Leverage within the Financial Sector Increased before the Financial Crisis, and Financial Institutions Sought to Deleverage When the Crisis Began

Leverage steadily increased in the financial sector before the crisis began  around mid-2007 and created vulnerabilities that increased the severity of  the crisis, according to studies we reviewed. 1). 2). Some Studies Suggested That Deleveraging by Financial Institutions by Selling Financial Assets and Restricting New Lending Could Have Contributed to the Crisis

Some studies we reviewed highlighted the possibility that deleveraging  through asset sales by financial institutions could trigger downward  spirals in asset prices and contribute to a financial crisis. Importantly, other theories that do not involve asset spirals caused by  deleveraging through asset sales provide possible explanations for the  sharp price declines in mortgage-related securities and other financial  instruments. Moreover, as the crisis is complex, no single theory likely is  to explain in full what occurred or necessarily rule out other explanations. In addition, some studies we reviewed suggested that deleveraging by  restricting new lending could contribute to the crisis by slowing economic  growth. Regulators and Market Participants Had Mixed Views about the Effects of Deleveraging in the Recent Crisis

Officials from federal financial regulators, two securities firms, a bank,  and a credit rating agency whom we interviewed had mixed views about  the effects of deleveraging by financial institutions in the recent crisis. Regulatory officials said that hedge funds and other  asset managers also deleveraged by selling assets to meet redemptions or  margin calls. The regulators and market participants we interviewed had mixed views  on whether sales of financial assets contributed to a downward price  spiral. Regulators Limit Financial Institutions’ Use of Leverage Primarily Through Regulatory Capital Requirements

Federal financial regulators (Federal Reserve, FDIC, OCC, and OTS)  generally have imposed capital and other requirements on their regulated  institutions as a way to limit excessive use of leverage and ensure the  stability of the financial system and markets. Federal banking and thrift  regulators have imposed minimum risk-based capital and non-risk-based  leverage ratios on their regulated institutions. In addition, the regulators supervise the  capital adequacy of their regulated institutions through ongoing  monitoring, including on-site examinations and off-site tools. Bank holding  companies are subject to capital and leverage ratio requirements similar to  those for banks. Thrift holding companies are not subject to such  requirements; rather, capital levels of thrift holding companies are  individually evaluated based on each company’s risk profile. SEC primarily  uses its net capital rule to limit the use of leverage by broker-dealers. Other financial institutions, such as hedge funds, use leverage but, unlike  banks and broker-dealers, typically are not subject to regulatory capital  requirements; instead, market discipline plays a primary role in limiting  leverage. Regulators Are Considering Reforms to Address Limitations the Crisis Revealed in Regulatory Framework for Restricting Leverage

The financial crisis has revealed limitations in existing regulatory  approaches that serve to restrict leverage. Although regulators have  proposed changes to improve the risk coverage of the regulatory capital  framework, limit cyclical leverage trends and better address sources of  systemic risk, they have not yet fully evaluated the extent to which these  proposals would address these limitations. First, regulatory capital  measures did not always fully capture certain risks, particularly those  associated with some mortgage-related securities held on and off balance  sheets. As a result, a number of financial institutions did not hold capital  commensurate with their risks and some lacked adequate capital or  liquidity to withstand the market stresses of the crisis. Such an assessment is  critical to ensure that Basel II changes that would increase reliance on  complex risk models and banks’ own risk estimates do not exacerbate  regulatory limitations revealed by the crisis. With  multiple regulators primarily responsible for individual markets or  institutions, none of the financial regulators has clear responsibility to  assess the potential effects of the buildup of systemwide leverage or the  collective activities of the industry for the financial system.
Why GAO Did This Study

In 2009 GAO conducted a study on the role of leverage in the recent financial crisis and federal oversight of leverage, as mandated by the Emergency Economic Stabilization Act. This testimony presents the results of that study, and discusses (1) how leveraging and deleveraging by financial institutions may have contributed to the crisis, (2) how federal financial regulators limit the buildup of leverage; and (3) the limitations the crisis has revealed in regulatory approaches used to restrict leverage and regulatory proposals to address them. To meet these objectives, GAO built on its existing body of work, reviewed relevant laws and regulations and academic and other studies, and interviewed regulators and market participants.

What GAO Found

Some studies suggested that leverage steadily increased in the financial sector before the crisis began in mid-2007 and created vulnerabilities that have increased the severity of the crisis. In addition, subsequent disorderly deleveraging by financial institutions may have compounded the crisis. First, the studies suggested that the efforts taken by financial institutions to deleverage by selling financial assets could cause prices to spiral downward during times of market stress and exacerbate a financial crisis. Second, the studies suggested that deleveraging by restricting new lending could slow economic growth. However, other theories also provide possible explanations for the sharp price declines observed in certain assets. As the crisis is complex, no single theory is likely to fully explain what occurred or rule out other explanations. Regulators and market participants we interviewed had mixed views about the effects of deleveraging. Some officials told us that they generally have not seen asset sales leading to downward price spirals, but others said that asset sales have led to such spirals. Federal regulators impose capital and other requirements on their regulated institutions to limit leverage and ensure financial stability. Federal bank regulators impose minimum risk-based capital and leverage ratios on banks and thrifts and supervise the capital adequacy of such firms through on-site examinations and off-site monitoring. Bank holding companies are subject to similar capital requirements as banks, but capital levels of thrift holding companies are individually evaluated based on each company's risk profile. The Securities and Exchange Commission uses its net capital rule to limit broker-dealer leverage and used to require certain broker-dealer holding companies to report risk-based capital ratios and meet certain liquidity requirements. Other important market participants, such as hedge funds, also use leverage. Hedge funds typically are not subject to regulatory capital requirements, but market discipline, supplemented by regulatory oversight of institutions that transact with them, can serve to constrain their leverage. The crisis has revealed limitations in regulatory approaches used to restrict leverage. First, regulatory capital measures did not always fully capture certain risks, which resulted in some institutions not holding capital commensurate with their risks and facing capital shortfalls when the crisis began. Federal regulators have called for reforms, including through international efforts to revise the Basel II capital framework. The planned U.S. implementation of Basel II would increase reliance on risk models for determining capital needs for certain large institutions. The crisis underscored concerns about the use of such models for determining capital adequacy, but regulators have not assessed whether proposed Basel II reforms will address these concerns. Such an assessment is critical to ensure that changes to the regulatory framework address the limitations the crisis had revealed. Second, regulators face challenges in counteracting cyclical leverage trends and are working on reform proposals. Finally, the crisis has revealed that with multiple regulators responsible for individual markets or institutions, none has clear responsibility to assess the potential effects of the buildup of systemwide leverage or the collective effect of institutions' deleveraging activities.