Based on a review of the FDIC and  Federal Reserve recommendations, the Secretary of the Treasury, in  consultation with the President, may make a systemic risk determination  authorizing FDIC to take action or provide assistance that does not meet  the least-cost requirements. Such  announcements can affect market expectations and contribute to moral  hazard, but the announcements alone—absent a Treasury determination— do not trigger requirements established by Congress for documentation  and communication of the agencies’ use of the systemic risk exception. Also as required by  the FDI Act, Treasury sent letters to Congress to notify the relevant  committees of all three determinations. Announcements of Emergency Actions without a Systemic Risk Determination Diminish the Level of Transparency and Accountability Intended by Congress

In all five cases, planned emergency actions were announced by  regulators, but Treasury did not make an immediate determination for  three of these announcements and still has not made a determination to  date in two of them. FDIC  could have effected a least-cost resolution of Wachovia Bank, N.A. Systemic Risk Determinations and Related Federal Assistance Raise Concerns about Moral Hazard and Market Discipline That May Be Addressed by Potential Regulatory Reforms

While the systemic risk determinations and associated federal assistance  may have helped to contain the crisis by mitigating potential systemic  adverse effects, they may have induced moral hazard—encouraging  market participants to expect similar emergency actions in future crises,  thereby weakening their incentives to properly manage risks and also  creating the perception that some firms are too big to fail. Furthermore,  uncertainty in these situations can arise because there is no requirement  for Treasury to communicate that it will not make a systemic risk  determination for an announced action. Legislators and regulators currently are considering regulatory proposals  to subject systemically important institutions, including those whose  market discipline is likely to have been weakened by the recent exercises  of the systemic risk exception, to stricter regulatory standards such as  higher capital and stronger liquidity and risk management requirements. Legislation has been proposed to expand  resolution authority to large financial holding companies deemed  systemically important that is intended to impose greater market  discipline and limit moral hazard by forcing market participants to face  significant costs from their risk-taking decisions. GAO staff who made major contributions to this  report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

To describe the steps taken by the Federal Deposit Insurance Corporation  (FDIC) and the Board of Governors of the Federal Reserve System  (Federal Reserve) to make the recommendations and the Department of  the Treasury (Treasury) to make determinations in some cases, we  reviewed documentation of recommendations that FDIC and the Federal  Reserve made for Wachovia, the Temporary Liquidity Guarantee Program  (TLGP), Citigroup, Bank of America, and the Public-Private Investment  Programs proposed Legacy Loans Program (LLP) as well as  documentation of Treasury’s determination for Wachovia, TLGP, and  Citigroup. We agree there is some support for the agencies’ position that the statute  authorizes systemic risk assistance of some type under TLGP facts, as well  as for their position that the exception permits assistance to the entities  covered by TLGP. What is clear, however, is that the  systemic risk exception overrides important statutory restrictions  designed to minimize costs to the Deposit Insurance Fund, and, in the case  of TLGP, that the agencies used it to create a broad-based program of  direct FDIC assistance to institutions that had never before received such  relief—”healthy” banks, bank holding companies, and other bank affiliates. (iv)  GAO review  The Comptroller General of the United States shall review and report to  the Congress on any determination under clause (i), including—  (I) the basis for the determination;  (II) the purpose for which any action was taken pursuant to such clause;  and  (III)  the likely effect of the determination and such action on the  incentives and conduct of insured depository institutions and  uninsured depositors.
Why GAO Did This Study

In 2008 and 2009, the Federal Deposit Insurance Corporation (FDIC) provided emergency assistance that required the Secretary of the Department of the Treasury (Treasury) to make a determination of systemic risk under the systemic risk exception of the Federal Deposit Insurance Act (FDI Act). The FDI Act requires GAO to review each determination made. For the three determinations made to date, this report examines (1) steps taken by FDIC, the Board of Governors of the Federal Reserve System (Federal Reserve), and Treasury to invoke the exception; (2) the basis of the determination and the purpose of resulting actions; and (3) the likely effects of the determination on the incentives and conduct of insured depository institutions and uninsured depositors. To do this work, GAO reviewed agency documentation, relevant laws, and academic studies; and interviewed regulators and market participants.

What GAO Found

Treasury, FDIC, and the Federal Reserve collaborated before the announcement of five potential emergency actions that would require a systemic risk determination. In each case, FDIC and the Federal Reserve recommended such actions to Treasury, but Treasury made a determination on only three of the announced actions. Although two recommendations have not resulted in FDIC actions to date, their announcement alone could have created the intended effect of increasing confidence in institutions, while similarly generating negative effects such as moral hazard. However, because announcements without a determination do not trigger FDI Act requirements for documentation and communication, such as Treasury consultation with the President and notification to Congress, such de facto determinations heightened the risk that the decisions were made without the level of transparency and accountability intended by Congress. Further, uncertainties can arise because there is no requirement for Treasury to communicate that it will not be invoking a systemic risk determination for an announced action. Two of Treasury's systemic risk determinations--for Wachovia and Citigroup--were made to avert the failure of an institution that regulators determined could exacerbate liquidity strains in the banking system. A third determination was made to address disruptions to bank funding affecting all banks. Under this latter determination, FDIC established the Temporary Liquidity Guarantee Program (TLGP), which guaranteed certain debt issued through October 31, 2009, and certain uninsured deposits of participating institutions through December 31, 2010, to restore confidence and liquidity in the banking system. While there is some support for the agencies' position that the statute authorizes systemic risk assistance of some type under TLGP facts and that it permits assistance to the entities covered by the program, there are questions about these interpretations, under which FDIC created a broad-based program of direct assistance to institutions that had never before received such relief--"healthy" banks, bank holding companies, and other bank affiliates. Because these issues are matters of significant public interest and importance, the statutory requirements may require clarification. Regulators' use of the systemic risk exception may weaken market participants' incentives to properly manage risk if they come to expect similar emergency actions in the future. The financial crisis revealed limits in the current regulatory framework to restrict excessive risk taking by financial institutions whose market discipline is likely to have been weakened by the recent use of the systemic risk exception. Congress and regulators are considering reforms to the current regulatory structure. It is important that such reforms subject systemically important financial institutions to stricter regulatory oversight. Further, legislation has been proposed for an orderly resolution of financial institutions not currently covered by the FDI Act. A credible resolution regime could help impose greater market discipline by forcing participants to face significant costs from their decisions and preclude a too-big-to-fail dilemma.