	U.S. Financial Regulatory System’s Failure to Keep Pace with Market Developments Underscores the Need for Reforms

As a result of 150 years of changes to financial regulation in the United  States, the regulatory system has become complex and fragmented. Today,  responsibilities for overseeing the financial services industry are shared  among almost a dozen federal banking, securities, futures, and other  regulatory agencies, numerous self-regulatory organizations, and hundreds  of state financial regulatory agencies. Various Market Developments Have Revealed Limitations in the Existing Regulatory Structure

Several key developments in financial markets and products in the past  few decades have significantly challenged the existing financial regulatory  structure. Regulators have struggled, and often failed, to identify the systemic risks  posed by large and interconnected financial conglomerates, as well as new  and complex products, and to adequately manage these risks. In addition, regulators have had to address  problems in financial markets resulting from the activities of sometimes  less-regulated and large market participants—such as nonbank mortgage  lenders, hedge funds, and credit rating agencies—some of which play  significant roles in today’s financial markets. Further, the increasing  prevalence of new and more complex financial products has challenged  regulators and investors, and consumers have faced difficulty  understanding new and increasingly complex retail mortgage and credit  products. And  despite the increasingly global aspects of financial markets, the current  fragmented U.S. regulatory structure has complicated some efforts to  coordinate internationally with other regulators. Our recent work has further revealed limitations in the current regulatory  system, reinforcing the need for change and the need for an entity  responsible for identifying existing and emerging systemic risks. In  January 2009, we designated modernizing the outdated U.S. financial  regulatory system as a new high-risk area to bring focus to the need for a  broad-based systemwide transformation to address major economy,  efficiency, and effectiveness challenges. Other Countries Have Adopted Various Structures for Their Regulatory Systems, but the Recent Crisis Is Prompting Additional Changes

In response to consolidation in the financial services industry and past  financial crises, other countries have previously made changes to their  financial regulatory systems in the years before the most recent crisis. For  the purposes of our study, we selected five countries—Australia, Canada,  Sweden, the Netherlands, and the United Kingdom—that had  sophisticated financial systems and different regulatory structures. The countries we reviewed chose one of two models—with some  implementing an integrated approach, in which responsibilities for  overseeing safety and soundness issues and business conduct issues are  centralized and unified in usually a single regulator, and with others  implementing what is commonly referred to as a “twin peaks” model, in  which separate regulatory organizations are responsible for safety and  soundness and business conduct regulation. However, regardless of the regulatory system structure, these and many  other countries were affected to some extent by the recent financial crisis. However, regulators or financial institutions in some of these countries  took steps that may have reduced the impact of the crisis on their  institutions. Authorities in these five countries have taken actions or are contemplating  additional changes to their financial regulatory systems based on  weaknesses identified during the current financial crisis. appropriately comprehensive coverage to ensure that financial institutions  and activities are regulated in a way that ensures regulatory goals are fully  met;    a mechanism for identifying, monitoring, and managing risks on a  systemwide basis, regardless of the source of the risk or the institution in  which it is created;    an adaptable and forward-looking approach allows regulators to readily  adapt to market innovations and changes and evaluate potential new risks;    efficient oversight of financial services by, for example, eliminating  overlapping federal regulatory missions, while effectively achieving the  goals of regulation;    consumer and investor protection as part of the regulatory mission to  ensure that market participants receive consistent, useful information, as  well as legal protections for similar financial products and services,  including disclosures, sales practices standards, and suitability  requirements;    assurance that regulators have independence from inappropriate  influence; have sufficient resources and authority, and are clearly  accountable for meeting regulatory goals;    assurance that similar institutions, products, risks, and services are  subject to consistent regulation, oversight, and transparency; and    adequate safeguards that allow financial institution failures to occur while  limiting taxpayers’ exposure to financial risk. Various organizations have made proposals to reform the U.S. regulatory  system, and several proposals have been introduced to the Congress. The administration’s proposal includes various elements that could  potentially improve federal oversight of the financial markets and better  protect consumers and investors. As discussed, the inability of regulators to take  appropriate action to mitigate problems that posed systemic risk  contributed to the current crisis. Although the Administration’s proposal would make various  improvements in the U.S. regulatory system, our analysis indicated that  additional opportunities exist to further improve the system exist. As we reported in our January 2009  report, having multiple regulators performing similar functions presents  challenges. Appendix I: Framework for Crafting and Evaluating Regulatory Reform

As a result of significant market developments in recent decades that have  outpaced a fragmented and outdated regulatory structure, significant  reforms to the U.S. regulatory system are critically and urgently needed. Financial Regulation: A Framework for Crafting and Assessing  Proposals to Modernize the Outdated U.S. Financial Regulatory System. This is a work of the U.S. government and is not subject to copyright protection in the  United States.
Why GAO Did This Study

This testimony discusses issues relating to efforts to reform the regulatory structure of the financial system. In the midst of the worst economic crisis affecting financial markets globally in more than 75 years, federal officials have taken unprecedented steps to stem the unraveling of the financial services sector. While these actions aimed to provide relief in the short term, the severity of the crisis has shown clearly that in the long term, the current U.S. financial regulatory system was in need of significant reform. Our January 2009 report presented a framework for evaluating proposals to modernize the U.S. financial regulatory system, and work we have conducted since that report further underscores the urgent need for changes in the system. Given the importance of the U.S. financial sector to the domestic and international economies, in January 2009, we also added modernization of its outdated regulatory system as a new area to our list of high-risk areas of government operations because of the fragmented and outdated regulatory structure. We noted that modernizing the U.S. financial regulatory system will be a critical step to ensuring that the challenges of the 21st century can be met. This testimony discusses (1) how regulation has evolved and recent work that further illustrates the significant limitations and gaps in the existing regulatory system, (2) the experiences of countries with other types of varying regulatory structures during the financial crisis, and (3) how certain aspects of proposals would reform the U.S. regulatory system.

What GAO Found

The current U.S. financial regulatory system is fragmented due to complex arrangements of federal and state regulation put into place over the past 150 years. It has not kept pace with major developments in financial markets and products in recent decades. Today, almost a dozen federal regulatory agencies, numerous self-regulatory organizations, and hundreds of state financial regulatory agencies share responsibility for overseeing the financial services industry. Several key changes in financial markets and products in recent decades have highlighted significant limitations and gaps in the existing U.S. regulatory system. For example, regulators have struggled, and often failed, both to identify the systemic risks posed by large and interconnected financial conglomerates and to ensure these entities adequately manage their risks. In addition, regulators have had to address problems in financial markets resulting from the activities of sometimes less-regulated and large market participants--such as nonbank mortgage lenders, hedge funds, and credit rating agencies--some of which play significant roles in today's financial markets. Further, the increasing prevalence of new and more complex financial products has challenged regulators and investors, and consumers have faced difficulty understanding new and increasingly complex retail mortgage and credit products. Our recent work has also highlighted significant gaps in the regulatory system and the need for an entity responsible for identifying existing and emerging systemic risks. Various countries have implemented changes in their regulatory systems in recent years, but the current crisis affected most countries regardless of their structure. All of the countries we reviewed have more concentrated regulatory structures than that of the United States. Some countries, such as the United Kingdom, have chosen an integrated approach to regulation that unites safety and soundness and business conduct issues under a single regulator. Others, such as Australia, have chosen a "twin peaks" approach, in which separate agencies are responsible for safety and soundness and business conduct regulation. However, regardless of regulatory structure, each country we reviewed was affected to some extent by the recent financial crisis. One regulatory approach was not necessarily more effective than another in preventing or mitigating a financial crisis. However, regulators in some countries had already taken some actions that may have reduced the impact on their institutions. These and other countries also have taken or are currently contemplating additional changes to their regulatory systems to address weaknesses identified during this crisis. The Department of the Treasury's recent proposal to reform the U.S. financial regulatory system includes some elements that would likely improve oversight of the financial markets and make the financial system more sound, stable, and safer for consumers and investors. For example, under this proposal a new governmental body would have responsibility for assessing threats that could pose systemic risk. This proposal would also create an entity responsible for business conduct, that is, ensuring that consumers of financial services were adequately protected. However, our analysis indicated that additional opportunities exist beyond the Treasury's proposal for additional regulatory consolidation that could further decrease fragmentation in the regulatory system, reduce the potential for differing regulatory treatment, and improve regulatory independence.