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Dobrynya Shiryaev
Dobrynya Shiryaev

The Financial System, Financial Regulation And ...

The U.S. financial regulatory structure is complex, with responsibilities fragmented among multiple agencies that have overlapping authorities. As a result, financial entities may fall under the regulatory authority of multiple regulators depending on the types of activities in which they engage (see figure on next page). While the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) made a number of reforms to the financial regulatory system, it generally left the regulatory structure unchanged.

The Financial System, Financial Regulation and ...


In 2009, GAO established a framework for evaluating regulatory reform proposals and noted that an effective regulatory system would need to address certain structural shortcomings created by fragmentation and overlap. While changes made by the Dodd-Frank Act were consistent with some of the characteristics identified in this framework, the existing regulatory structure does not always ensure (1) efficient and effective oversight, (2) consistent financial oversight, and (3) consistent consumer protections. As a result, negative effects of fragmented and overlapping authorities persist throughout the system. For example, regulation of the swaps and security-based swaps markets by separate agencies creates potential market inefficiencies because of differences in certain of the agencies' rules for each product. GAO has previously made suggestions to Congress to modernize and improve the effectiveness of the financial regulatory structure. Without congressional action it is unlikely that remaining fragmentation and overlap in the U.S. financial regulatory system can be reduced or that more effective and efficient oversight of financial institutions can be achieved.

The U.S. financial regulatory structure has evolved over the past 150 years in response to various financial crises and the need to keep pace with developments in financial markets and products in recent decades.

GAO was asked to review the financial regulatory structure and any related impacts of fragmentation or overlap. This report examines the structure of the financial regulatory system and the effects of fragmentation and overlap on regulators' oversight activities. GAO reviewed relevant laws and agency documents on their oversight responsibilities; held discussion groups with former regulators, industry representatives, and experts; and interviewed agency officials.

Congress should consider whether changes to the financial regulatory structure are needed to reduce or better manage fragmentation and overlap. Congress should also consider whether legislative changes are needed to align FSOC's authorities with its mission to respond to systemic risks. GAO also recommends that OFR and the Federal Reserve (1) jointly articulate individual and common goals for their systemic risk monitoring activities and engage in collaborative practices to support those goals; and (2) regularly and fully incorporate their monitoring tools, assessments, or results of monitoring activities into Systemic Risk Committee deliberations. Federal Reserve and OFR agreed with GAO's recommendations.

The theme of the Federal Reserve Bank of Boston's Economic Conference this year--reevaluating regulatory, supervisory, and central banking policies in the wake of the crisis--is certainly timely. Not much more than a year ago, we and our international counterparts faced the most severe financial crisis since the Great Depression. Fortunately, forceful and coordinated policy actions averted a global financial collapse, and since then, aided by a range of government programs, financial conditions have improved considerably. However, even though we avoided the worst financial and economic outcomes, the fallout from the crisis has nonetheless been very severe, as reflected in the depth of the global recession and the deep declines in employment both here and abroad. With the financial turmoil abating, now is the time for policymakers to take action to reduce the probability and severity of any future crises.

Although the crisis was an extraordinarily complex event with multiple causes, weaknesses in the risk-management practices of many financial firms, together with insufficient buffers of capital and liquidity, were clearly an important factor. Unfortunately, regulators and supervisors did not identify and remedy many of those weaknesses in a timely way.1 Accordingly, all financial regulators, including of course the Federal Reserve, must take a hard look at the experience of the past two years, correct identified shortcomings, and improve future performance.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firmwide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or systemwide, approach that should help us better anticipate and mitigate broader threats to financial stability.

Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act. We have seen numerous instances when weaknesses and gaps in the regulatory structure itself contributed to the crisis, many of which can only be addressed by statutory change. Notably, to promote financial stability and to address the extremely serious problem posed by firms perceived as "too big to fail," legislative action is needed to create new mechanisms for oversight of the financial system as a whole; to ensure that all systemically important financial firms are subject to effective consolidated supervision; and to establish procedures for winding down a failing, systemically critical institution without seriously damaging the financial system and the economy. In the rest of my remarks, I will elaborate on each of these areas.

Strengthening Regulations and GuidanceFirst, I would like to report on changes already under way to strengthen the regulatory standards that limit the risks taken by financial firms and establish the capital and liquidity buffers that they must hold. Through the course of the crisis, it became increasingly clear that many firms lacked adequate capital and liquidity to protect themselves as well as the financial system as a whole. These problems became apparent not just in the United States but around the world, necessitating an internationally coordinated response. The Federal Reserve has played a key part in the international effort, working through organizations such as the Basel Committee on Bank Supervision and the Financial Stability Board. For example, we were extensively involved in the Basel Committee's recent decisions to strengthen capital requirements for trading activities and securitizations, and we continue to work with domestic and foreign supervisors to raise capital requirements for other types of on- and off-balance-sheet exposures.2

Additional steps are necessary to ensure that all banking organizations hold adequate capital. Internationally, the Financial Stability Board has called for significantly stronger capital standards, and the Group of Twenty has committed to develop rules to improve both the quantity and quality of bank capital.5 The Federal Reserve supports these initiatives. The structure of capital requirements should also be reviewed. For example, to reduce the tendency of current capital requirements to promote credit growth in booms and to restrict credit during downturns, the Federal Reserve has supported international efforts to develop capital standards that would be countercyclical. Countercyclical standards would require firms to build larger capital buffers in good times and allow them to be drawn down--but not below prudent levels--during more-stressed periods. We also are working with our domestic and international counterparts to develop capital and prudential requirements that take account of the systemic importance of large, complex firms whose failure would pose a significant threat to overall financial stability. Options under consideration include assessing a capital surcharge on these institutions or requiring that a greater share of their capital be in the form of common equity. For additional protection, systemically important institutions could be required to issue contingent capital, such as debt-like securities that convert to common equity in times of macroeconomic stress or when losses erode the institution's capital base.

In addition to insufficient capital and inadequate liquidity risk management, flawed compensation practices at financial institutions also contributed to the crisis. Compensation, not only at the top but throughout a banking organization, should appropriately link pay to performance and provide sound incentives. In particular, compensation plans that encourage, even inadvertently, excessive risk-taking can pose a threat to safety and soundness. The Federal Reserve has just issued proposed guidance that would require banking organizations to review their compensation practices to ensure they do not encourage excessive risk-taking, are subject to effective controls and risk management, and are supported by strong corporate governance including board-level oversight.7

A fundamental element of effective financial regulation is protecting consumers from unfair and deceptive practices. The recent crisis clearly illustrated the links between consumer protection and the safety and soundness of financial institutions. We have seen that flawed financial instruments can both harm families and impair financial stability. Strong consumer protection helps to preserve household savings and to provide families access to credit on terms that are fair and well matched with their financial needs and resources. At the same time, effective consumer protection promotes healthy competition in the financial marketplace, supports sound lending practices, and increases confidence in the financial system as a whole. 041b061a72


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