Alert August 04, 2009

GAO Issues Report on Federal Oversight of Leverage

The Government Accountability Office (the “GAO”) released a report (the “Report”) on the role of leverage in the current financial crisis and federal oversight of leverage pursuant to a requirement in the Emergency Economic Stabilization Act of 2008.  In preparing the Report, the GAO reviewed the following: (1) how leveraging and deleveraging by financial institutions may have contributed to the current financial crisis; (2) regulations adopted by federal financial regulators to try to limit the use of leverage by financial institutions, and how regulators oversee the institutions’ compliance with the regulations; and (3) any limitations the current crisis has revealed in regulatory approaches used to restrict leverage and regulatory proposals to address them.

The Report notes that the causes of the current financial crisis remain subject to debate and additional research.  Nevertheless, the Report also notes that some studies have suggested that leverage steadily increased within the financial sector before the crisis began around mid‑2007, and that banks, securities firms, hedge funds, and other financial institutions have since sought to deleverage and reduce their risk, thereby compounding the current crisis.  In particular, some studies have suggested that deleveraging by selling financial assets could trigger downward spirals in financial asset prices, and that deleveraging by restricting new lending could contribute to the crisis by slowing economic growth.  However, other theories also provide possible explanations for the sharp price declines.  For example, the current market prices may be the result of asset prices reverting to their fundamental values after a period of overvaluation, or they may reflect uncertainty surrounding the true value of the assets.  In this regard, the Report concludes that because the crisis is complex, “no single theory is likely to fully explain what occurred or rule out other explanations.”  The Report also notes that financial regulators and market participants interviewed by the GAO had mixed views about the effects of deleveraging in the current crisis.

With respect to capital adequacy regulations, the Report states that the crisis has revealed limitations in existing regulatory approaches used to restrict leverage.  For example, the Report notes that, although large banks and broker-dealers generally held capital above the minimum regulatory capital requirements prior to the crisis, regulatory capital measures did not always fully capture certain risks.  As a result, a number of these institutions did not hold capital commensurate with their risks, and some lacked adequate capital or liquidity when the crisis began.  Federal financial regulators have acknowledged the need to improve the risk coverage of the regulatory framework and are considering reforms, including through international efforts to revise the Basel II capital framework.  Basel II, as it will be implemented in the U.S., allows for increased reliance on risk models for determining capital needs for certain large institutions.  Although the crisis highlighted concerns about the ability of such models to adequately measure risks for capital adequacy purposes, the Report notes that regulators have not formally assessed the extent to which Basel II reforms proposed by U.S. and international regulators may address these concerns.  According to the Report, such “an assessment is critical to ensure that Basel II reforms, particularly those that would increase reliance on complex risk models for determining capital needs, do not exacerbate regulatory limitations revealed by the crisis.”

The Report also discusses how the existing regulatory framework, as well as other factors, might have contributed to cyclical leverage trends that potentially exacerbated the financial crisis.  For example, minimum regulatory capital requirements, as currently structured, may not provide appropriate incentives for banks to build capital buffers in benign markets when it is relatively less expensive to do so.  While regulators are considering several options to counteract this procyclicality, the Report notes that implementation of these proposals presents challenges.

The Report also notes that the crisis has reinforced the need to focus greater attention on systemic risk and the potential for financial market disruptions, not just firm failures, to be a source of systemic risk.  In order to ensure that there is a systemwide approach to addressing leverage-related issues across the financial system, the Report recommends that, as Congress moves toward establishing a systemic risk regulator, it should consider the merits of assigning to such regulator the responsibility for (i) measuring and monitoring systemwide leverage and (ii) evaluating options to limit procyclical leverage trends.

Furthermore, the Report recommends that the federal banking agencies assess the extent to which Basel II reforms may “address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches used for capital adequacy purposes.”  The Report notes that the GAO received written comments from the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the SEC, all of whom generally agreed with the Report’s conclusions and recommendations.