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Title: Financial Services Industry
Subtitle:
Report No.: GAO/OCG-93-10TR Date: December 1992
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Author: United States General Accounting Office
Office of the Comptroller General
Addressee: Transition Series
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CONTENTS
The Financial Services Industry
Financial Institutions at a Crossroads
- Expanded Powers
- Regulatory Burden
- The Savings and Loan Cleanup
Better Understanding of Rapidly Changing Financial Markets Needed
- Globalization of Trading Markets
- New Trading Systems
- New Financial Products
- Oversight of Investment Advisory Industry
- Government Securities Markets
Strengthened Insurance Solvency Regulation Needed
Related GAO Products
Transition Series
- Economics
- Management
- Program Areas
Office of the Comptroller General
Washington, DC 20548
December 1992
The Speaker of the House of Representatives
The Majority Leader of the Senate
In response to your request, this transition series report discusses major
policy, management, and program issues facing the Congress and the new
administration in the financial services industry. These issues include (1)
regulating financial institutions, which are at a crossroads; (2)
understanding rapidly changing financial markets; and (3) strengthening
insurance industry solvency regulation.
As part of our high-risk series on program areas vulnerable to waste, fraud,
abuse, and mismanagement, we are issuing separate reports on the _Bank
Insurance Fund_ (GAO/HR-93-3, Dec. 1992) and the _Resolution Trust
Corporation_ (GAO/HR-93-4, Dec. 1992).
The GAO products upon which this transition series report is based are listed
at the end of the report.
We are also sending copies of this report to the President-elect, the
Republican leadership of the Congress, the appropriate congressional
committees, and the designated heads of the appropriate agencies.
THE FINANCIAL SERVICES INDUSTRY
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The nation's financial institutions and markets are vital to a smoothly
functioning economy. Our November 1988 transition report discussed problems
and solutions for our financial services industry, which was experiencing its
most turbulent and troubled period since the Great Depression. Banks, savings
and loans, and insurance companies were failing at rates not seen for decades.
The securities and futures markets became linked, and in 1987 they experienced
their most severe decline in 58 years.
Much has been done legislatively and administratively since our last
transition report to address the weaknesses and vulnerabilities in the
financial services industry that were evidenced during the past decade. In
1989, the Congress enacted the Financial Institutions Reform, Recovery, and
Enforcement Act (FIRREA) to fund the cleanup of the savings and loan disaster
and better ensure that the disaster did not repeat itself. In 1991, the
Congress enacted the Federal Deposit Insurance Corporation Improvement Act
(FDICIA) to better ensure a safe and sound banking industry and a financially
strong deposit insurance system. In the wake of the 1987 stock market crash,
many changes were implemented by the market regulators and the exchanges
themselves to ensure that market systems and mechanisms could better cope with
any future massive shifts in investor sentiment.
Despite this progress, it is unrealistic to believe that the job is done.
First, the cleanup of the savings and loan industry is not completed. The
Resolution Trust Corporation (RTC) estimates that another $25 billion will be
needed to finish this effort, and the industry's new insurance fund must be
provided with funding in 1993 so that it can meet its responsibilities.
Second, great care needs to be taken to ensure that FDICIA is properly
implemented. Third, the structure of financial regulation will need to be
modernized sometime during the 1990s to recognize the realities of today's
highly competitive financial marketplace. However, before action is taken,
very careful consideration will need to be given to how and under what
circumstances to safely expand the geographic and product-line powers of
banking organizations. Fourth, changes in the financial services industry
continue to accelerate at a dizzying pace. Regulators need to assess and fully
understand how the proliferation of new products, such as derivatives, as well
as domestic and international market developments affect their ability to
ensure that our markets and institutions continue to function safely, soundly,
and smoothly. Finally, regulation of the insurance industry warrants more
attention in light of the increasing number and size of companies that fail,
the effects of those failures on policyholders, and the serious weaknesses
that have been exposed in the state system of solvency regulation.
The new administration and the Congress must address these issues if we are to
have a stable, efficient, and competitive financial system in the years to
come.
FINANCIAL INSTITUTIONS AT A CROSSROADS
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Many of the provisions of FDICIA will, if effectively implemented, greatly
strengthen the industry, the power of the regulators in identifying and acting
on problems experienced by troubled depository institutions, and the deposit
insurance system. FDICIA's accounting, corporate governance, and regulatory
reforms are designed to accomplish these goals. Among other measures, FDICIA's
early warning reforms provide for the timely disclosure of internal control
weaknesses and violations of laws and regulations. The act's early
intervention requirements are designed to ensure that regulators take prompt
and appropriate action to correct unsafe banking practices.
We remain concerned about the lack of action by the Financial Accounting
Standards Board or the federal regulators to effectively tighten the flexible
accounting rules that helped to mask the industry's problems during the 1980s.
Legislation needs to be considered for solving this problem. We have a number
of additional concerns about the quality of bank examinations and the
effectiveness of regulations that will be issued to implement FDICIA's
provisions.
Though the banking industry had record profits during the first half of 1992,
over 1,000 banks with assets exceeding $500 billion remain on the Federal
Deposit Insurance Corporation's (FDIC) problem bank list--largely as a result
of bad loans made in the past. The insurance fund itself ended 1991 with a
deficit of $7 billion and, according to FDIC's estimates, faces potential
costs of about $40 billion between 1992 and 1995.
A discussion of our concerns with the act's implementation as well as the
condition of the banking industry and its insurance fund is contained in our
high risk report on the Bank Insurance Fund.
Recent proposals to expand banks' product-line and geographic powers were not
successful. But there will no doubt be similar proposals in the future. A
cautious approach should be followed in expanding the powers of banking
organizations. It is unrealistic to expect that deregulation of geographic and
product-line powers will do much in the short run to solve the banking
industry's current problems. These problems stem largely from bad loans. While
institutions entering new lines of business or new territories might increase
profits, they would also be exposed to the opportunity to lose vast sums of
money. FDICIA's system of safety and soundness regulation should be in place
and operating properly before the powers of banks are expanded.
However, implementation of FDICIA is not all that must be done to deal with
the regulatory issues associated with expanded powers. Each major decision
about changing powers must also seek to ensure that
(1) treatment of uninsured depositors in bank failures is similar in all cases
so that small banks can compete effectively with big ones, (2) holding company
supervision is adequate and the responsibilities of the various federal
regulatory agencies in supervising such companies are clearly defined, and (3)
regulatory controls are sufficient to protect against conflict-of-interest
abuses.
With the passage of FDICIA, there is increasing concern that the cumulative
effect of regulation may be placing too great a burden on the industry. Some
industry-sponsored studies have estimated that FDICIA's new consumer
disclosure, credit availability, and many other regulations are costly. We are
not now in a position to say whether the benefits of regulation exceed its
costs. Nor is anyone else. But clearly, in today's competitive financial
services environment, this topic needs to be considered and reviewed
carefully.
As part of formulating a plan of action to deal with concerns over regulatory
burden, it is critical that certain issues be addressed. There must be a clear
understanding of what is meant by regulatory burden. In this regard, more
needs to be known about how the perceived burden is divided between rules and
requirements designed to promote safety and soundness and those designed to
protect consumers. It is also necessary to decide whether the burden lies in
what the statutes and regulations are trying to accomplish or in how the
regulations are administered.
In addition to understanding the nature of regulatory burden, measures of its
importance should be compared to other factors, such as overcapacity, lack of
experience operating in competitive environments, or poor controls over
risk-taking in explaining the performance of banks. Finally, the industry
enjoys significant benefits as a result of its regulated status. Any
assessment of regulatory burden should weigh that burden against the benefits
of a lower cost of capital, lower cost of funds, access to and control of the
payments system, and access to the Federal Reserve.
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THE SAVINGS AND LOAN CLEANUP
In addition to coming to grips with further deregulation and regulatory burden
issues, attention must also remain focused on the continuing cleanup of the
savings and loan industry. The job is not done yet. In the more than 3 years
since the passage of FIRREA, RTC has closed more than 650 failed thrifts and
has sold more than $287 billion of assets as of September 30, 1992. RTC's
resolution efforts have been hampered by funding disruptions, the most recent
of which occurred in April 1992. Since then, RTC has been unable to fund the
resolution of most failed thrifts under its control.
In September 1992, RTC estimated that the current funding disruption had
already increased its cost by at least $600 million and would continue to add
an average of about $6 million each day. In October 1992, RTC estimated that
it would need between $8 billion and $27 billion in additional loss funds to
resolve its expected remaining caseload of about 150 thrifts, bringing the
total resolution cost estimate to between $95 billion and $114 billion. In
December 1992, RTC's Chief Executive Officer indicated that $25 billion in
loss funds would be needed--near the upper end of the range estimated in
October.
An early priority for the Congress and the administration will be to decide
how to proceed with the funding for the remaining cleanup of the industry and
provide that funding before the Savings Association Insurance Fund assumes
full resolution responsibility in October 1993. Steps also need to be taken to
ensure that this new fund is adequately financed by that time.
In addition to completing its resolution responsibilities, RTC can also
improve its asset management methods and strategies. RTC has generally done a
good job selling financial assets. However, its real estate sales approaches
have sometimes been inefficient, poorly planned, and poorly executed.
Moreover, RTC has not evaluated its real estate sales strategies to determine
which methods were most effective for which type of asset and in which
particular market each method worked best. As a result, there is no assurance
that RTC is maximizing recoveries on the sale of real estate assets.
Furthermore, RTC's contracting system--a critical element in RTC's asset
disposition approach--remains a key weakness in RTC's operations. Specific
problems with the contracting system include poor contract planning and
oversight. These problems have added millions of dollars in costs to the
government's bailout efforts.
RTC needs to (1) better plan its real estate disposition strategies and
determine which methods are most effective for different types of assets and
different markets, (2) set disposition goals tied to maximizing recoveries,
and (3) strengthen contract planning and the key information systems needed to
oversee, manage, and dispose of assets. A more detailed discussion of these
issues is contained in our high-risk report on RTC.
BETTER UNDERSTANDING OF RAPIDLY CHANGING FINANCIAL MARKETS NEEDED
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In October 1987, the nation's equity markets experienced their most serious
disruption since the crash of 1929. Much has been done to help ensure that our
markets can better cope with a "run for the exits" should the 1987 event
repeat itself. But other events have greatly changed the world since 1987.
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GLOBALIZATION OF TRADING MARKETS
International trading has increased, and with it so too have concerns about
the risks to investors, firms, and markets resulting from differences in
standards and rules that various countries use to regulate or operate their
domestic securities markets. These concerns include (1) the risks of trading
with firms operating in countries with lower requirements and of financial
problems in one country's markets affecting firms and markets in other
countries, (2) the opportunity for illegal or improper activities by
individuals operating outside of the country whose markets are being abused,
and (3) the ability of U.S. firms to compete with firms that are subject to
lower regulatory costs in other countries.
The efforts of international organizations such as the European Community and
the International Organization of Securities Commissions to harmonize
standards and rules to meet these concerns have been resisted because of the
vast differences among countries' regulatory approaches. None of the efforts
have been completed.
As globalization of financial markets continues, U.S. regulators need to
continue in their attempts to achieve meaningful harmonization. These efforts
should include development of a coordinated U.S. strategy for achieving
harmonized financial regulations either by working through existing
international bodies or by negotiating directly with other countries. The
efforts should also include an assessment of whether the current structure of
regional and international financial organizations is capable of achieving
harmonized financial regulations.
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NEW TRADING SYSTEMS
Here at home, the Securities and Exchange Commission (SEC) has sanctioned new
trading systems in response to demands by institutional investors for lower
trading costs and anonymity in their trading. Because these systems are small
or only involve trading by sophisticated investors, SEC has not subjected them
to the same level of regulation as existing markets. These new systems have
taken some market share from the existing markets, especially the New York
Stock Exchange.
There is a lack of consensus about the effects of this trend on investors and
the capital formation process. For example, some argue that when order flow is
dispersed from a primary market, the market's efficiency and liquidity are
impaired. Others argue that efficiency is not affected and that liquidity is,
in fact, enhanced. Most, however, agree that without a primary market, other
trading systems could not exist. This raises a fundamental issue of fairness
because trading systems that compete with the primary markets incur lower
regulatory costs while deriving benefits from the primary market.
The importance of these issues raises questions about the future structure of
the U.S. markets. Attention needs to be focused on understanding the risks and
benefits of new market systems to investors and market participants, and
deciding which market structure will best meet the future needs of U.S.
business for capital formation. In addition, decisions are needed about
whether new trading systems that rely on prices derived from a primary market
should pay the primary market for that service.
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NEW FINANCIAL PRODUCTS
There has been an explosion in the development and use of new financial
products, such as currency and interest rate swaps. For example, the worldwide
market for interest rate swaps grew from its inception in 1981 to a notional
principal amount over $3 trillion by 1992. These products, called derivatives,
offer a way for financial institutions and corporations to protect themselves
from volatility in interest and foreign exchange rates.
These products are risky, and they are generally unregulated. Information
about financial institutions' losses from trading these products is limited.
But some firms have lost hundreds of millions of dollars trading derivatives
because of mispricing, poor risk management systems, or inappropriate trading
strategies.
Financial regulators have expressed uncertainty and concern about the risks of
derivative products and the potential threat they pose to the financial
system. More needs to be known about the nature and extent of use of these
products as well as the risks they pose to the financial system, including (1)
the extent to which financial institutions use these products and have
adequate systems to manage their risks,
(2) the resources and abilities of financial regulators to evaluate the risks
these products pose, and (3) whether a different U.S. regulatory approach
toward derivatives would be viewed as harmful by market participants and drive
the business overseas.
In addition to these emerging market developments and the concerns they pose,
some other areas also need attention.
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OVERSIGHT OF INVESTMENT ADVISORY INDUSTRY
Legislation is needed to strengthen SEC's oversight of the investment advisers
industry. This industry, consisting of about 17,500 registered advisers who
manage a total of more than $5 trillion in assets, affects the lives of
millions of Americans who set up a plan for retirement, for their children's
education, or for their survivors. It is also an industry that has
significantly damaged the lives of many individuals through fraud,
embezzlement, or the provision of misleading or inappropriate advice.
SEC's current oversight program may be doing more harm than good by giving
investors a false sense of confidence that SEC-approved advisers are both well
qualified and well regulated. In 1992, SEC had only 46 inspectors for all
registered advisers. In 1990, almost 60 percent of advisers registered for
more than 1 year had never been inspected. SEC needs additional resources and
enhanced registration and inspection programs. Enhanced programs would (1)
verify adviser-supplied education and experience information and check all
available federal criminal history sources; (2) identify advisers who should
be registered but are not; (3) register all individuals at advisory firms who
give advice; and (4) inspect adviser business operations within a reasonable
time, such as within 1 year of registration, and periodically thereafter
according to risk.
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GOVERNMENT SECURITIES MARKETS
The market for U.S. Treasury and agency securities is perhaps the largest,
most liquid securities market in the world, and it works reasonably well.
However, the 1991 revelations of irregularities in bidding and secondary
market trading by Salomon Brothers highlighted some impairments to the
efficiency and integrity of the market that could raise the interest rates
that Treasury has to pay on the debt. Interest on the national debt is now the
third largest item in the budget. A slight increase in the interest rate
Treasury pays on its marketable debt would add billions of dollars to the
deficit. The following actions are needed:
-- Treasury rule-making authority under the Government Securities Act of 1986
should be renewed. This authority expired in 1991, and Treasury is now
unable to update or promulgate rules involving prudential regulation of
the government securities market as required by the 1986 act.
-- Sales practice rules should be extended to the government securities
market. Market participants need to be protected against such things as
churning and unsuitable investments just as participants are protected
in markets for corporate stocks and bonds.
-- The government should be given backup authority to require that information
on interdealer broker screens be made available to the public.
-- Bidding arrangements should be changed to protect against rigged bids and
to encourage the widest possible participation in auctions.
Insurance is an important component of the financial system. Between 1988 and
1991, an average of about 60 insurance companies failed each year. These
failures have raised serious concerns about the quality of insurance
regulation as well as the strength of the state guaranty funds that protect
individuals when their insurers fail. Solvency regulation of the insurance
industry is conducted solely by the states. However, because the business of
insurance involves interstate commerce and because adverse developments in the
industry could harm policyholders, the federal government has both ultimate
responsibility for and an interest in its safety and soundness. In this
regard, the Congress has exercised a direct oversight role through
investigations and hearings.
We have several concerns about the quality of insurance solvency regulation
and the protection for policyholders in the event of insolvency:
-- The quality and usefulness of financial and management information provided
to regulators and others is insufficient to evaluate the risks faced by and
the solvency of insurers.
-- The willingness and ability of state regulators to develop regulatory
capabilities, consistent rules, and interstate coordination is insufficient
to effectively regulate national and international insurance entities.
-- The strength and fairness of the state guaranty funds is not adequate to
protect policyholders should their insurer fail.
Insurers are required to report their financial results to the responsible
state regulators using "statutory accounting principles." Statutory
accounting, in theory, is more conservative than generally accepted accounting
principles, but in practice it has allowed insurance companies to overstate
the value of their assets and inflate their reported surplus. Adoption of
generally accepted accounting principles for insurance companies could provide
a common framework for more meaningful financial reporting to the regulators.
However, flexibility in generally accepted accounting rules for treatment of
problem loans and investment securities still provides too much latitude to
company managers in reporting asset losses. The accounting rules for insurance
companies need to be strengthened to better ensure that financial information
provided to regulators and others is reliable for evaluating insurance company
risks.
The need for more consistency in insurance regulation and the need to
strengthen the regulatory capabilities of some states have become widely
recognized. Several options at the state and federal levels have been proposed
or implemented to address this problem.
First, the National Association of Insurance Commissions (NAIC) has
established Financial Regulation Standards that it believes are necessary for
effective state-by-state solvency regulation. A program to accredit states
that adopt these minimum standards has also been created. We doubt the ability
of NAIC to get the necessary degree of cooperation from the states because it
has no authority either to require the states to adopt consistent laws or to
monitor state compliance with the Financial Regulation Standards. Moreover,
the standards themselves are weak, and the accreditation process lacks
credibility.
Second, the National Conference of Insurance Legislators has proposed an
interstate compact to shift some state authority to an interstate insurance
regulatory agency. This proposal could solve the lack of authority that
cripples NAIC but only if all the states could agree on the form of the
compact and the degree of authority that would be surrendered.
Third, two congressional bills have been introduced in the Congress that would
create a federal agency with responsibility for regulating some insurers and
for overseeing insurance regulation in the states. Direct federal involvement
in insurance regulation could impose a consistent regulatory framework on the
insurance industry and reduce the regulatory burden that large insurers now
face in the 50 states. However, establishment of a new federal agency could be
costly and could result in either an explicit or an implicit expansion of the
federal safety net in the event of mounting insurer failures.
While many unanswered questions remain about the advantages and disadvantages
of these specific regulatory alternatives, we believe that there is a clear
need for a more consistent, uniform system of insurance regulation than
currently exists in the state-by-state system. Moving toward a more effective
national (although not necessarily federal) insurance regulatory system will
require considerable discussion of the alternatives and may entail greater
federal-state cooperation.
The financial services industry has played a vital role in the development of
the modern U.S. economy, and it must continue to play that role. The United
States has learned an enormously costly lesson from its experience with the
savings and loan disaster. We must ensure that this episode in our nation's
financial history is never repeated.
Our financial system continues to change, and with this change come a host of
issues that need to be addressed to ensure the system's safety, efficiency,
and competitiveness. This job will not be easy. But it remains as important
today as it was in 1988 that the approach taken to addressing the issues
remains focused on
-- protecting against unacceptable financial damage to our financial
institutions and markets as well as individual investors,
-- encouraging innovation and flexibility to keep up with rapidly evolving
market developments, and
-- allowing financial markets to function without undue interference.
_Insurer Failures: Regulators Failed to Respond in Timely and Forceful Manner
in Four Large Life Insurer Failures_ (GAO/T-GGD-92-43, Sept. 9, 1992).
_Securities and Futures Markets: Cross-border Information Sharing Is
Improving, but Obstacles Remain_ (GAO/GGD-92-110, July 28, 1992).
_Investment Advisers: Oversight Is Inadequate for Investor Protection_
(GAO/T-GGD-92-46, June 4, 1992).
_Depository Institutions: Flexible Accounting Rules Lead to Inflated Financial
Reports_ (GAO/AFMD-92-52, June 1, 1992).
_Insurance Regulation: The Financial Regulation Standards and Accreditation
Program of the National Association of Insurance Commissioners_
(GAO/T-GGD-92-27, Apr. 9, 1992).
_Securities Markets: Challenges to Harmonizing International Capital Standards
Remain_ (GAO/GGD-92-41, Mar. 10, 1992).
_Audit Committees: Legislation Needed to Strengthen Bank Oversight_
(GAO/AFMD-92-19, Oct. 21, 1991).
_Credit Unions: Reforms for Ensuring Future Soundness_ (GAO/GGD-91-85, July
10, 1991).
