Objectives, Scope, and Methodology

To help Congress and others better understand current regulatory capital requirements, developments in those requirements, and regulatory issues these developments raise, the objectives of this report are to describe, for the banking, securities, futures, and life insurance sectors of the financial services industry, (1) regulatory views of the purpose of capital and current regulatory requirements; (2) the approaches of some large, diversified financial firms to risk measurement and capital allocation; and (3) issues in capital regulation and initiatives being considered for changes to regulatory capital requirements. The differences in regulatory purpose are reflected in the regulators’ views of the purpose of regulatory capital. Securities and Futures Regulatory Capital Requirements Emphasize Liquid Capital to Meet Customer Obligations in the Event of Firm Failure

As discussed earlier, regulators of securities broker-dealers and FCMs seek to protect customers of the firms they oversee as well as to protect the integrity of their markets. Some Large, Diversified Financial Firms Are Measuring Risks With Mathematical Models

Unlike regulators, whose focus on the capital levels of firms is driven by regulatory public purposes, firms analyze their use of capital to help ensure that they can achieve their business objective—maximizing the value of the capital provided by stockholders. Therefore, the ability to set limits on trading activity or manage risks is especially important to large financial firms. 3. As competition within and among different financial sectors has increased and as large, diversified firms have improved their ability to measure and manage risks and capital, financial regulators are responding by exploring possible changes to capital requirements. Financial Regulators and SROs Are Exploring Ways to Make Capital Requirements More Sensitive to Risk

Regulatory agencies and SROs are exploring or have proposed a number of initiatives for modifying or changing current capital requirements in banking, securities, futures, and life insurance that would make the requirements more sensitive to the actual risks in firm activities. 2. 4. 5. 1.
Why GAO Did This Study

GAO reviewed: (1) the regulatory views on the purpose of capital and current regulatory requirements; (2) the approaches of some large financial firms to risk measurement and capital allocation; and (3) issues in capital regulation and initiatives being considered for changes to regulatory capital requirements.

What GAO Found

GAO noted that: (1) capital requirements differ by financial regulator due to differences in the regulators' purpose; (2) historically, regulators based capital regulation on the traditional risks in each financial sector; (3) within the past decade, both the banking and life insurance sectors adopted new capital requirements that are specifically designed to be more sensitive to exposure to multiple risks; (4) securities broker-dealers and futures commission merchants continue to operate under net capital rules that the Securities Exchange Commission and the Commodity Futures Trading Commission use in order to protect customers and other market participants in the financial markets from losses due to firm failures, not from bad investments; (5) unlike regulators, firms analyze their use of capital to help ensure that they can achieve their business objectives; (6) although many large firms GAO spoke with use the results of their risk measurements to set limits on trading activities, some go farther and use them to allocate capital within the firm; (7) these techniques have limitations; however, firms and regulators believe they significantly improve firms' ability to measure and manage their risks; (8) the three principal issues pertaining to regulatory capital requirements that are important when considering possible future changes include: (a) the competitive implications for firms stemming from differences in capital rules of different financial regulators; (b) whether regulatory capital requirements create incentives to manage risks inappropriately; and (c) the administration of regulatory capital rules; and (9) regulatory agencies and self-regulatory organizations are exploring or have proposed a number of initiatives for modifying or changing current capital requirements in the banking, securities, futures, and life insurance sectors.