functional" areas 
preventing them from identifying potential systemic crises and limiting 
opportunities for fraud and abuse (see ch. 5). In addition, we noted 
limitations on effectively planning strategies that cut across 
regulatory agencies.

In addition, there is no mechanism for the regulatory agencies to 
perform this task cooperatively. From an overall perspective the system 
is not proactive, but instead reacts in a piecemeal, ad hoc fashion--
often when there is a crisis. No one has the authority, and there is no 
cooperative mechanism to conduct risk analyses, prioritize tasks, or 
allocate resources across agencies, although the Office of Management 
and Budget may perform some of these tasks for agencies that are funded 
by federal appropriations. Similarly, no one has the responsibility, 
and there is no cooperative mechanism, for putting together a long run 
strategic plan that develops a clearly defined set of objectives for 
the financial regulatory system and lays out a plan for achieving those 
goals over time.

Each agency does develop its own strategic plan. The Federal Reserve, 
for instance, published its most recent plan in December 2001, 
providing three primary goals--including promoting "a safe, sound, 
competitive, and accessible banking system and stable financial 
markets." The plan provided specific objectives and performance 
measures, and discussed the external factors that would affect the 
Federal Reserve. For instance, it noted the following:

Continued integration of U.S. financial market sectors, accompanied by 
the introduction of new financial products and means for their 
delivery, is further blurring lines between banks and nonbanks. 
Securities firms, insurance companies, financial companies, and even 
many prominent industrial companies--as well as commercial banks--are 
exploiting technological and financial innovations to seek to capture 
larger shares of the financial services market. Industry consolidation 
will affect the way the Federal Reserve operates to ensure safety and 
soundness and limit systemic risk.

However, no entity is charged with developing a strategic plan like 
this that would address how industry changes affect the ability of the 
financial regulatory system, as a whole, to meet its many missions.

Structure of U.S. Financial Services Regulatory System May Not 
Facilitate Oversight of Large, Complex Firms:

Legal experts and some regulators in EU and Joint Forum countries 
believe that large, complex, internationally active firms need to be 
supervised on a consolidated level. In response, the EU is requiring 
consolidated supervision for certain financial institutions on the 
assumption that these firms are so large and so complex that a failure 
at anyone of them could pose systemic threats within and across 
countries. In addition, many of the countries we studied said that one 
of the primary reasons they consolidated their regulatory structure was 
to better supervise conglomerates. Historically, in the U.S., holding 
company supervision--a form of consolidated supervision--has been 
required for companies owning commercial banks and thrifts. These bank 
and thrift holding companies were expected to be sources of financial 
and managerial strength to their subsidiary banks. They were supervised 
to ensure this, and to enforce laws intended to protect the insured 
bank even if the parent failed. The goal is to protect the banking 
system and, by extension, the deposit insurance fund. Another goal of 
this supervision has been to wall off the bank, so that other parts of 
the holding company do not benefit from any subsidy inherent in the 
provision of deposit insurance or other safety net provision. Holding 
company supervision in the United States has evolved to include broader 
concerns about the potential systemic risk posed by large financial 
services firms.

GLBA continued the U.S. tradition of requiring holding company 
supervision when such a company owns a commercial bank or thrift, and 
provided for supervision of investment bank holding companies. However, 
the structure set up in GLBA has led to concerns about (1) the scope 
and effectiveness of the Federal Reserve's authority to examine 
functionally regulated entities within a financial holding company, and 
(2) the possibility of competitive imbalances among holding company 
supervisors. Officials at the Federal Reserve say that because firms 
file consolidated financial statements and the Federal Reserve has the 
authority to conduct examinations of the holding companies, including 
verifying information in the consolidated financial statements, it 
generally has the information it needs to oversee bank and financial 
holding companies. The officials also said that when the Federal 
Reserve has needed information from other regulators, they have been 
able to obtain it.

However, some large financial services firms offer insured deposits and 
provide a range of banking services without incurring bank holding 
company supervision from the Federal Reserve. By owning or obtaining 
thrift charters, for instance, some have opted to be thrift holding 
companies under OTS supervision. Given the complexity of some of these 
parent companies, OTS officials told us they have had to hire staff and 
develop expertise needed to understand these companies. We have neither 
evaluated OTS's efforts nor compared the depth and coverage of OTS 
examinations of large, complex thrift holding companies with that of 
Federal Reserve examinations of similarly large, complex bank and 
financial holding companies. Other companies have obtained or control 
firms with ILC charters, and are not, by virtue of that affiliation, 
subject to federal holding company supervision unless the holding 
company elects to be a CSE subject to SEC consolidated oversight.

The differential oversight of holding companies in the different 
sectors has the potential to create competitive imbalances. In 
discussions with some of these companies, we were told they offer 
similar services and see themselves as competing more with other large, 
internationally active firms in other sectors than with smaller 
entities in their own sector. They also raise funds in the same markets 
and often participate in the same transactions. Thus, they are taking 
on similar risk profiles. However, they may not be subject to the same 
supervision and regulation. Bank and financial holding companies are 
supervised by the Federal Reserve. Other companies may opt to organize 
themselves as thrift holding companies under OTS supervision, and with 
SEC's recent CSE and SIBHC rules, some may opt for SEC oversight. While 
these differences stem from differences among the supervisory agencies 
and their regulatory goals, the differences potentially could have 
competitive implications as well. There is no mechanism to ensure that 
differences in these regulatory approaches do not create competitive 
differences among the different types of holding companies. Further, 
under the new CSE rules some firms could be subject to both SEC and OTS 
holding company oversight and, as OTS pointed out in its response to 
the CSE proposal, perhaps subject to conflicting regulatory 
requirements. Finally, there is no mechanism to ensure that any 
systemic risk that these large firms might pose would be treated in a 
consistent manner.

The regulatory system for consolidated supervision set up under GLBA 
rests on the "functional" regulatory system envisioned there--a system 
in which "functional" regulators oversee specific activities or 
products. Some industry experts believe that this system conflicts with 
reality in that it rests, in part, on preserving distinctions between 
financial firms based on their lines of business, even though the 
differences between financial products and services are blurring and 
management of affiliated firms is more efficient and effective when it 
is performed centrally, rather than on a firm-by-firm basis. Businesses 
say that to benefit from conglomeration, they integrate certain 
functions such as risk management and capital allocation. In addition, 
new corporate governance standards require that the board and senior 
management of a consolidated corporation be responsible for a variety 
of conduct-of-business issues throughout the organization. Moreover, 
using a brand name or symbol across these legal entities further links 
subsidiaries and affiliates in these large, complex firms. Some legal 
experts and regulators note that because conglomerates are managed 
centrally, regulators that specialize in understanding risks specific 
to their "functional" sector may not appreciate complex risks that span 
financial sectors and may not understand the risk aggregation 
methodologies employed by these firms. Moreover, they note that the 
existence of a range of supervisory authorities poses the risk that 
financial firms will engage in a form of regulatory arbitrage that 
involves the placement of particular financial services or products in 
that part of the financial conglomerate in which supervisory oversight 
is the least intrusive.

GLBA considers linkages among affiliated firms and contains several 
provisions under which regulators are to coordinate and cooperate with 
each other to achieve effective and efficient regulation. However, as 
we have seen, cooperation among regulators in different sectors is 
difficult within a system that values regulatory competition--a feature 
of our system that is often credited with making the regulatory system 
dynamic and innovative but that may be inefficient as well. As figure 9 
shows, the agency overseeing a holding company might have to rely on a 
large number of other regulators for information about subsidiaries 
engaged in many different functions.

Figure 9: Regulators for a Hypothetical Financial Holding Company:

[See PDF for image]

[End of figure]

Consolidated regulators in the United States also rely on consolidated 
financial statements that may include descriptions of risk management 
techniques as well. However, these same firms have to create reports 
and risk analyses to meet the specific demands of individual 
"functional" regulators, particularly when the focus of the regulators 
differs from the firm's focus on its consolidated position and risk 
management techniques. These reports may have little connection to the 
overall risk position of the larger entity.

Regulators say that in certain cases they are not concerned about the 
holding company because the entity they supervise is walled off from 
the larger entity. For example, several state insurance regulators 
noted that the entities they regulate are incorporated and do business 
only within their states, although the companies are subsidiaries of 
parent companies in other states. Similarly, FDIC notes that the safety 
net provided in the form of deposit insurance is only extended to banks 
as legal entities. However, it is difficult to imagine that problems in 
a significant subsidiary of a conglomerate would not impact the rest of 
the organization. Especially when the parts of an organization are 
being managed centrally and a company brand name is used across 
sectors, the reputation of any part of an organization is likely to 
impact the other parts. The problems of its junk bond operations led to 
the wider collapse of Drexel Burnham Lambert Group, for instance. Some 
observers have noted that when an organization is interconnected in 
these ways, it is less likely that a healthy organization would let any 
one of its significant parts fail. In addition, Federal Reserve 
regulations say that bank holding companies are to be a source of 
strength for their bank subsidiaries. Regulators also note that unlike 
other countries, the United States still has a large number of small 
and medium-sized firms in all of the financial sectors who engage in 
activities that are primarily within one sector; however, a research 
study issued in 2000 by IMF staff shows that based on a sample of the 
top 500 financial services firms in assets worldwide, 73 percent of the 
financial assets held by U.S. firms in the sample were held by firms 
that engaged in some significant degree in at least two financial 
services sectors.[Footnote 90]

Structure of U.S. Financial Services Regulatory System May Not 
Facilitate Response to Increased Globalization:

For multinational financial services firms to have effective oversight, 
regulators from various countries must coordinate, if not harmonize, 
regulation/supervision of financial services across national borders 
and must communicate regularly. Many of the companies we spoke with 
told us that international harmonization of regulatory requirements 
would be good for their businesses. In addition, the degree to which 
financial services are integrated across countries makes it essential 
for regulators in different countries to communicate regularly. (See 
ch. 5.) However, as we have seen in the Basel II discussions and with 
the U.S.-EU dialogue, the current U.S. regulatory structure is not 
conducive to communicating a single U.S. position in these discussions. 
Negotiations related to harmonizing financial regulation across 
international borders differ from negotiations related to international 
trade, such as those involving the General Agreement on Tariffs and 
Trade or the allocation of radio-frequency spectrum.[Footnote 91] In 
those negotiations, a structure is in place to develop a unified 
negotiating position. And while the outcome of negotiations may not 
depend on the number of regulators involved--the relative importance of 
U.S. financial institutions, especially in overseas capital markets, 
and many other factors are also important--speaking with a single voice 
would ensure that the U.S. position is effectively heard.

One area where the mismatch between globalization and the U.S. 
regulatory structure is marked is in the area of insurance regulation. 
Companies in the insurance industry increasingly operate on a national 
and international basis and many companies are foreign-owned, but the 
industry is regulated by 55 independent jurisdictions. While insurance 
regulators in the United States responded through NAIC to a solvency 
crisis in that industry during the early 1990s, the NAIC process 
remains cumbersome in a multinational world. Some of the kinds of 
problems that can develop as a result of an international industry 
being overseen at the state level are evident in the case of Executive 
Life. In 1998, issues surrounding the sale of Executive Life, a life 
insurer that became insolvent in the early 1990s after investing 
heavily in junk bonds, came to light. The issue essentially pitted the 
insurance regulator of California against the national government of 
France. While this problem was handled within the current structure, 
the structure did not facilitate the solution. Not surprisingly, 
officials at the EU, UK-FSA, and BaFin told us that having a single 
point of contact on insurance issues within the United States would 
facilitate international decision making. EU officials noted that 
international negotiations with NAIC led to the creation of IAIS; 
however, the effectiveness of this organization may be limited by its 
inability to speak for the actual insurance regulators in the U.S. In 
addition, NAIC's supervisory stance embodied in its model laws differs 
from the Solvency II model being created in the EU, especially with 
regard to the oversight of insurance groups. NAIC says that IAIS is 
developing a model for insurance supervision that conforms to the U.S. 
position. Finally, some foreign-based financial services firms that 
want to sell insurance products in the United States have characterized 
the fragmented U.S. regulatory system as an unfair trade barrier.

Regulators Provide Some Other Benefits by Specializing in Particular 
Industry Segments or Geographic Units, but Specialization Has Costs As 
Well:

Since there are still significant differences in many areas of the 
banking, securities, insurance, and futures businesses, specialized 
expertise with knowledge of those businesses is still deemed important. 
In addition, state regulators often argue that they have better 
knowledge of the needs of consumers in their respective states. 
Officials at OTS felt that even though all of the banking regulators 
are in the banking sector, OTS is able to focus its skills on the needs 
of institutions whose primary asset is mortgages. According to 
officials in the futures industry and at CFTC, creating a specialized 
regulator for the futures industry has permitted that industry to be 
innovative in ways that would not have been possible under either an 
SEC or bank regulatory environment. Many of the people we talked with 
were concerned about what might happen to these specialized skills and 
knowledge if regulators were combined into fewer agencies. In addition, 
a few industry representatives in the United Kingdom mentioned the lack 
of industry specific skills and knowledge as a concern in the United 
Kingdom once the regulator was unified across sectors.

Specialization in a particular industry segment ensures that the issues 
of that segment will get considered in larger forums, before Congress, 
or in international negotiations. This is particularly evident in the 
Basel II negotiations, where FDIC and OTS have expressed the concerns 
facing smaller banks--including the possibility that lower capital 
requirements for larger banks could place smaller banks at a 
competitive disadvantage. The Federal Reserve says that it is 
conducting a series of studies looking at the likely impact of Basel 
II. After two such studies, they have found no potential negative 
effects on smaller banks; however, one study did suggest that larger 
banks that do not adopt Basel II could face some competitive 
disadvantage. Similarly, OCC expressed the concerns of trust banks over 
the capital charges they will have for operational risk.

Of course, specialization can be a double-edged sword that requires 
vigilance on the part of the regulator. First, a regulator's 
specialization can lead to an inability to track risks that cross 
sectors. This inability can be the result of statutory limitations on 
the regulator, as well as the regulator's policies and procedures that 
reflect its focus on particular risks. Second, if the regulator becomes 
too responsive to the needs of the industry, its independence can be in 
jeopardy. Again, the Basel II negotiations illustrate the trade-offs. 
It is unclear whether regulators who presented the views of particular 
segments of the industry were exhibiting their specialized knowledge or 
lobbying for the segment of the industry they oversee. One regulator 
told us they did not present certain issues earlier in the process 
because the regulator had not yet heard from the industry. The chance 
for regulators to lose their independence is stronger for agencies that 
oversee relatively few entities. An agency is at greater risk of being 
"captured" by the industry as consolidation in industry segments 
reduces the number of firms being overseen by that regulator. 
Alternatively, combining regulators could reduce the impact of any one 
segment in decisions, but runs the risk of swallowing up particular 
industry segments.

Although having knowledge of a particular industry segment is important 
for regulators, other specialized skills and knowledge cut across 
regulatory agencies, and these skills and knowledge may not be 
efficiently allocated across some of the smaller agencies. All 
regulators write rules, conduct off-site monitoring, and examine firms 
to determine whether firms are managing their risks effectively and 
complying with rules and regulations. In Massachusetts, we found former 
Federal Reserve examiners on the staff of OCC and at the Massachusetts 
Department of Insurance. In addition, CFTC told us that part of their 
implementation of new risk-focused examination procedures includes some 
training by Federal Reserve examiners. However, having some relatively 
small agencies limits the ability of these agencies to take advantage 
of economies of scope and scale relative to these skills. This is 
especially true with regard to the specialized skills related to 
understanding the complex statistical models that firms are using to 
manage risks and the structured products they provide. These skills are 
needed in varying degrees by all financial regulatory agencies. Finding 
people with the requisite skills is complicated because they are scarce 
and in demand by the industry, where the pay is often considerably 
higher than at a regulatory agency. Regulators say that consolidating 
regulatory agencies would not alleviate this shortage because even if 
they added together all of the staff of all of the regulatory agencies 
involved in these complex tasks, there would still not be enough staff 
with the requisite skills. However, the current system does not provide 
a mechanism to ensure that the staff is allocated optimally.

[End of section]

Chapter 7: Congress May Want to Consider Changes to the U.S. Regulatory 
Structure:

As we have seen, over the last several decades the financial services 
industry has changed in many significant ways. These changes have 
blurred the clear-cut boundaries between the "functional" areas 
underlying our regulatory structure, so that large firms and products 
increasingly compete across or otherwise ignore these boundaries. Very 
large firms are increasingly competing in more than one of the four 
sectors of the industry and across national boundaries. In addition, 
these firms take on similar risks and manage these risks at the 
consolidated level. Policies and procedures related to market conduct 
and corporate governance also tend to be set centrally in these 
organizations. Moreover, hybrid products are blurring the lines between 
"functional" activities, and even firms that specialize in a specific 
functional area are competing to provide similar services to the same 
consumers and businesses.

The financial services industry is critical to the health and vitality 
of the U.S. economy. While the industry itself bears primary 
responsibility to effectively manage its risks, the importance of the 
industry and the nature of those risks have created a need for 
government regulation as well. While the specifics of a regulatory 
structure, including the number of regulatory agencies and the roles 
assigned to each, may not be the critical determinant in whether a 
regulatory system is successful, the structure can facilitate or hinder 
the attainment of regulatory goals. The skills of the people working in 
the regulatory system, the clarity of its objectives, its independence, 
and its management systems are critical to the success of financial 
regulation.

The U.S. regulatory structure facilitates regulators having detailed 
knowledge about banking, insurance, securities, and futures activities, 
and these regulators report that they do exchange information relevant 
to the supervision of institutions that operate in more than one of 
these areas. However, the regulatory structure hinders comprehensively 
understanding and, when appropriate, containing the risk-taking 
activities of large, complex, internationally active institutions; 
promoting the global competitiveness of the U.S. financial services 
industry; maintaining to the greatest extent possible competitive 
neutrality; and handling possible systemic repercussions. The U.S. 
regulatory structure also does not have an ability to develop a 
strategic focus that would guide the priorities and activities of each 
agency and does not have the ability to allocate resources across 
agencies.

Because our regulatory structure relies on having clear-cut boundaries 
between the "functional" areas, industry changes that have caused those 
boundaries to blur have challenged the regulatory framework. While 
diversification across activities and locations may have lowered the 
risks being faced by some large, complex, internationally active firms, 
understanding and overseeing them has also become a much more complex 
undertaking, requiring staff that can evaluate the risk portfolio of 
these institutions and their management systems and performance. 
Regulators must be able to ensure effective risk management without 
needlessly restraining risk taking, which would hinder economic growth. 
Similarly, because firms are taking on similar risks across 
"functional" areas, to understand the risks of a given institution or 
of the system as a whole, regulators need a more complete picture of 
the risk portfolio of the financial services industry both in the 
United States and abroad. For example, in our report on LTCM and its 
rescue, we said the following:

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.[Footnote 92]

The regulatory framework envisioned in GLBA recognizes some of the 
linkages within institutions and contains a framework for consolidated 
oversight of some types of firms. Activities at the Basel Committee and 
requirements that take affect in early 2005 for firms conducting 
business in EU countries have led regulators to adopt some new policies 
and rules in this area. However, different regulatory treatment of bank 
and financial holding companies, consolidated supervised entities, 
supervised investment bank holding companies, and thrift holding 
companies may not provide a basis for consistent oversight of their 
consolidated risk management strategies, guarantee competitive 
neutrality, or contribute to better oversight of systemic risk.

Recognizing that regulators could potentially overcome the impediments 
of a fragmented regulatory structure through better communication and 
coordination across agencies, Congress has created mechanisms for 
coordination and on a number of specific issues directed agencies to 
coordinate their activities. In addition, we have repeatedly 
recommended that federal regulators improve communication and 
coordination. For example, in our report on LTCM, we recommended that 
federal financial regulators develop ways to better coordinate 
oversight activities that cut across traditional regulatory and 
industry boundaries. While we continue to support these 
recommendations, we recognize that the sheer number of regulatory 
bodies, their underlying competitive nature, and differences in their 
regulatory philosophies will continue to make the sharing of 
information difficult and true coordination and cooperation in the most 
important or most visible areas problematic as well. Therefore, 
Congress might want to consider some changes to the U.S. financial 
services regulatory structure that address weaknesses and potential 
vulnerabilities in our current system, while maintaining its strengths.

However, structural changes themselves will not ensure the attainment 
of various regulatory goals. That will require a structure with the 
right people and skills, clear regulatory objectives, effective tools, 
and appropriate policies and procedures. A different organizational 
structure will not necessarily make the inherently difficult task of 
detecting fraud in a financial institution easier, and it also would 
not ensure more accurate and comprehensive detection. In addition, any 
major change in the regulatory structure poses the risk of unintended 
consequences and transition costs. Organizational changes may take 
place over several years, and regulators might lose sight of their 
objectives while management jockeys for control of the agenda of a new 
or reformulated regulatory body, staff worry about having jobs in the 
new system, or employees become accustomed to their new roles in the 
new organization.

Matter for Congressional Consideration:

While maintaining sector expertise and ensuring that financial 
institutions comply with the law, Congress may want to consider some 
consolidation or modification of the existing regulatory structure to 
(1) better address the risks posed by large, complex, internationally 
active firms and their consolidated risk management approaches; (2) 
promote competition domestically and internationally; and (3) contain 
systemic risk. If so, our work has identified several options that 
Congress may wish to consider:

* consolidating the regulatory structure within the "functional" areas;

* moving to a regulatory structure based on a regulation by objective 
or twin peaks model;

* combining all financial regulators into a single entity; or:

* creating or authorizing a single entity to oversee all large, 
complex, internationally active firms, while leaving the rest of the 
structure in place.

If Congress does wish to consider these or other options, it may want 
to ensure that legislative goals are clearly set out for any changed 
regulatory structure and that the agencies affected by any change are 
given clear direction on the priorities that should be set for 
achieving these goals. In addition, any change in the regulatory 
structure would entail changing laws that currently govern financial 
services oversight to conform to the new structure.

The first option would be to consolidate the regulatory structure 
within "functional" areas--banking, securities, insurance, and 
futures--so that at the federal level there would be a primary point of 
contact for each. The two major changes to accomplish this at the 
federal level would be consolidation of the bank regulators and, if 
Congress wishes to provide a federal charter option for insurance, the 
creation of an insurance regulatory entity. The bank regulatory 
consolidation could be achieved within an existing banking agency or 
with the creation of a new agency. In 1996, we recommended that the 
number of federal agencies with primary responsibilities for bank 
oversight be reduced. However, we noted that in the new structure, FDIC 
should have the necessary authority to protect the deposit insurance 
fund and that the Federal Reserve and Treasury should continue to be 
involved in bank oversight, with access to supervisory information, so 
that they could carry out their responsibilities for promoting 
financial stability. We have not studied the issue of an optional 
federal charter for insurers, but have through the years noted 
difficulties with efforts to normalize insurance regulation across 
states through the NAIC-based structure. Having a primary federal 
entity for each of the functional sectors would likely improve 
communications and coordination across sectors because it would reduce 
the number of entities that would need to be consulted on any issue. 
Similarly, it would provide a central point of communication for issues 
within a sector. Fewer bank regulators might reduce the cost of 
regulation and the opportunities for regulatory arbitrage, choosing 
charters so that transactions have the least amount of oversight. In 
addition, issues related to the independence of a regulator from the 
firms they oversee with a given kind of charter would be alleviated. 
However, consolidating the banking regulators and establishing a 
federal insurance regulator would raise concerns as well. While 
improved communication and cooperation within sectors would help to 
achieve the other objectives outlined above, it would not directly 
address many of them. In addition, some constituencies, such as 
thrifts, might feel they were not getting proper attention for their 
concerns; and opportunities for regulatory experimentation and the 
other positive aspects of competition in banking could be reduced. 
Further, while this option represents a more evolutionary change than 
some of the others, it might still entail some costs associated with 
change, including unintended consequences that would undoubtedly erupt 
as various banking agencies and their staff jockeyed for position 
within the new banking regulator. Similarly, the establishment of a 
federal insurance regulator might have unintended consequences for 
state regulatory bodies and for insurance firms as well.

Another option would be consolidating the regulatory structure using a 
regulation by objective, or twin peaks model. The twin peaks model 
would involve setting up one safety and soundness regulatory entity and 
one conduct-of-business regulatory entity. The former would oversee 
safety and soundness issues for insurers, banks, securities, and 
futures activities, while the latter would ensure compliance with the 
full range of conduct-of-business issues, including consumer and 
investor protection, disclosure, money laundering, and some governance 
issues. This could be accomplished by changing the tasks assigned to 
existing agencies or by restructuring the agencies or creating new 
ones. On the positive side, this option would directly address many of 
the regulatory objectives related to larger, more complex institutions, 
such as allowing for consolidated supervision, competitive neutrality, 
understanding of the linkages within the safety and soundness and 
conduct-of-business spheres, and regulatory independence. In addition, 
conduct-of-business issues would not become subservient to safety and 
soundness issues, as some fear. On the negative side, in addition to 
the issues raised by any change in the structure, this structure would 
not allow regulators to oversee the linkages between safety and 
soundness and conduct-of-business. As reputational risk has become more 
important, the linkages between these activities have become more 
evident. In addition, if the controls and processes for conduct-of-
business issues and safety and soundness issues are coming from the top 
of the organization, they are probably closely related. Finally, 
combining regulators into multifunctional units might not allow the 
regulatory system to maintain some of the advantages it now has, 
including specialized expertise and the benefits of regulatory 
competition and experimentation.

The most radical option would combine all financial regulators into a 
single entity, similar to UK-FSA. The benefits of the single regulator 
are that one body is accountable for all regulatory endeavors. It can 
more easily evaluate the linkages within and across firms, including 
those between conduct-of-business and safety and soundness 
considerations, plan strategically across sectors, and facilitate the 
allocation of resources to their highest priority use. However, 
achieving these goals would depend on having the right people and 
skills, clear regulatory objectives, effective tools, and appropriate 
policies and procedures. While the UK-FSA model is intriguing, this 
option raises some concerns for the United States. First, because of 
the size of the U.S. economy and the number of financial institutions 
this entity would have to be very large and, thus, could be unwieldy 
and costly. UK-FSA has about 2,300 employees, while estimates of the 
number of regulators currently in the United States range from about 
30,000 to 40,000. In addition, officials at UK-FSA have commented about 
the difficulty of setting priorities when a large number of issues have 
to be dealt with. Prioritizing these issues for the United States would 
be particularly difficult. Further, an entity with this scope and size 
might have difficulty responding to smaller players and might therefore 
damage the diversity that has enriched the U.S. financial industry. 
Also, staff at such an entity might lose or not develop the specialized 
skills needed to understand both large and small companies and risks 
that are specific to the different "functional" sectors. And without 
careful oversight, such a large and all-powerful entity might not be 
accountable to consumers or the industry.

A more evolutionary change would be to have a single entity with 
responsibility for the oversight of all large, complex, or 
internationally active financial services firms that manage risk 
centrally, compete with each other within and across sectors, and, by 
their size and presence in a wide range of markets, pose systemic 
risks. Having a single regulatory entity for large, complex, or 
internationally active firms could be accomplished by giving this 
responsibility to an existing regulator or by creating a new entity. A 
new entity might consist of a small staff that would rely on the 
expertise of staff at existing regulatory agencies to accomplish 
supervisory tasks.

Having a single regulatory entity for large, complex, or 
internationally active firms would have the advantage of addressing 
industry changes, while leaving much of the U.S. regulatory structure 
unchanged. A single regulatory entity for large, complex holding 
companies would have responsibilities that more closely align with the 
businesses' approach to risk than the current regulatory structure. In 
addition, this entity could promote competition between these firms by 
ensuring, to the greatest extent possible, that oversight is 
competitively neutral. A single regulatory entity for internationally 
active firms would also be better positioned to help coordinate the 
views of the United States in international forums, so that the U.S. 
firms are not competitively disadvantaged during negotiations. Finally, 
this entity would be better able to appraise the linkages across large, 
complex, internationally active firms and, thus, with the aid of the 
Federal Reserve and Treasury, could contribute to promoting financial 
stability. These potential improvements could be obtained without 
losing the advantages afforded by our current specialized regulators, 
who would continue to supervise the activities of regulated firms such 
as broker-dealers or banks. However, this option also has drawbacks. 
While the transition costs might be less than in some of the other 
options, the creation of a new entity or changing the role of an 
existing regulatory entity would still entail costs and likely some 
unintended consequences. It might also be difficult to maintain the 
appropriate balance between the interests of the large or 
internationally active firms and smaller, more-specialized entities. It 
also could involve creating one more regulatory agency in a system that 
already has many agencies.

Agency Comments and Our Evaluation:

We received written comments on a draft of this report from the 
Chairman of the Board of Governors of the Federal Reserve System, the 
Chairman of Federal Deposit Insurance Corporation, the Comptroller of 
the Currency, the Director of the Office of Thrift Supervision, and the 
Director of SEC's Division of Market Regulation. These letters are 
reprinted in appendixes I-V of this report.

In his comments, the Chairman of the Federal Reserve's Board of 
Governors said that GLBA provided for a regulatory framework that 
struck a balance between the need for regulation and the need for 
adaptability. Congress at that time chose to retain and build upon the 
functional regulation approach, one that has worked well for the United 
States and, as the report notes, has helped promote the competition and 
innovation that is a "hallmark" of the U.S. financial system. He 
further wrote that, in GLBA, "Congress also reaffirmed its 
determination that functional regulation needed to be supplemented by 
consolidated supervision of holding companies only in the case of 
affiliations involving banks and other insured depository institutions" 
because of risks associated with the access that banks and other 
insured depository institutions have to the federal safety net. These 
risks include the subsidy implicit in the federal safety net being 
extended to nonbank affiliates and ownership of an insured bank 
reducing market discipline. In addition, he cautioned that if Congress 
were to consider restructuring the federal financial regulatory 
agencies, it should carefully consider the benefits and costs, 
including the effect on the industry's competition and innovation and 
that any agency "strategic plan" would be unable to anticipate the 
effects of this innovation.

The Chairman of the Federal Deposit Insurance Corporation wrote that 
the draft report paid insufficient attention to the fact that deposit 
insurance is limited to insured depository institutions, and the danger 
that focusing on consolidated supervision would blur the distinction 
between the insured depository institution and any uninsured 
affiliates. He noted that this distinction would become more important 
if the marketplace drives greater mixing of commerce and finance than 
currently occurs. He also warned that, if federal financial regulators 
were to be consolidated, the value of differing perspectives within the 
regulatory system would be lost and independence of the deposit insurer 
could be diminished.

The Comptroller of the Currency also warned that any change in the 
federal financial regulatory structure "should be approached 
judiciously and cautiously." Like the Chairman of the Federal Reserve's 
Board of Governors, the Comptroller cautioned that changes in the 
federal regulatory structure could diminish the value of the dual 
banking system, with both state and federal charters for banks and 
thrifts. He noted that, while some foreign regulators may have 
preferred the "convenience" of having only one U.S. negotiator in the 
Basel II negotiations, this might have been less important than their 
desire to reach an agreement without the formal rule-making process 
that U.S. regulators must follow.

We agree with many of these comments, and believe the report accurately 
reflects the challenges that Congress would face if it were to choose 
to consider some consolidation or modification of the current federal 
financial regulatory structure. Achieving a balance between market 
forces and regulation is an inherently difficult task. We have made 
several changes to our report to ensure that it reflects this 
difficulty. In particular, we expanded our discussion of the statutory 
goals for the federal financial regulators. We also changed phrasing in 
the report to make clear that federal deposit insurance does not extend 
beyond FDIC-insured depository institutions. It is a valid concern that 
deposit insurance not be extended beyond the insured depository under 
any circumstances. We have also noted that the federal rule-making 
process could contribute to the statements made to us by foreign 
financial regulators about U.S. participation in the Basel II 
negotiations. In addition, we expanded our discussion of agency 
strategic plans to make clear that their purpose is better preparing 
agencies to meet the challenges posed by the industry's innovations. 
During our study, we were impressed by the strategic focus that appears 
to permeate UK-FSA and believe that, in this regard, it is a useful 
model for U.S. agencies to study. We agree with the Chairman of the 
Federal Reserve's Board of Governors that a single regulator could 
"prohibit or restrain" innovation, and believe that the report does 
recognize this risk. In addition, while we recognize that Congress 
referred to the importance of deposit insurance and of not extending 
the safety net in its discussion of the Federal Reserve's role as a 
consolidated supervisor, it did not limit its discussion of 
consolidated supervision to this purpose and did not ensure that all 
insured depositories owned by other entities would be subject to 
consolidated supervision. For example, GLBA gave SEC the authority to 
oversee SIBHCs--investment bank holding companies that do not own 
certain types of insured depositories (at the option of the investment 
bank.) In addition, because GLBA exempts some insured depositories, 
either directly or as a result of grandfathering some pre-existing 
conditions, some of the most complex institutions in the United States 
that own insured depositories are not required to have consolidated 
supervision. Instead, these institutions are seeking consolidated 
supervision because of changes in EU law.

In his comments, the Director of the Office of Thrift Supervision wrote 
that the report inadequately recognized OTS's authority over thrift 
holding companies, including the top-tier parent company; that the 
report inaccurately portrayed OTS's international activities; and 
presented an "unbalanced" view in referring to the failure of Superior 
Bank, FSB, without referring to other bank failures.

We do not agree. Our report recognizes OTS's authority, noting that, 
under the Home Owners' Loan Act and other legislation, "companies that 
own or control a savings association are subject to supervision by 
OTS." Further, the report includes a section in chapter 1 devoted to a 
discussion of OTS's authority to oversee thrift holding companies; 
again in chapter 4, we discuss OTS's authority as a consolidated 
supervisor. In the report, we acknowledge that because OTS oversees 
some of the largest, most complex U.S. financial services firms, it may 
serve as the consolidated supervisor for some of these firms under the 
Conglomerates Directive of the EU Action Plan. As noted, however, we 
have neither evaluated OTS's thrift holding company examinations nor 
compared them with Federal Reserve examinations of bank or financial 
holding companies of similar size and complexity. Our report also 
discusses OTS's role in international forums--specifically its 
participation in the Basel II negotiations--and at OTS's suggestion, we 
have modified the report to make clear that OTS has applied to be a 
permanent member of the Basel Committee. However, we note that they 
continue to be the only federal regulator of depository institutions, 
other than NCUA, that does not have a permanent seat on this important 
committee.

Finally, while Superior Bank failed because of its own actions, the 
failure also provided lessons on the need for federal regulators to 
work together better. The then-Director of OTS acknowledged this need 
in testimony before the Senate Committee on Banking, Housing, and Urban 
Affairs.[Footnote 93] In our assessments of that failure, both the FDIC 
Inspector General and we found that effective coordination was 
lacking.[Footnote 94] We did revise this report to make explicit that 
the primary reason for Superior's failure was actions by its owners and 
management. We also added a reference to the failure of the First 
National Bank of Keystone (West Virginia) that, according to a report 
by the Treasury Inspector General, also showed the need for better 
communication between FDIC and a primary federal regulator. (In the 
Keystone instance, OCC was the primary federal regulator.) Our report 
does discuss an agreement among federal bank regulators establishing a 
better process to determine when FDIC will join in the examination of 
an insured bank. In the comments, OTS also noted that, as a percentage 
of assets, the cost to the insurance fund of resolving Superior Bank 
was the lowest of the group of failures it cited (including Keystone). 
However, the Keystone and Superior failures did incur the largest costs 
to the insurance funds ($635 million and $436 million, respectively) of 
the failures that OTS cited.

In SEC's comments on the draft report, the Director of the Division of 
Market Regulation noted that "supervision and regulation can always be 
improved, but the costs of change must always be weighed against its 
benefits." As noted above, we concur.

In addition to the written comments, we also received technical 
comments and corrections from the staffs at these agencies, or in the 
case of OTS as part of their written comments. We have incorporated 
these into the report, as appropriate.

We also provided the Department of the Treasury and CFTC with a draft 
of the report, so that they could provide written comments, if they 
wished. Neither agency chose to provide such comments. Because the 
report discusses proposals for an optional federal insurance charter, 
we also provided a draft to NAIC, representing the state insurance 
regulatory agencies, for them to provide comments; NAIC did not provide 
comments. We did receive technical comments and corrections from 
Treasury, CFTC, and NAIC staff that we have incorporated into the 
report, as appropriate.

[End of section]

Appendixes:

Appendix I: Comments from the Board of Governors of the Federal Reserve 
System:

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM: 
WASHINGTON, D.C. 20551:

September 16, 2004:

ALAN GREENSPAN: 
CHAIRMAN:

Mr. Thomas J. McCool: 
Managing Director: 
Financial Markets and Community Investment: 
U.S. Government Accountability Office:
441 G Street, N.W., Room 2A32: 
Washington, D.C. 20548:

Dear Mr. McCool:

The Federal Reserve appreciates the opportunity to provide comments on 
a draft of the GAO's report on the regulatory structure of the U.S. 
financial services industry (GAO-04-0889). The report reviews the 
existing regulatory structure for the U.S. financial services industry, 
as well as the financial services regulatory structure implemented by a 
few other countries, and offers some broad alternatives that the 
Congress might wish to consider for consolidating the U.S. structure. 
These alternatives include vesting a single agency with regulatory 
responsibility for the entire financial services industry; establishing 
two overarching agencies, with one having responsibility for safety and 
soundness regulation and the other for market conduct across all 
financial services sectors; vesting a single agency with responsibility 
to oversee all large or internationally active financial services 
firms; or consolidating the regulatory agencies within individual 
sectors.

The report takes on a challenging task, especially given the breadth 
and diversity of the financial services industry in the United States 
and the fact that, by all indications, our regulatory framework has 
worked well and helped promote innovation, competition and stability in 
the financial markets. The Congress serves as the "strategic planner" 
of the U.S. financial system and in this capacity shapes the overall 
structure of our financial regulatory system and balances the costs and 
benefits of modifications to that system. Less than five years ago, the 
Congress considered the issues of financial modernization, 
globalization, concentration and competition across sectors of the 
financial services market along with the implication of these forces 
for the U.S. regulatory framework in connection with its passage of the 
Gramm-Leach-Bliley Act (GLBA). The resulting historic legislation 
eliminated outdated restrictions that previously limited the ability of 
financial services firms to affiliate and compete with one another and 
enhanced the ability of U.S. financial services firms to respond to 
technological changes and compete internationally.

GLBA also provided for a regulatory framework that struck a balance 
between the need for regulation and the need for adaptability. The 
Congress at that time chose to retain and build upon the functional 
regulation approach, one which has worked well for the United States 
and, as the report notes, has helped promote the competition and 
innovation that is a hallmark of the U.S. financial system. Functional 
regulation helps ensure that regulatory oversight is imposed in each 
sector only to the extent necessary to address perceived market 
failings in that sector, such as to provide appropriate protection of 
investors (in securities markets) and consumers (in banking markets) 
and to ensure the safety and soundness of insured depository 
institutions where counterparty discipline is undermined by the effects 
of the government subsidy provided to depository institutions through 
deposit insurance and access to the discount window and payments 
system. Given the variety of goals associated with the regulation of 
different components of the financial system, the Congress determined 
that supervision was best accomplished by individual functional 
regulators who implement statutory mandates tailored to their 
individual sectors.

The Congress also reaffirmed its determination that functional 
regulation needed to be supplemented by consolidated supervision of 
holding companies only in the case of affiliations involving banks and 
other insured depository institutions. Notably the Congressional 
decision to require consolidated supervision of such financial services 
firms was not driven by size, but by the unique risks that occur when 
these firms are affiliated with depository institutions that have 
access to the federal safety net (that is, the risk that the subsidy 
arising from the federal safety net may spread to non-bank affiliates, 
as well as the reduced market discipline that may result from the 
company's ownership of an insured bank). In retaining the Federal 
Reserve's role as the consolidated or umbrella supervisor for bank and 
financial holding companies, the Congress reaffirmed the need for the 
central bank to maintain a significant role in the supervision of 
banking entities. The Federal Reserve, through consolidated capital 
requirements, examinations and reporting requirements (supplemented, 
where appropriate, by enforcement authority) seeks to ensure that the 
risks from the consolidated operations of a bank or financial holding 
company--including large and internationally active organizations--do 
not pose a risk to its subsidiary depository institutions. Moreover, in 
its role as umbrella supervisor, the Federal Reserve works to 
coordinate its supervisory functions and share information as 
appropriate with the functional regulators of the subsidiaries of a 
financial or bank holding company.

On balance, while our present regulatory structure is admittedly 
complex, the dynamism of our financial system also owes much to the 
opportunities, checks and balances that it provides. This no doubt 
helps explain why, less than five years ago, the Congress decided to 
build on the existing system of functional regulation when it reviewed 
the regulatory system for financial services in connection with the 
GLBA. Certainly, if the Congress should decide at some point in the 
future to revisit the issue of significant regulatory consolidation, it 
should conduct a careful and in-depth analysis of the potential costs 
and benefits associated with any proposed changes, including the impact 
of any changes on competition and innovation in the financial services 
industry.

In particular, the Congress should recognize that it may be difficult 
to consolidate the regulators for different sectors without altering 
the extent and nature of regulation for at least some sectors of the 
industry. Historically, our regulatory system has been guided by the 
principle that the best means to promote competition among financial 
institutions and to maintain a resilient financial system is to provide 
regulation only as needed to address demonstrated market deficiencies. 
The long and remarkable history of product innovation in U.S. financial 
markets speaks eloquently to the power of this prescription. The 
Congress has found functional regulation to be the most desirable 
approach to achieve this goal, since it allows the type of regulation 
to be tailored to the market short-comings in each sector and allows 
individual regulators to focus on the goals mandated by the Congress. 
One danger of consolidating the regulatory agencies for different 
sectors is that it may lead to the extension of regulation beyond the 
individual segments where it currently is focused or to the expansion 
of the federal safety net. Spreading the ambit of supervision and 
regulation might well increase risk by reducing private market 
surveillance and discipline.

Consolidating regulatory responsibility for the entire financial 
services industry within a single agency also involves special risks. 
No matter how wise the particular regulatory agency, no "strategic 
plan" by that agency can adequately foresee innovations in the 
industry. Indeed, a single financial regulator with oversight 
responsibilities for all sectors of the financial services industry may 
well have prohibited or restrained the kinds of innovations and 
advances that have contributed so much to the growth and vitality of 
the U.S. economy.

If the Congress considers consolidation of the regulatory agencies in 
the banking sector, it also should be careful to preserve the "dual" 
banking system, which has contributed greatly to competition and 
innovation in banking markets.

The Federal Reserve staff has given GAO detailed comments on a draft of 
its report to the Congress on regulatory structure. We hope that these 
comments have been addressed in the final report.

Sincerely,

Signed by: 

Alan Greenspan: 

[End of section]

Appendix II: Comments from the Federal Deposit Insurance Corporation:

FEDERAL DEPOSIT INSURANCE CORPORATION, 
Washington DC 20429:

DONALD E. POWELL: 
CHAIRMAN:

September 14, 2004:

Mr. Thomas J. McCool: 
Managing Director: 
Financial Markets and Community Investment: 
General Accounting Office:
Washington, D.C. 20548:

Dear Mr. McCool:

Thank you for the opportunity to comment on your draft report on the 
U.S. financial regulatory structure. Your report recommends that 
Congress consider ways to improve the current regulatory structure and 
proposes several options as a starting point for those discussions.

The U.S. financial services system is the most vibrant and innovative 
in the world. As we explore options for regulatory reform, we should 
take care to preserve the strengths that presently underpin our 
financial services industry. But the industry is dynamic and what has 
served us well in the past may not be sufficient for the many and 
profound changes that have occurred in recent history. I have spoken on 
several occasions about the need to consider changes to the current 
regulatory structure in order to reflect the changes in the industry, 
to improve operating efficiencies, and to deliver policy in a timelier 
and more consistent manner. In 2003, the Federal Deposit Insurance 
Corporation held a symposium on the future of financial regulation, 
where some of the questions and issues raised in your report were 
explored.

The report is an important contribution to an extensive literature 
addressing options for restructuring the U.S. financial regulatory 
system. We are concerned, however, that the report did not address 
certain significant issues that need to be considered in any discussion 
of regulatory structure.

One major concern we have is that the report's treatment of 
consolidated supervision does not address the importance of legal-
entity distinctions. In the U.S., significant federal safety net 
protections are extended to FDIC-insured depository institutions. 
Banks' parents and affiliated organizations do not enjoy similar 
protections. Choosing the scope of the federal financial institutions 
safety net is one of the most important choices in the financial arena 
that Congress can make. Once that choice is made, certain consequences 
follow, for with the safety-net protection comes a critical need to 
protect against the danger that market discipline will erode, risks 
undertaken by the protected entities will increase, and the taxpayers 
will be forced to underwrite the cost.

The danger in focusing on consolidated supervision is that the line 
delimiting the scope of the federal safety net may become blurred. 
Strong supervision and regulation of FDIC-insured depository 
institutions at the entity level is necessary to contain the cost of 
administering the deposit insurance guarantee. From this perspective it 
is imperative that the regulatory structure be designed so that any 
additional layers of consolidated or parent company supervision do not 
interfere with the ability to regulate and supervise insured 
institutions. The more a bank becomes inextricably linked with its 
affiliates, the greater the likelihood that problems elsewhere in the 
organization will lead to that bank's failure, and the greater the 
costs the FDIC will incur in the receivership.

The issue of consolidated versus entity-level supervision will become 
increasingly important if, as we expect, the marketplace continues to 
evolve toward greater mixing of banking and commerce. The report is 
essentially silent on this matter. Will commercial firms that choose to 
enter the banking business be subject to consolidated supervision, thus 
bringing more and more economic activity into a regulatory framework 
designed to administer the financial safety net? Or will we limit our 
regulatory attention to the bank itself, the entity that has the direct 
connection to the federal safety net, and let the discipline of the 
market oversee the nonbank activity?

The tone of the report is generally supportive of some regulatory 
consolidation. The FDIC agrees that some degree of regulatory 
consolidation would lead to regulatory efficiencies. The current 
system, with four federal banking regulators, is complex and 
inefficient and occasionally burdensome to the regulated entities. 
Indeed, having multiple regulators can too often lead to gridlock on 
important policy issues, resource allocation challenges in the presence 
of a shifting workload, and operational coordination difficulties.

While correctly noting a number of potential benefits of regulatory 
consolidation, the report does not sufficiently address a risk that 
could exist under a single regulator model-the loss of effective 
independent voices in the regulatory process. A beneficial aspect of 
our current regulatory structure is the checks-and-balances that are 
built into it. We should consider the experience of countries whose 
largest banks dominate their domestic banking markets to a much greater 
extent than in the U.S., and where the bank regulatory framework is 
more monolithic than in the U.S. In such countries, capital 
requirements and capital levels are substantially lower than in the 
U.S., and some of those banking systems are experiencing weakness. U.S. 
banks are relatively stronger than banks around the world for a number 
of reasons, but perhaps especially because bankers, regulators and 
Congress learned important lessons in the 1980s and early 1990s. The 
lessons were in part embodied in the Federal Deposit Insurance 
Corporation Improvement Act and its Prompt Corrective Action framework, 
enacted in substantial measure to contain the costs of deposit 
insurance. In this regard, we must not lose sight of the importance of 
minimum capital requirements for institutions, such as FDIC-insured 
banks and thrifts, that enjoy explicit safety-net support.

The need to contain the costs of deposit insurance, and the tools the 
FDIC needs to do this, are straightforward and, we believe, necessary 
components of any regulatory reform package. First, to fulfill its role 
effectively, the deposit insurer needs continued independence and back-
up supervisory authority over the institutions it insures. Along with 
that independence, the power to approve or deny applications for 
deposit insurance, examine any insured institution or its affiliate, 
take enforcement actions, and participate on an ongoing basis in on-
site supervision are vital. While a perfect regulatory framework may 
never be attained, a strong and independent deposit insurer can, as 
history has shown, serve as an important line of defense against 
systemic problems in the industry and, ultimately, losses to the 
insurance fund. History also has proven that when an insurer has no 
supervisory authority and no input into who receives access to the 
federal safety net, the outcome can be costly and even disastrous. 
Although your report does not specifically address the importance of a 
strong independent insurer with the appropriate authority, the GAO's 
historical support for a strong independent insurer indicates that you 
share this view.

Finally, we applaud the report for noting the importance of people. The 
report mentions how regulatory agencies can essentially rise above a 
regulatory framework that is less than ideal, appropriately noting that 
"having an adequate number of people with the right skills, clear 
objectives, appropriate policies and procedures, and independence are 
probably more important" than the regulatory structure. To that end, 
the FDIC introduced a legislative proposal on September 1, 2004, that 
will, if enacted, enhance the agency's responsiveness to rapidly 
changing business and regulatory demands through changes in the size 
and composition of the Corporation's employment levels and skill sets.

Thank you again for your efforts. The FDIC looks forward to continued 
involvement in discussions of the U.S. regulatory framework.

Sincerely,

Signed by: 

Donald E. Powell: 

cc: Honorable Wayne Abernathy: 
Honorable Thomas J. Curry:
Honorable James E. Gilleran: 
Honorable Alan Greenspan: 
Honorable John D. Hawke: 
Honorable John Reich: 

[End of section]

Appendix III: Comments from the Office of the Comptroller of the 
Currency:

Comptroller of the Currency: 
Administrator of National Banks:

Washington, DC 20219:

September 17, 2004:

Mr. Thomas J. McCool:
Managing Director, Financial Markets and Community Investment: 
United States Government Accountability Office:
Washington, DC 20548:

Dear Mr. McCool:

We have received and reviewed your draft report entitled Financial 
Regulation: Industry Changes Prompt Need to Reconsider U.S. Regulatory 
Structure. The report was prepared at the request of Congress to 
describe the current state of the U.S. financial services regulatory 
structure in light of the passage of the 1999 Gramm-Leach-Bliley Act 
and increased competition within the financial services industry at 
home and abroad. The draft report concludes that (1) the financial 
services industry has undergone dramatic changes; (2) some countries 
and states have consolidated their regulatory structures, but the 
United States has not adopted consolidation proposals; (3) some 
regulators are adapting regulatory and supervisory approaches to 
industry changes; (4) regulators communicate and coordinate through 
multiple venues, but concerns remain; and (5) the U.S. regulatory 
system has strengths, but its structure may hinder effective 
regulation.

The report offers options for Congress to consider for changing the 
regulatory structure to (1) better address the risks posed by large, 
complex firms and their consolidated risk management approaches, (2) 
promote competition domestically and internationally, and (3) contain 
systemic risk. Options for consolidation could take place within 
functional areas, by regulatory objective, by combining all regulators 
into a single entity, or by creating a single regulator with 
responsibility for the oversight of large and/or internationally active 
financial services firms that manage risk centrally.

The report will provide a useful reference for continued discussions 
and deliberations on this important issue. In particular, the report 
underscores two important points with which we agree and that should be 
prominent in any dialog on regulatory restructuring. First, no one 
regulatory structure or framework is ideal. Each framework has its 
strengths and weaknesses and different jurisdictions have adopted 
different approaches-most of which remain untested in terms of a 
large scale, systemic problem or issue. Second, while any given 
regulatory structure may facilitate or hinder the attainment of 
regulatory goals, ultimately it is, as your report points out, the 
"skills of the people working in the regulatory system, the clarity of 
its objectives, its independence, and its management systems that are 
critical to the success of financial regulation."

I publicly observed in a speech before the Exchequer Club in April 2003 
that the current bank regulatory structure offends many of our 
aesthetic and logical instincts. It's complicated; it probably has 
inefficiencies; and it takes a great deal of explaining. But, I 
concluded that the system works-perhaps not in theory but in 
practice. Indeed, it works well. Coordination occurs among the agencies 
on a routine basis, with regard to both the supervision of individual 
firms and broader supervisory policies and procedures. While there are 
examples of inconsistency, such as the recent CRA rulemaking, 
regulatory cooperation is the norm, not the exception. On the whole the 
agencies have recognized the need to work together to avoid 
inconsistencies and to respect one another's jurisdictions and 
responsibilities. The exemplary manner in which the agencies cooperated 
to prepare for the Year 2000 date conversion and to cope with the 
aftermath of the September 11 emergency demonstrate the effectiveness 
of the existing relationships.

Another important consideration in deliberating the regulatory 
structure is the roles of the Federal Reserve System and the Federal 
Deposit Insurance Corporation (FDIC). The Federal Reserve maintains 
that it must have a major presence in bank supervision as an adjunct to 
its monetary policy and payments system responsibilities. Similarly, 
the FDIC opines that it must have a role in bank supervision to 
minimize risks and losses to the deposit insurance fund. Adopting the 
foreign models described in GAO's report would suggest that bank 
supervisory roles be extracted from these entities. Whether such a 
dramatic change in a system that is working well overall is warranted, 
is debatable.

For example, the GAO's draft report provides the perspective of some 
foreign regulators and other parties about the efficacy of the U.S. in 
recent Basel II negotiations. While some European regulators may have 
preferred the convenience of having only one U.S. regulator at the 
"negotiating table," their preference may be more indicative of a 
desire to finalize a Basel Accord without regard to the U.S. 
deliberative rulemaking process than of a judgment of the value that 
all of the U.S. regulators have contributed to the Basel II efforts. 
The U.S. agencies have been very clear in the Basel II discussions that 
the U.S. will have a rigorous and open rulemaking process. And it is 
precisely because of our insistence on this point that important 
changes have been made to the Basel II framework so as to not 
disadvantage U.S. firms even though this may have resulted in delays to 
the Basel Committee's initial timetable.

Finally, it is especially important to weigh the effect of any change 
in the regulatory structure at the federal level on the dual banking 
system. If the federal bank supervisory agencies were consolidated into 
a single independent agency that supervised both federally and state 
chartered institutions, then charter choice could become meaningless 
and result in pressure for uniformity of powers between state and 
federal institutions.

For these reasons, any decision to change or overhaul the U.S. 
financial regulatory structure should be approached judiciously and 
cautiously.

Thank you for providing us the opportunity to review and comment on the 
draft report. Technical suggestions were provided to the analysts 
separately.

Sincerely,

Signed by: 

John D. Hawke, Jr.: 
Comptroller of the Currency: 
[End of section]

Appendix IV: Comments from the Office of Thrift Supervision:

Office of Thrift Supervision: 
Department of the Treasury:
1700 G Street, N.W., 
Washington, DC 20552 
* (202) 906-6590:

James E. Gilleran:
Director:

September 9, 2004:

Thomas J. McCool:
Managing Director, Financial Markets and Community Investment:
United States Government Accountability Office: 
441 G Street, NW:
Washington, DC 20548:

Dear Mr. McCool:

This letter provides comments with regard to United States Government 
Accountability Office's (GAO) study entitled Financial Regulation: 
Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure. 
We have carefully considered the findings and recommendations contained 
therein, and feel that inferences made throughout the report will 
mislead the reader into drawing inaccurate conclusions, not only about 
Office of Thrift Supervision's (OTS) regulatory role in supervising 
thrift institutions and their holding companies, but the regulatory 
framework in the United States (U.S.) and abroad in general. We ask 
that you change your report to accommodate our concerns. The following 
discussion summarizes particular areas of concern.

1. OTS's Authority as a Consolidated Regulator:

The highlights page that accompanied the draft report asserts that in 
the U.S. regulatory structure today, "no one regulator has a complete 
picture of complex institutions engaged in more than one functional 
area." This statement is not accurate with respect to the thrift 
industry. Unique among U.S. Federal banking agencies, OTS has 
supervisory authority over the entire thrift holding company structure 
up through the top-tier parent company. The origin of OTS's current 
authority to supervise thrift holding companies dates to the Savings 
and Loan Holding Company Amendments of 1967. Thrift institutions and 
their affiliates (including thrift holding companies and their 
subsidiaries) are subject to OTS-prescribed regulations and 
examinations and are required to give OTS complete access to all books, 
records and personnel. Under this authority, we may require reports on 
the condition and operations of the thrift institution, its holding 
company(ies) and other related entities. OTS may also regulate and 
examine independent entities that provide services to thrift 
institutions, subsidiaries or affiliates pursuant to 12 U.S.C. 1464(d)
(7). OTS can take enforcement action against the service provider just 
as it can against the thrift, subsidiary or affiliate itself.

OTS supervises thrift holding companies that engage in more than one 
functional area. More than 100 thrift holding company structures are 
engaged in significant lines of business other than banking. These 
include insurance, asset management, financial services, retailing and 
manufacturing. The following list is representative of the diverse 
holding companies OTS supervises and is not all-inclusive. Some 
companies are mixed conglomerates with financial and non-financial 
operations while others are financial conglomerates. All have an OTS-
licensed thrift, cross-sector and cross-border operations, and are 
supervised on a consolidated basis by OTS:

Thrift Holding Company: American International Group; 
Consolidated Assets (as of June 2004): $736.0 billion. 

Thrift Holding Company: General Electric; 
Consolidated Assets (as of June 2004): $697.1 billion. 

Thrift Holding Company: General Motors; 
Consolidated Assets (as of June 2004): $454.2 billion. 

Thrift Holding Company: Lehman Brothers Holdings; 
Consolidated Assets (as of June 2004): $346.5 billion. 

Thrift Holding Company: American Express Company; 
Consolidated Assets (as of June 2004): $179.2 billion. 

Thrift Holding Company: The Allstate Insurance Company; 
Consolidated Assets (as of June 2004): $139.8 billion. 

Thrift Holding Company: Massachusetts Mutual Life Insurance Co; 
Consolidated Assets (as of June 2004): $ 89.9 billion. 

Thrift Holding Company: Capital One Financial; 
Consolidated Assets (as of June 2004): $ 50.1 billion. 

Thrift Holding Company: E*Trade Group; 
Consolidated Assets (as of June 2004): $ 30.2 billion. 

Thrift Holding Company: John Deere; 
Consolidated Assets (as of June 2004): $ 26.0 billion. 

Thrift Holding Company: Federated Department Stores; 
Consolidated Assets (as of June 2004): $ 14.6 billion. 

Thrift Holding Company: Auto Club Insurance Association; 
Consolidated Assets (as of June 2004): $ 3.1 billion. 

Thrift Holding Company: T Rowe Price Group; 
Consolidated Assets (as of June 2004): $ 1.7 billion. 

[End of table]

OTS is in a unique position of having comprehensive supervisory and 
enforcement powers over the entire corporate structure. The Home 
Owners' Loan Act clearly enables OTS to obtain a complete picture of 
the interrelationships and risks present, regardless of the complexity 
of the structure or whether it crosses more than one functional area. 
Figures 7 and 10 in the draft report fail to recognize that thrift 
holding companies have this level of complexity. Furthermore, the chart 
portrayed in Figures 7 and 10 is replete with errors. (For example, the 
chart refers to thrifts as "National" as opposed to "Federal." 
Furthermore, as crafted, the chart could be construed to imply that a 
financial holding company must always control a thrift holding company; 
and, most importantly, a holding company structure that controls both a 
thrift and a bank is subject to supervision by the Federal Reserve. 
OTS would not be involved in holding company supervision in this 
example.)

In order to facilitate group-wide supervision, and consistent with the 
functional regulation provisions of the Gramm-Leach-Bliley Act (GLBA), 
we have entered into regulatory cooperation agreements with supervisors 
in the U.S. and abroad. These cooperation agreements generally outline 
the type of information to share, procedures for sharing information, 
and expectations regarding handling of confidential information. Each 
agreement is adapted to address unique circumstances resulting from 
different state laws. To date, OTS has executed agreements with 48 
state insurance regulators, as well as state banking agencies, state 
thrift regulators, the Federal Home Loan Banks, and the National 
Association of Securities Dealers (NASD).

OTS also engages in a host of collaborative activities to further 
communications and enhance understanding of issues in all financial 
sectors. OTS staff has conducted meetings with Securities and Exchange 
Commission staff, NASD staff, and state securities regulators to 
understand their examination programs and practices so that we may 
address any gaps between functional regulators as we conduct our 
consolidated review. OTS staff also attends quarterly meetings 
sponsored by the National Association of Insurance Commissioners, as 
well as cross sector meetings hosted by the Board of Governors of the 
Federal Reserve. We have participated in training programs conducted 
by the insurance industry, as well as developed training for insurance 
supervisors to better understand the banking industry. Furthermore, OTS 
staff has been instrumental in bridging the gap between regulators to 
understand differences in cross-sector and cross-border banking, 
insurance and securities industry practices.

II. OTS International Initiatives:

OTS is extremely concerned with the GAO's inaccurate portrayal of OTS's 
international activities. These concerns are two-fold. First, we 
believe the report understates OTS's role in international initiatives 
on the Basel 11 Capital Framework and the European Union's Financial 
Conglomerates Directive. Recognizing that drafts of the Basel II 
capital framework and bifurcated capital requirements in the U.S. 
failed to address issues unique to mortgage-focused lenders and small 
institutions, OTS aggressively started attending and participating in 
meetings in Basel. Previously, OTS had informally participated by 
providing comments to other U.S. banking agencies that are permanent 
members of the Basel Committee. Furthermore, the changes to the Basel 
II framework, that some may have perceived as late, substantially 
improved the final product. Working together, the U.S. regulators, 
including OTS, were successful in negotiating improvements to include:

* The bifurcation of risk into two components--the long-run average 
losses (expected losses) and the variability around those losses 
(unexpected losses). The U.S. banking agencies took the lead in 
developing the appropriate capital treatment for these different types 
of losses. This separation of risk into component parts has made the 
framework more risk sensitive, especially for such assets as mortgages 
and credit cards, which are significant areas of concern to the U.S.

* The appropriate recognition of recovery risk. Periods of high default 
rates are often accompanied by low recovery rates on defaulted assets. 
The Basel II framework now incorporates recovery risk into the minimum 
capital requirement calculation.

* U.S. banks and thrifts make heavy use of securitization structures to 
redistribute risk. The U.S. banking agencies have been instrumental in 
incorporating the various aspects of securitization into the new 
framework.

Without these improvements, the new Basel framework would have been 
less risk sensitive and potentially detrimental to certain U.S. banking 
interests.

OTS has also been a leader in working with European Union 
representatives to implement the Financial Conglomerates Directive 
issued in December 2002. In fact, OTS had already implemented a 
comprehensive, more formalized supervisory planning process for high 
risk or other complex holding companies. For the most part, the 
majority of OTS-regulated holding companies that are considered 
complex, are identified as such because they either engage in a variety 
of financial services or other diverse activities such as commercial, 
retail or manufacturing. OTS responded to the convergence of banking, 
securities, and/or insurance activities in the thrift industry 
significantly before the enactment of GLBA expanded options for banks 
and their holding companies.

Our familiarity with these complex structures allowed us to share 
experiences not only as a consolidated regulator, but also as a 
regulator of structures with a variety of financial and commercial 
activities. Preliminary information provided by OTS to colleagues in 
the European Union was used as the cornerstone in developing a 
questionnaire for determining equivalency status. The legal authority 
that OTS has, combined with its' supervisory philosophy and strong 
tradition of cooperating with functional regulators across financial 
industries, were quickly identified as critical factors in consolidated 
supervision. OTS actively employs this tradition with a broader base of 
foreign regulators as they become more sensitive to consolidated 
supervision. OTS has actively engaged in extensive dialogue with a 
variety of foreign regulators, facilitated examination participation, 
coordinated numerous meetings, and had countless other communications 
on specific cases to deal with issues that arise in internationally 
active complex holding companies.

On July 7, 2004, the Banking Advisory Committee for the European Union 
issued general guidance on the extent to which the supervisory regime 
in the U.S. is likely to meet the objectives of consolidated 
supervision. The guidance concluded that there is broad equivalence in 
the U.S. supervisory approaches, including that employed by OTS. [NOTE 
1]

III. Superior Bank, FSB and Interagency Cooperation:

Throughout the report, the GAO asserts that the failure of Superior 
Bank, FSB of Hinsdale, Illinois (Superior), is attributed to poor 
interagency cooperation between the Federal Deposit Insurance 
Corporation (FDIC) and OTS. The singular focus on Superior's failure in 
2001 is unbalanced in light of the fact that there were several other 
bank failures around the same time with similar fact patterns. It is 
misleading, at best, to elaborate on only one of several similar 
failures and conclude without a comparative analysis that if regulatory 
cooperation were greater, the failure might not have occurred. In fact, 
the FDIC incurred significant losses in the resolution of three other 
depository institutions, two of which were regulated at the Federal 
level exclusively by the FDIC itself:

Institution: First National Bank of Keystone in Keystone, West 
Virginia; 
Approximate Cost to Insurance Fund [NOTE 2]: $635 million; 
Approximate Cost as a Percentage of Assets: 57%.

Institution: BestBank, Boulder, Colorado; 
Approximate Cost to Insurance Fund [NOTE 2]: $172 million; 
Approximate Cost as a Percentage of Assets: 55%.

Institution: Pacific Thrift and Loan Company in Woodland Hills, 
California; 
Approximate Cost to Insurance Fund [NOTE 2]: $52 million; 
Approximate Cost as a Percentage of Assets: 44%. 

[End of table]

While Superior is the only one in this group discussed in the report, 
it did not represent the largest loss to the insurance fund. The cost 
to the insurance fund to resolve Superior ($436 million) amounted to 22 
percent; the lowest cost of this group as a percentage of assets.

In each of these cases, the FDIC identified characteristics similar to 
Superior contributing to the failure of the institutions, including 
subprime lending and/or high loan-to-value lending without adequate 
prudential standards, apparent fraud, and/or large holdings of retained 
interests (or residuals) with questionable value. [NOTE 3] In two of 
these failures, there was not another primary Federal regulator to 
communicate and coordinate with; yet, the failure still occurred. 
These failures occurred not because of an isolated incidence that 
could be interpreted as a lack of interagency cooperation, but because 
these institutions poorly managed a significant level of asset 
securitizations while retaining residual interests that were 
overvalued. This is not recognized in the GAO study and, thus, the 
references to Superior should be deleted.

IV. Other Corrections:

In addition to the concerns noted above, we note the following 
corrections to the report.



Page: Multiple pages; 
Clarification/Correction: The report uses the term "bank" both 
generically as a depository institution and specifically as a 
commercial bank (as opposed to thrift). The dual usage is problematic 
to the reader.

Page: 3; 
Clarification/Correction: Line 3, after "For banks" add "and state 
savings banks." OTS regulates all federal savings associations and 
federal savings banks, state savings associations, but not state 
savings banks. Similar to state bank charters, the primary regulator 
is the state banking department, with FDIC or FRB also providing direct 
supervision.

Page: 6; 
Clarification/Correction: The first paragraph implies that Basel 11 
and consolidated supervision apply beginning January 1, 2005. 
Consolidated supervision is effective on that date, but Basel II is not 
effective until December 31, 2006, and can be postponed until the end 
of 2007 to allow for transition.

Page: 6; 
Clarification/Correction: The sentence "These activities may change 
the regulation of some. . ." does not make sense.

Page: 6; 
Clarification/Correction: The reference on this page, and all other 
references to the "Basel Committee on Bank Supervision" should be 
changed to "Basel Committee on Banking Supervision."  

Page: 7; 
Clarification/Correction: Text on this page is based purely on 
conjectures (i.e., may hinder, has the potential to create, may limit). 
There is not enough emphasis devoted to the current regulatory 
structure's contributions to development of U.S. capital markets and 
overall economic growth.

Page: 12; 
Clarification/Correction: Revise the sentence mid-paragraph that 
starts "The Financial Conglomerates Directive requires that non-
European financial conglomerates" (not just banks and security firms). 

Page: 12; 
Clarification/Correction: On this page, and elsewhere in the document 
the term "inappropriately supervised" firm has negative connotations.
Such terminology is not used in the Financial Conglomerates Directive.
The sentence should read as follows: "Under the directive, which goes 
into effect at the beginning of 2005, a non-European financial 
conglomerate, securities firm, or bank or financial holding company 
that is not supervised (delete "considered inappropriately) on a 
consolidated basis by an equivalent (delete "in its") home country 
supervisor would be subject to additional . . ."  

Page: 12; 
Clarification/Correction: Same paragraph, the sentence that starts "As 
a result many major U.S. companies. ." change "illustrate" to 
"demonstrate" and delete "acceptable" before consolidated supervision.

Page: 12; 
Clarification/Correction: Same paragraph, next sentence "Those 
companies that own thrift institutions may meet the requirement because 
OTS oversees thrift holding companies (insert on a consolidated 
comprehensive basis)."  

Page: 13; 
Clarification/Correction: First line, insert the word "investment" 
before holding companies.

Page: 13; 
Clarification/Correction: Line 13, sentence that begins "Securities 
regulators have repeatedly revised. . ." change "had" to "have."  

Page: 14; 
Clarification/Correction: Line 1, statement that "coordinated 
responses are not reached on some major issues." At end of sentence, 
add, "however, when there is a divergence, it reflects the need to 
address specific issues associated with a particular regulator's 
licensees (for example, thrift institutions that are primarily mortgage 
lenders, or small institutions)."  

Page: 14; 
Clarification/Correction: First paragraph, line 7, what does "On the 
international front" refer to? Basel 11 negotiations? Other 
negotiations? Clarification is needed.

Page: 15; 
Clarification/Correction: Paragraph 2, line 2, "some cases" is an 
overstatement.

Page: 15; 
Clarification/Correction: Paragraph 2, line 9, change "stat" to 
"state."  

Page: 18; 
Clarification/Correction: Line 2, change "communicate" to 
"communication."  

Page: 18; 
Clarification/Correction: Third line from the bottom. It is fallacious 
for the GAO to suggest that a "small agency" could be created to 
supervise the largest and most complex firms. Extensive resources are 
needed to accomplish a mission this expansive.

Page: 19; 
Clarification/Correction: Line 8 references footnote 2, there is no 
accompanying footnote.

Page: 20; 
Clarification/Correction: Line 1 refers to "International Stability 
Forum" whereas page 35 refers to "Financial Stability Forum."  

Page: 20; 
Clarification/Correction: Capitalize "Financial" in footnote 4.

Page: 21; 
Clarification/Correction: Footnote 5 runs across three pages, also 
reference to percent of domestic deposits held by ILCs is inconsistent 
between text (line 8) and footnote 5 age 22).

Page: 26; 
Clarification/Correction: Paragraph l, line 1, delete extra "be."  

Page: 26; 
Clarification/Correction: Middle paragraph, line 3. Add "and thrifts" 
after "Banks," and add "or Federal thrifts" after "national banks" 
later in the same sentence.

Page: 26; 
Clarification/Correction: Second line from bottom, change "thrifts" to 
"state savings banks."  

Page: 27; 
Clarification/Correction: In addition to federally chartered thrifts, 
OTS supervises state chartered savings associations.

Page: 27; 
Clarification/Correction: Line 6, change "bank regulator" to "federal 
regulator."  

Page: 27; 
Clarification/Correction: Line 13, change to "...regulators oversee 
and enforce compliance with consumer. . ."  

Page: 27; 
Clarification/Correction: Third and fourth lines from the bottom, 
delete "was first housed at" and delete the second "Farm Credit 
Administration."  

Page: 27; 
Clarification/Correction: Footnote 9, correct legal cite to read 
"Enforcement" not "Enhancement" regarding FIRREA.

Page: 28; 
Clarification/Correction: Line 3, change "position's" to "agencies'."  

Page: 28; 
Clarification/Correction: Footnote 11 ends abruptly. Should "security" 
or another word be added after "underlying?"

Page: 29; 
Clarification/Correction: Footnote 12, thrifts, as well as national 
banks, may engage in the certain types of insurance activities noted.

Page: 30; 
Clarification/Correction: Third to last line, reference should be to a 
thrift or bank.

Page: 30; 
Clarification/Correction: Last line, delete hanging "s" in middle of 
line.

Page: 31; 
Clarification/Correction: Line 4, change "Bank" to "bank."  

Page: 32; 
Clarification/Correction: Line 1, change "Owner's" to "Owners' ."  

Page: 32; 
Clarification/Correction: Line 8, change "an" thrift holding company to 
"a"thrift holding company.

Page: 34; 
Clarification/Correction: First bullet, line 2, insert "as members" 
after "participate." At the end of the sentence after the footnote, 
insert "OTS participates as a temporary member pending acceptance of 
its request for permanent membership by the Basel Committee." Same 
bullet, line 9, delete "foreign" before "bank."  

Page: 34; 
Clarification/Correction: Footnote 18 is misplaced. It belongs on page 
33.

Page: 37; 
Clarification/Correction: Footnote 24 missing a period.

Page: 45; 
Clarification/Correction: Footnote 26, change "consolidatiob" to 
"consolidation."  

Page: 49; 
Clarification/Correction: Line 3, change "that" to "whether."  

Page: 53; 
Clarification/Correction: Line 2, change "reduce risk and securitized" 
to "reduce risk while securitized."  

Page: 53; 
Clarification/Correction: Line 5, change "geographic lines and" to 
"geographic lines along with." regulators do not routinely assess 
risks. . ." [OTS does assess risk.].

Page: 94; 
Clarification/Correction: Middle paragraph, line 1, change to include 
OTS as follows "The Federal Reserve, FDIC, OCC and OTS. . ."  

Page: 94; 
Clarification/Correction: Footnote 55 is misplaced. It belongs on page 
93.

Page: 95; 
Clarification/Correction: Line 5, add "OTS participates as a temporary 
member on the Basel Committee while its permanent membership request is 
considered by the Committee."  

Page: 95; 
Clarification/Correction: Footnote 56 is misplaced. It belongs on page 
94.

Page: 96; 
Clarification/Correction: Line 11, the sentences "For example, OTS" and 
"Since the large firms" are not factually correct. Although OTS does 
not have a permanent seat as a member of the Basel Committee, we have a 
temporary seat on the committee while our membership request is 
considered. Also, OTS supervised firms were represented in the 
negotiations on Basel II; not only do we attend Basel Committee 
meetings, we are also active members on two Basel capital 
implementation subgroups.

Page: 96; 
Clarification/Correction: Footnote 57 is misplaced. It belongs on page 
95.

Page: 98; 
Clarification/Correction: Footnote 59 is misplaced. It belongs on page 
97.

Page: 104; 
Clarification/Correction: Footnote 63 is misplaced. It belongs on page 
103.

Page: 106; 
Clarification/Correction: Footnote 67 is misplaced. It belongs on page 
105.

Page: 108; 
Clarification/Correction: Line 14, add "system" after "regulatory." We 
also disagree with the sentence "The U.S regulatory system is also not 
well structured for dealing with issues in a world where financial 
firms and markets operate globally." U.S. supervisors have had no 
significant problems in dealing with supervisors around the world, in 
banking or other sectors, regarding issues of mutual interest.

Page: 111; 
Clarification/Correction: Footnote 68 is misplaced. It belongs on page 
110.

Page: 123; 
Clarification/Correction: Line 11, change "communicate" to 
"communications."  

[End of table]

V. Conclusion:

Financial regulators in the U.S. have continually adapted to industry 
change with innovative and flexible regulatory and supervisory 
strategies. This level of flexibility and responsiveness cannot be 
guaranteed in an alternate structure. A healthy tension between the 
federal banking regulators has developed as we each bring the unique 
perspectives of the industry we supervise and regulate. This has 
significantly benefited the U.S. banking system, making it the 
healthiest, most innovative and robust in the world. Further, we note 
that the regulatory systems of other countries addressed in this report 
were restructured in response to significant problems or failing 
banking systems. The report's conclusions fail to recognize that this 
is not the case in the U.S., and, in fact, as noted by the GAO in the 
highlights cover page, the "strength and vitality of the U.S. financial 
services industry demonstrates that the regulatory structure has not 
failed." The countries studied did not take on change for the sake of 
change, nor have their new regulatory structures been tested by a 
crisis to determine if they perform as hoped. In fact, in one country 
systemic problems have continued to exist, even after the regulatory 
system was restructured.

The regulatory consolidation undertaken by the United Kingdom, Germany, 
Japan, the Netherlands, and Australia, individually, cannot 
realistically be compared due to the much greater size of the U.S. 
financial markets and corresponding number of regulators required. To 
adjust the scale, the entire European market (not individual countries) 
should be compared to the United States market as a whole. One 
regulator supervising the entire U.S. financial services industry would 
be unresponsive to the complexities of our dynamic and large financial 
marketplace. We also do not agree with statements in the draft report 
that U.S. firms are competitively disadvantaged by the presence of 
multiple regulators during international negotiations. Instead, we 
firmly believe that they are more ably represented by regulators that 
are attuned to their specific issues.

Finally, we note that one of the matters you highlight for 
Congressional consideration is that fewer bank regulators might reduce 
the cost of regulation and the opportunities for regulatory arbitrage. 
Regardless of how many Federal regulators exist, as long as financial 
institutions have the option of a state charter or license, the 
opportunity for regulatory arbitrage will continue to exist. We believe 
in the dual regulation of financial institutions by state and federal 
regulators, and we do not recommend it be abolished.

The caliber of U.S. banking regulation is unparalleled in the world 
today and U.S. financial institutions have been operating in recent 
years at historically unprecedented levels of profitability and 
capitalization; therefore, any major change to the regulatory structure 
would be ill-advised. If you have any questions or need additional 
follow-up information, please contact Scott M. Albinson at (202) 
906-7984.

Sincerely,

Signed by: 

James E. Gilleran: 

cc: Wayne A. Abernathy, Assistant Secretary for Financial Institutions, 
DOT: 
Susan Schmidt Bies, Governor, FRB:
Roger W. Ferguson, Jr., Vice Chairman, FRB: 
Cynthia A. Glassman, Commissioner, SEC: 
John D. Hawke, Comptroller, OCC:
James E. Newsome, Chairman, CFTC: 
Donald E. Powell, Chairman, FDIC:

NOTES: 

[1] The guidance did note certain caveats with many of the U.S. 
financial regulators. In the case of OTS, the only caveat noted was 
that because of the diverse population of holding companies we 
regulate, we do not employ a rigid, consolidated minimum capital 
requirement. The Banking Advisory Committee clearly understood our 
thinking behind our case-by-case approach. No other comments were noted 
with respect to OTS.

[2] Data from several FDIC Office of Inspector General reports (see 
Report Nos. 04-004 and 02-024) and from FDIC update of September 8, 
2004.

[3] See Testimony of Donna Tanoue, then Chairman of the Federal Deposit 
Insurance Corporation, on recent bank failures and regulatory 
initiatives before the Committee on Banking and Financial Services on 
February 8, 2000. 

[End of section]

Appendix V: Comments from the Securities and Exchange Commission:

UNITED STATES SECURITIES AND EXCHANGE COMMISSION:
WASHINGTON, D.C. 20549:

DIVISION OF MARKET REGULATION:

September 15, 2004:

Mr. Thomas J. McCool:
Managing Director:
Government Accountability Office:
Financial Markets and Community Investment Issues: 
441 G Street, N.W.
Washington DC 20548:

Re: Draft Report GAO-04-889:

Dear Mr. McCool:

Thank you for the opportunity to comment on the Government 
Accountability Office's draft report GAO-04-889, entitled "Financial 
Regulation: Industry Changes Prompt Need to Reconsider U.S. Regulatory 
Structure." The draft report discusses the current U.S. financial 
regulatory structure and suggests potential alternatives. The draft 
report also notes that U.S. regulators and financial market 
participants generally expressed the view that the current regulatory 
structure has contributed to the development of U.S. capital markets 
and the overall growth and stability in the U.S. economy.

The GAO acknowledges the existence of factors, apart from structure, 
that make for good and effective regulation. For example, the draft 
report notes that the regulatory system benefits from the specialized 
knowledge regulators acquire within their specialized agencies. In 
addition, the draft report acknowledges that some regulators are 
adapting their regulatory and supervisory approaches to industry 
changes. The draft report includes as one example the SEC's voluntary 
oversight of holding companies as Consolidated Supervised Entities.

The SEC takes the goal of good and effective regulation seriously. 
[NOTE 1] We also share the conclusion in the draft report that 
cooperation and coordination among financial services regulators are 
important, especially in light of the consolidation of the financial 
services industry and the existence of large, multifaceted, global 
enterprises. Notably, however, while the financial services industry 
has been changing over the past several years, Congress reaffirmed the 
functional regulation of financial services conglomerates through the 
enactment of the Gramm-Leach-Bliley Act of 1999.

The draft report acknowledges that there are a number of permanent 
groups and regular meetings that bring together the agency heads and 
staff from the financial institution regulators, as well as 
international regulators. Some of these groups and regular meetings 
have existed for a number of years and others have been established 
since the passage of the Gramm-Leach-Bliley Act. The regular meetings 
of interagency and international working groups promote communication 
and the creation of working relationships among regulators at the staff 
level. The existence of working relationships among staff permits the 
agencies to work together more quickly and effectively both during 
crisis situations and in exercising their ongoing regulatory and 
supervisory functions.

Of course, supervision and regulation can always be improved, but the 
costs of change must always be weighed against its benefits. As a 
general matter, the U.S. financial services regulators focus their 
resources on integrity, safety, soundness, investor protection, and 
responding to the changing needs of the financial industry for more 
flexible and constructive regulation. These efforts have resulted in 
financial markets that are globally competitive and provide a broad 
array of services nationally.

Thank you again for the opportunity to comment on the draft report. We 
request that the GAO include a copy of this letter in the final report.

Sincerely,

Signed by: 

Annette L. Nazareth: 
Director:

NOTES: 

[1] 

For example, the SEC's Strategic Plan states:

The SEC will strengthen the integrity and soundness of U.S. securities 
markets for the benefit of investors and other market participants, and 
will conduct its work in a manner that is as sophisticated, flexible, 
and dynamic as the securities markets it regulates.

The mission of the Securities and Exchange Commission is to protect 
investors, maintain fair, orderly, and efficient markets, and 
facilitate capital formation.

Securities and Exchange Commission, FY 2004-2009 Strategic Plan, July 
2004.

[End of section]

Appendix VI: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Thomas J. McCool, (202) 512-8678: 
James M. McDermott, (202) 512-5373:

Staff Acknowledgments:

In addition to the individuals named above, Nancy S. Barry, Emily 
Chalmers, Patrick Dynes, James Kim, Marc W. Molino, Suen-Yi Meng, Kaya 
Leigh Taylor, Paul Thompson, John Treanor, and Cecile Trop also made 
key contributions to this report.

[End of section]

Related GAO Products:

SEC Operations: Oversight of Mutual Fund Industry Presents Management 
Challenges. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-584T]
Washington, D.C.: April 20, 2004.

Securities Markets: Opportunities Exist to Enhance Investor Confidence 
and Improve Listing Program Oversight. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-75]
Washington, D.C.: April 8, 2004.

Mutual Funds: Assessment of Regulatory Reforms to Improve the 
Management and Sale of Mutual Funds. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-533T]
Washington, D.C.: March 10, 2004.

Government-Sponsored Enterprises: A Framework for Strengthening GSE 
Governance and Oversight. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-269T]
Washington, D.C.: February 10, 2004.

Credit Unions: Financial Condition Has Improved, but Opportunities 
Exist to Enhance Oversight and Share Insurance Management. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-91]
Washington, D.C.: October 27, 2003.

Critical Infrastructure Protection: Efforts of the Financial Services 
Sector to Address Cyber Threats. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-173]
Washington, D.C.: January 30, 2003.

Potential Terrorist Attacks: Additional Actions Needed to Better 
Prepare Critical Financial Market Participants. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-251]
Washington, D.C.: February 12, 2003.

Securities Markets: Competition and Multiple Regulators Heighten 
Concerns about Self-Regulation. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-362]
Washington, D.C.: May 3, 2002.

SEC Operations: Increased Workload Creates Challenges. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-302]
Washington, D.C.: March 5, 2002.

Bank Regulation: Analysis of the Failure of Superior Bank, FSB, 
Hinsdale, Illinois. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-02-419T]
Washington, D.C.: February 7, 2002.

Insurance Regulation: The NAIC Accreditation Program Can Be Improved. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-01-948]
Washington, D.C.: August 31, 2001.

Federal Reserve System: Mandated Report on Potential Conflicts of 
Interest. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-01-160]
Washington, D.C.: November 13, 2000.

CFTC and SEC: Issues Related to the Shad-Johnson Jurisdictional Accord. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-89]
Washington, D.C.: April 6, 2000.

Responses to Questions Concerning Long-Term Capital Management and 
Related Events. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-67R]
Washington, D.C.: February 23, 2000.

Financial Regulatory Coordination: The Role and Functioning of the 
President's Working Group. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-46]
Washington, D.C.: January 21, 2000.

Long-Term Capital Management: Regulators Need to Focus Greater 
Attention on Systemic Risk. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-3]
Washington, D.C.: October 29, 1999.

The Commodity Exchange Act: Issues Related to the Commodity Futures 
Trading Commission's Reauthorization. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-99-74]
Washington, D.C.:

Risk-Based Capital: Regulatory and Industry Approaches to Capital and 
Risk. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-153]
Washington, D.C.: July 20, 1998.

OTC Derivatives: Additional Oversight Could Reduce Costly Sales 
Practice Disputes. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-98-5]
Washington, D.C.: October 2, 1997.

Financial Crisis Management: Four Financial Crises in the 1980s. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-96]
Washington, D.C.: May 1997.

Financial Derivatives: Actions Taken or Proposed Since May 1994. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD/AIMD-97-8]
Washington, D.C.: November 1, 1996.

Bank Oversight Structure: U.S. and Foreign Experience May Offer Lessons 
for Modernizing U.S. Structure. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-23]
Washington, D.C.: November 20, 1996.

Financial Regulation: Modernization of the Financial Services 
Regulatory System. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/T-GGD-95-121]
Washington, D.C.: March 15, 1995.

Financial Derivatives: Actions Needed to Protect the Financial System. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-94-133]
Washington, D.C.: May 18, 1994.

Bank Regulation: Consolidation of the Regulatory Agencies. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/T-GGD-94-106]
Washington, D.C.: March 4, 1994.

Regulatory Burden: Recent Studies, Industry Issues, and Agency 
Initiatives. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-94-28]
Washington, D.C.: December 13. 1003. 

[End of section]

(250151):

FOOTNOTES

[1] OTS is the supervisor for state-chartered saving associations that 
belong to the Savings Association Insurance Fund.

[2] The Basel Committee, a group of central bankers and regulators from 
13 countries, adopted the Basel II capital standards in June 2004. 
Different countries will implement these standards at different times 
and to varying degrees. In addition, regulatory agencies in the United 
States that oversee different functional areas may implement these 
standards differently. 

[3] Futures are one type of derivatives contract. The market value of a 
derivatives contract is derived from a reference rate, index, or the 
value of an underlying asset, including stocks, bonds, commodities, 
interest rates, foreign currency exchange rates, and indexes that 
reflect the collective value of underlying financial products. The 
regulation of derivatives generally varies depending on whether they 
are traded on exchanges (exchange-traded) or traded over-the-counter 
(OTC) and on the nature of the underlying asset, reference rate, or 
index. Futures 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 and are often traded on exchanges. 
Options--contracts that grant their purchasers the right but not the 
obligation to buy or sell a specific amount of the underlying asset, 
reference rate, or index at a particular price within a specified 
period--are also sometimes traded on exchanges. See chapter 2 for more 
information about derivatives.

[4] We use the term "thrifts" to refer to savings and loan associations 
and the term "thrift holding companies" to refer to savings and loan 
holding companies throughout this report.

[5] Our report Credit Unions: Financial Condition Has Improved, but 
Opportunities Exist to Enhance Oversight and Share Insurance 
Management, GAO-04-91 (Washington, D.C.: Oct. 27, 2003) discusses the 
credit union industry and the National Credit Union Administration 
(NCUA). Because credit unions have only about 9 percent of domestic 
deposits, this report does not discuss them in detail.

[6] ILCs are state-chartered institutions that may take deposits and 
offer some banking services, but generally are not permitted to offer a 
full range of bank services. GAO has an ongoing engagement looking at 
certain issues related to ILCs. Because ILC's have only about 1 percent 
of domestic deposits, this report does not discuss them in detail. 

[7] For example, associated persons who may act on behalf of other 
futures firms also play a role in futures markets.

[8] We recognize that there are alternative ways to categorize risks. 

[9] We use the term Federal Reserve throughout this report to refer to 
the Federal Reserve's Board of Governors, the 12 Federal Reserve Banks, 
or both, unless otherwise specified.

[10] See Financial Institution Reform, Recovery and Enforcement Act of 
1989 (FIRREA) § 407, 103 Stat. 363. 

[11] NASD is registered as a national securities association under 
section 15A of the Securities Exchange Act of 1934, 15 U.S.C. § 78o-3, 
(2000 & Supp. 2004) and is considered an SRO pursuant to section 
3(a)(26), 15 U.S.C. & 78c(a)(26). 

[12] These SROs include those dealing in exchange-traded options. SEC 
shares oversight of exchange-traded options with CFTC depending on the 
nature of the underlying. 

[13] SEC regulates sales of discrete products, such as certain types of 
annuities considered to be securities. Also, banks engage in certain 
types of insurance activities, such as underwriting credit insurance 
and, under certain circumstances, acting as an insurance agent either 
directly or through a subsidiary. Although these activities are subject 
to OCC regulation, national banks can be subject to nondiscriminatory 
state laws applicable to certain insurance-related activities. 

[14] The Bank Holding Company Act exempts certain types of depository 
institutions, such as ILCs chartered in certain states, from its 
definition of "bank," as well as some grandfathered banks. 
Consequently, a company's ownership or control of an ILC does not 
necessarily subject the company to supervision by the Federal Reserve. 

[15] The "functionally regulated" affiliates (and their respective 
functional regulators) are: registered broker-dealers, investment 
advisers, and investment companies (SEC); state-regulated insurance 
companies (state insurance authority); and CFTC-regulated firms (CFTC).

[16] Before the enactment of GLBA, a unitary thrift holding company 
whose subsidiary thrift was a qualified thrift lender generally could 
operate without activity restrictions. Additionally, a multiple thrift 
holding company that acquired all, or all but one, of its subsidiary 
thrifts as a result of supervisory acquisitions generally could operate 
without activity restrictions if all of the subsidiary thrifts were 
qualified thrift lenders. These thrift holding companies have been 
referred to as "exempt." The majority of thrift holding companies 
qualify as exempt. Nonexempt thrift holding companies were permitted to 
engage only in those nonbanking activities that were: specified by the 
Home Owners' Loan Act; approved by regulation as closely related to 
banking by the Federal Reserve; or authorized by regulation on March 5, 
1987.

[17] Pub. L. No. 101-432§ 4(a), 15 U.S.C. § 78q(h) (providing for, 
among other things, SEC risk assessment of holding company systems).

[18] For the SEC rules regarding consolidated supervised entities, see 
69 Fed. Reg. 34428 (June 21, 2004). For the SEC rules regarding 
supervised investment bank holding companies, see 69 Fed. Reg. 34472 
(June 21, 2004).

[19] See GAO, Federal Reserve System: Mandated Report on Potential 
Conflicts of Interest, GAO-01-160 (Washington, D.C.: Nov. 13, 2000).

[20] The Federal Reserve is represented by principals from the Federal 
Reserve Board of Governors and the Federal Reserve Bank of New York. 
OTS officials say that they participate in the Basel Committee as a 
temporary member pending acceptance of OTS's request for permanent 
membership. 

[21] The committee's members come from Belgium, Canada, France, 
Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, 
Switzerland, the United Kingdom, and the United States.

[22] The Joint Forum was initially referred to as "The Joint Forum on 
Financial Conglomerates." During 1999, its name was shortened to "The 
Joint Forum" to recognize that its new mandate went beyond issues 
related to financial conglomerates to other issues of common interest 
to all three sectors.

[23] The countries are Australia, Belgium, Canada, France, Germany, 
Italy, Japan, the Netherlands, Spain, Sweden, Switzerland, the United 
Kingdom, and the United States.

[24] We recently reviewed our work on regulation of government-
sponsored enterprises in Government-Sponsored Enterprises: A Framework 
for Strengthening GSE Governance and Oversight, GAO-04-269T 
(Washington, D.C.: Feb. 10, 2004).

[25] See GAO-04-91. 

[26] Pub. L. No. 103-328, 108 Stat. 2238 (1994).

[27] Gianni De Nicoló, Philip Bartholomew, Jahanara Zaman, and Mary 
Zephirin, "Bank Consolidation, Internationalization, and 
Conglomeration: Trends and Implications for Financial Risk" (IMF 
Working Paper 03/158, Washington, D.C., July 2003).

[28] Mortgage-backed securities numbers are from the Federal Reserve's 
flow of funds data and include federal agency and government sponsored 
enterprise-backed mortgage pools and mortgages backing privately issued 
pool securities and collateralized mortgage obligations.

[29] See chapter 4 for information about capital requirements.

[30] For earlier information on derivatives, see GAO, Financial 
Derivatives: Actions Needed to Protect the Financial System, GAO/GGD-
94-133 (Washington, D.C.: May 18, 1994); and Financial Derivatives: 
Actions Taken or Proposed Since May 1994, GAO/GGD/AIMD-97-8 
(Washington, D.C.: Nov. 1, 1996).

[31] IMF, Global Financial Stability Report: Market Developments and 
Issues, April 2004 (Washington, D.C., April 2004).

[32] See IMF, Global Financial Stability Report, April 2004; FSA, 
Cross-Sector Risk Transfers (London, U.K., May 2002); and Committee on 
the Global Financial System of the Bank for International Settlements, 
Global Credit Risk Transfer (Basel, Switzerland, January 2003).

[33] GAO, Long-Term Capital Management: Regulators Need to Focus 
Greater Attention on Systemic Risk, GAO/GGD-00-3 (Washington, D.C.: 
Oct. 29, 1999). 

[34] Bank for International Settlements, 69th Annual Report, 1 April 
1998-31 March 1999 (Basel, Switzerland; June 7, 1999).

[35] Richard Herring and Til Schuermann, "Capital Regulation for 
Position Risk in Banks, Securities Firms, and Insurance Companies" 
(paper at the Conference on Risk-Based Capital: The Tensions between 
Regulatory and Market Standards, Program on International Financial 
Systems, Harvard Law School (Cambridge, Massachusetts; June 10, 2003). 

[36] The failure of Barings did not involve the use of British 
government funds. In addition, officials at the Federal Reserve note 
that Barings was much smaller than many of today's banking 
organizations.

[37] José de Luna Martínez and Thomas A. Rose, "International Survey of 
Integrated Financial Sector Supervision" (World Bank Policy Research 
Working Paper 3096, July 2003).

[38] The EU is a treaty-based organization of European countries in 
which those countries cede some of their sovereignty so that decisions 
on specific matters of joint interest can be made democratically at the 
European level.

[39] Together with the state central banks, the European Central Bank 
conducts monetary policy for the EU, but has no regulatory or 
supervisory powers.

[40] Officials in the Netherlands call this functional regulation as do 
officials in other countries that have adopted a similar structure.

[41] Regarding exchange-traded futures, federal law generally pre-empts 
state authority. However, states may have jurisdiction to enforce anti-
fraud laws related to activities involving futures contracts. 

[42] See Federal Reserve Board, Order Approving Formation of a Bank 
Holding Company and Notice to Engage in Nonbanking Activities, 84 Fed. 
Res. Bull. 985 (1998).

[43] Under OCC regulations effective December 31, 1996, national banks 
were permitted to engage in a broader range of activities through 
subsidiaries than the Comptroller permitted within the banks 
themselves. See 61 Fed. Reg. 60351-52 (Nov. 27, 1996).

[44] National banks can be subject to SEC broker registration 
requirements if they execute orders for customers that involve 
securities not exempt from SEC jurisdiction or transactions not subject 
to an exception under the securities laws. See 15 U.S.C. § 78c(a)(4) 
(2000 & Supp. 2004).

[45] Subject to the preemption standard set forth in GLBA and 
prohibitions against discriminatory state laws, GLBA authorizes limited 
state regulation of insurance sales by banks and savings associations. 
Pub. L. No. 106-102 § 104, 15 U.S.C. § 6701 (2000 & Supp. 2004).

[46] Pub. L. No. 106-102 § 307, 15 U.S.C. § 6716 (2000 & Supp. 2004).

[47] Pub. L. No. 106-102 §§ 111, 112, 12 U.S.C. §§ 1844(c), (g).

[48] Pub. L. No. 106-102 § 111, 12 U.S.C. § 1844(c).

[49] Pub. L. No. 106-102 § 321.

[50] This proposal was outlined in the statement of the Honorable Lloyd 
Bentsen, Secretary of the Treasury, before the Committee on Banking, 
Housing, and Urban Affairs of the U.S. Senate (Mar. 1, 1994).

[51] H.R. 1227: The Bank Regulatory Consolidation and Reform Act of 
1993 (Mar. 4, 1993).

[52] CRS, Bank Regulatory Agency Consolidation Proposals: A Structural 
Analysis (Washington, D.C; Mar. 18, 1994).

[53] This proposal was outlined in the statement of Alan Greenspan, 
Chairman, Board of Governors of the Federal Reserve System, before the 
Committee on Banking, Housing, and Urban Affairs of the U.S. Senate 
(Mar. 2, 1994).

[54] SIA, Reinventing Self-Regulation, White Paper of the Securities 
Industry Association's Ad Hoc Committee on Regulatory Implications of 
De-Mutualization (Washington, D.C; Jan. 5, 2000). We discussed this 
report and SEC's views in our report Securities Markets: Competition 
and Multiple Regulators Heighten Concerns about Self-Regulation, GAO-
02-362 (Washington, D.C.: May 3. 2002).

[55] GAO-02-362.

[56] In 1965, SEC became responsible for direct regulation of a small 
number of broker-dealers that traded only in the over-the-counter 
market. This program, called the Securities and Exchange Only program, 
was designed to provide participating firms with a regulatory 
alternative to NASD. In 1983, SEC concluded that the industry would be 
better served if the program were discontinued, because needed 
improvements would be costly and not an efficient use of agency 
resources.

[57] The Basel II framework includes several levels of approaches for 
determining capital requirements for banks. While the standard 
approaches will be available for implementation in 2006, the most 
advanced approaches, which are the only ones being proposed for some 
U.S. banks, will not be available for implementation until 2007. 

[58] Off-balance sheet items are financial contracts that can create 
credit losses for banks but are not reported on banks' balance sheets 
under standard accounting practices. An example of such an off-balance 
sheet position is a letter of credit or an unused line of credit 
committing the bank to making a loan in the future that would be on the 
balance sheet and thus creates a credit risk. To adjust for credit 
risks created by financial positions not reported on the balance sheet, 
U.S. regulations provide conversion factors to express off-balance 
sheet items as equivalent on-balance sheet items, as well as rules for 
incorporating the credit risk of off-balance sheet derivatives. 

[59] EU member states have been required to adopt capital adequacy 
rules that are generally consistent with Basel standards for credit 
institutions (banks and securities firms). Thus, to satisfy the EU 
requirements, U.S. banks and securities firms operating in EU member 
states would be subject to similar requirements. The EU is currently 
considering amendments to relevant directives partly in response to the 
adoption of Basel II.

[60] See SEC, Alternative Net Capital Requirements for Broker-Dealers 
That Are Part of Consolidated Entities, 69 FR 34428 (June 21, 2004); 
and Supervised Investment Bank Holding Companies 69 FR 34472 (June 21, 
2004).

[61] Because the EU Financial Conglomerate Directive is effective in 
January 2005 and the Basel II standards are not required until year-end 
2006, there is some question as to whether CSEs will adopt Basel II 
standards at the time of their registration. 

[62] Some bank, financial, and thrift holding companies with 
significant broker-dealer affiliates may also register as CSEs. Their 
broker-dealers will have the option of complying with the capital 
standards consistent with Basel II rather than SEC's net capital rule.

[63] SEC staff notes that it raised this issue before completion of the 
final Basel II draft.

[64] GAO, Risk-Focused Bank Examinations: Regulators of Large Banking 
Organizations Face Challenges, GAO/GGD-00-48 (Washington, D.C.: Jan. 
24, 2000).

[65] See joint press release issued by Federal Reserve, FDIC, NCUA, 
OCC, and OTS (Washington, D.C; July 28, 2004), http://
www.federalreserve.gov/boarddocs/press/bcreg/2004/20040728/
default.htm (downloaded Sept. 10, 2004). See also 31 U.S.C. 5318(l) 
(2000 & Supp. 2004).

[66] GAO, SEC Operations: Increased Workload Creates Challenges, GAO-
02-302 (Washington, D.C.: Mar. 5, 2002). 

[67] GAO, SEC Operations: Oversight of Mutual Fund Industry Presents 
Management Challenges, GAO-04-584T (Washington, D.C.: Apr. 20, 2004).

[68] GAO-04-584T, 14.

[69] See 7 U.S.C. § 7a(d) (2000 & Supp. 2004).

[70] See Trading Facilities, Intermediaries and Clearing Organizations; 
New Regulatory Framework; Final Rule, 66 Fed. Reg. 42256-42289 (Aug. 
10, 2001); see also Proposed Rules for Execution of Transactions: 
Regulation 1.38 and Guidance on Core Principle 9 69 Fed. Reg. 39880-
39886 (July 1, 2004).

[71] 17 C.F.R. § 37.6 (2004).

[72] Pub. Law No. 95-630, Title X. See http://www.ffiec.gov/about.htm.

[73] Offices of the Inspector General at Treasury, FDIC, and Federal 
Reserve, Joint Evaluation of the Federal Financial Institutions 
Examination Council (Washington, D.C; June 21, 2002).

[74] See OCC, "Policy Statement on Examination Coordination and 
Implementation Guidelines," Examination Planning and Control Handbook 
(Washington, D.C., July 1997). 

[75] OTS officials say that they participate in the Basel Committee as 
a temporary member pending acceptance of OTS's request for permanent 
membership. 

[76] See GAO, Bank Regulation: Analysis of the Failure of Superior 
Bank, FSB, Hinsdale, Illinois, GAO-02-419T (Washington, D.C.: Feb. 7, 
2002).

[77] Letter from Representative Michael Oxley et al. to Chairman Alan 
Greenspan et al., Nov. 3, 2003.

[78] GAO, Securities Markets: Competition and Multiple Regulators 
Heighten Concerns about Self-Regulation, GAO-02-362 (Washington, D.C.: 
May 3, 2002).

[79] GAO, Insurance Regulation: The NAIC Accreditation Program Can Be 
Improved, GAO-01-948 (Washington, D.C.: Aug. 31, 2001). 

[80] GAO, Financial Regulatory Coordination: The Role and Functioning 
of the President's Working Group, GAO/GGD-00-46 (Washington, D.C.: Jan. 
21, 2000).

[81] GAO, Critical Infrastructure Protection: Efforts of the Financial 
Services Sector to Address Cyber Threats, GAO-03-173 (Washington, D.C.: 
Jan. 30, 2003). 

[82] The commission was created in Title V of the Fair and Accurate 
Credit Transactions Act of 2003, known as the Financial Literacy and 
Education Improvement Act. See Pub. L. No. 108-159, Title V, 117 Stat. 
2003 (codified at 20 U.S.C. §§ 9701-08). The act also mandated that GAO 
report on recommendations for improving financial literacy among 
consumers. On July 28, 2004, GAO hosted a forum entitled "Improving 
Financial Literacy: The Role of the Federal Government." The results of 
this forum will appear in a forthcoming GAO report.

[83] GAO/GGD-00-46. 

[84] GAO, Long-Term Capital Management: Regulators Need to Focus 
Greater Attention on Systemic Risk, GAO/GGD-00-3 (Washington, D.C.: 
Oct. 29, 1999).

[85] GAO, Financial Crisis Management: Four Financial Crises in the 
1980s, GAO/GGD-97-96 (Washington D.C.: May 1, 1997).

[86] GAO, Potential Terrorist Attacks: Additional Actions Needed to 
Better Prepare Critical Financial Market Participants, GAO-03-251 
(Washington, D.C.: Feb. 12, 2003).

[87] GAO, Better Information Sharing among Financial Services 
Regulators Could Improve Protections for Consumers, GAO-04-
882R (Washington, D.C.: June 29, 2004). 

[88] See GAO/GGD-00-3; and GAO, Responses to Questions Concerning Long-
Term Capital Management and Related Events, GAO/GGD-00-67R (Washington, 
D.C.: Feb. 23, 2000).

[89] See GAO-03-251. 

[90] Gianni De Nicoló, Philip Bartholomew, Jahanara Zaman, and Mary 
Zephirin, "Bank Consolidation, Internationalization, and 
Conglomeration: Trends and Implications for Financial Risk" (IMF 
Working Paper 03/158, Washington, D.C., July 2003).

[91] See GAO, Telecommunications: Better Coordination and Enhanced 
Accountability Needed to Improve Spectrum Management, GAO-02-906 
(Washington, D.C.: Sept. 30, 2002).

[92] GAO/GGD-00-3, 3.

[93] Statement of Ellen Seidman, Director of the Office of Thrift 
Supervision, in U.S. Senate, Committee on Banking, Finance, and Urban 
Affairs, "The Failure of Superior Bank, FSB, Hinsdale, Illinois," 
September 11, 2001, and October 16, 2001, S. Hrg. 107-698, p. 13.

[94] Office of the Inspector General, FDIC, Issues Related to the 
Failure of Superior Bank, FSB, Hinsdale, Illinois, Audit Report 02-005 
(Washington, D.C; Feb. 6, 2002); and GAO, Bank Regulation: Analysis of 
the Failure of Superior Bank, FSB, Hinsdale, Illinois, GAO-02-419T 
(Washington, D.C.: Feb. 7, 2002).

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