On May 6, 2010, the Government Accountability Office released the testimony of Orice Williams Brown, Director Financial Markets and Community Investment, before the House of Representatives Subcommittee on Oversight and Investigations, Committee on Financial Services. In Mr. Brown’s testimony, he noted that while the causes of the recent financial crisis remain subject to debate, some researchers and regulators have suggested that the buildup of leverage before the financial crisis and subsequent disorderly deleveraging compounded the crisis.
Mr. Brown noted that many financial institutions use leverage to expand their ability to invest or trade in financial assets and to increase their return on equity. A firm can use leverage through a number of strategies, including by using debt to finance an asset or entering into derivatives. Brown stated that greater financial leverage, as measured by lower proportions of capital relative to assets, can increase the firm’s market risk, because leverage magnifies gains and losses relative to equity. Leverage also can increase a firm’s liquidity risk, because a leveraged firm may be forced to sell assets under adverse market conditions to reduce its exposure. Although commonly used as a leverage measure, Brown noted that the ratio of assets to equity captures only on-balance sheet assets and treats all assets as equally risky.
Brown pointed out that federal financial regulators impose capital and other requirements such as leverage measures on their regulated institutions to limit leverage and ensure financial stability. For example, the SEC uses its net capital rule to limit broker-dealer leverage. Other important market participants, such as hedge funds, also use leverage. Although hedge funds typically are not subject to regulatory capital requirements, market discipline, supplemented by regulatory oversight of institutions that transact with them, can serve to constrain their leverage.
Mr. Brown found that the crisis revealed limitations in the financial regulatory capital framework’s ability to restrict leverage and to mitigate crisis. First, he noted that regulatory capital measures did not always fully capture certain risks. As a result, institutions did not hold capital commensurate with their risks and some faced capital shortfalls when the crisis began. Brown acknowledged that federal regulators have called for reforms, including international efforts to revise the Basel II capital framework (an international risk-based capital framework which sets requirements for how much capital banks need to put aside to guard against certain types of financial and operational risks). Brown noted that the planned U.S. implementation of Basel II would increase reliance on risk models for determining capital needs for certain large institutions. He stated that 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. Brown noted that such an assessment is critical to help ensure that changes to the regulatory framework address the limitations revealed by the recent crisis.
Second, Brown noted that regulators face challenges in neutralizing cyclical leverage trends. For example, according to regulators, minimum regulatory capital requirements may not provide adequate incentives for banks to build loss-absorbing capital buffers in benign markets when it would be less expensive to do so. When market conditions deteriorated, minimum capital requirements became binding for many institutions that lacked adequate buffers to absorb losses and faced sudden pressures to deleverage. Brown stated that regulators are considering several options to counteract potentially harmful cyclical leverage trends, but implementation of these proposals presents a challenge by itself.
Finally, 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 effects of institutions’ deleveraging activities. To ensure that there is a systemwide approach to addressing leverage-related issues across the financial system, Brown stated that the GAO has asked Congress to consider, as it moves toward the creation of a systemic risk regulator, the merits of tasking this entity with the responsibility for measuring and monitoring systemwide leverage and evaluating options to limit the positive correlation between leverage trends and the overall state of the economy. Brown also noted that the GAO recommended to the financial regulators that an assessment should be made regarding the extent to which Basel II reforms may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches used for capital purposes.
A complete copy of Mr. Brown’s testimony can be found here.