## _wp07195

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### I. INTRODUCTION
- Rapid evolution of the U.S. financial sector is creating new challenges for the regulatory structure.
- Share of financial sector assets owned by insured depositories fell from around half in 1980 to under one-quarter in 2006.
- Paper structure:
  - Section II: surveys the financial landscape, separating a highly regulated, multi-business “core” from a lightly regulated, more specialized “periphery”;
  - Section III: explains the U.S. regulatory philosophy and structure, with its focus on core institutions and its jurisdictional complexity;
  - Section IV: highlights certain new challenges;
  - Section V: draws out broad policy implications;
  - Section VI: concludes by tabling and discussing one specific streamlining measure.

### II. TOPOGRAPHY OF THE SYSTEM
- Financial innovation and mass-production techniques have enabled bundling of housing, consumer, student, business, and commercial real estate loans into securities; securitization waves have spread from mortgages to other asset classes.
- Special purpose vehicles / ABS pools:
  - ABS pools act as “obligors,” issuing debt backed by cash flows of owned assets; creditworthiness depends only on the quality of assets in the pool and the capital structure.
  - ABS pools can transform lower-quality assets into investment-grade liabilities via CDO structuring.
- CDO credit-enhancement techniques:
  - credit “wraps” (guarantees or insurance);
  - “excess spread”;
  - “over-collateralization”;
  - payment “waterfalls” (seniority/subordination).
- Typical tranche outcomes: an ‘AAA’-rated tranche, a speculative-grade “equity” tranche with “embedded leverage,” and a “mezzanine” tranche between.
- Hedge funds:
  - Key providers of liquidity and major contributors to trading volume, particularly in higher-risk segments; central to price discovery.
  - Well-equipped to cope with instrument complexity, including CDOs composed of ABSs, other CDOs (“CDO2s” and “CDO3s”), or CDSs (“synthetic” CDOs).
- Ratings dependency:
  - Increased complexity raises reliance on ratings; CDO tranches often provide more yield than identically rated single-name securities.
  - Less sophisticated investors are increasingly reliant on ratings, increasing responsibility on a small group of private rating agencies.
- Core vs. Periphery:
  - Core institutions: all federally insured depositories (7,380 commercial banks, 1,270 thrifts, and 8,362 credit unions), the government-sponsored enterprises (Fannie Mae and Freddie Mac), and the largest broker-dealers (organized into the “big five” investment banking groups). The core now holds less than one-third of total financial sector assets.
  - Periphery: small broker-dealers and all insurance companies, finance companies, mortgage companies, funding corporations, and private capital pools (pension funds, mutual funds, real estate investment trusts, ABS pools, hedge funds, and private equity funds). The periphery’s role as a holder and originator of financial assets has grown.
  - System totals indicated in Figure 3: $57 trillion = 430% of U.S. GDP =118% of world GDP.
- Heterogeneity within the core:
  - The 20 largest bank holding companies account for some two-thirds of BHC assets and dominate retail origination.
  - Thousands of regional and community banks focus on niche business and generally retain most loans they make.
- Originate-to-distribute model and income structure:
  - Large core institutions originate loans for securitization and run pipelines; servicing rights are typically retained by commercial banks, with servicing fees exceeding bundling fees at the largest BHCs.
  - Result: revenue diversification through growing noninterest income, cushioning net interest margin pressures and supporting profitability and capital ratios.
- Periphery as shock-absorber:
  - Specialized periphery institutions can absorb credit risk; examples include hedge funds and monoline mortgage originators responsible for more than half of subprime originations in 2005–06.
- Risk management transformation in the core:
  - Liquidity risk and counterparty credit risk have increased with active loan book management and hedging via CDSs; both strategies depend on continuous market liquidity.
  - Increased emphasis on collateral and understanding exposures to periphery entities that may supply limited information.
- Group structures straddle core and periphery:
  - Large BHCs vary from “bank centric” to “broker-dealer centric.”
  - The “big five” investment bank holding companies engage in broker-dealing, prime broking, securitization, syndication, financing originators, and own deposit-taking subsidiaries known as industrial loan companies (ILCs), a type of state-chartered, FDIC-insured commercial bank.

### III. REGULATORY PHILOSOPHY AND STRUCTURE
- U.S. regulatory philosophy (as enunciated by the Fed):
  - Supervising the entire system is neither feasible nor desirable due to risks of “halo effects,” cramping innovation, and practical limits given system complexity and international mobility.
- Two tests for safety-and-soundness oversight:
  - Moral hazard: applies to all commercial banks, thrifts, and credit unions because insured depositors have “little or no incentive to evaluate the risk-taking of their bank”; applies to the “big two” housing GSEs due to belief in government backing.
  - Systemic importance: applies to “very large commercial and investment banks” that “may not fully account for risks to general financial stability.”
- Prudential supervision focused on the “core”; market discipline relied upon in the periphery.
- Prudential oversight tools:
  - Emphasis on capital, receivership, and disclosure requirements.
  - FDICIA introduced credible, automatic wind-up provisions, prompt corrective action, and least-cost resolution requirements for depositories.
  - Consumer protection and disclosure regimes support market discipline.
- Special treatment for “too-large/complex-to-fail” institutions:
  - FDICIA includes a “systemic risk exception” to least-cost resolution, requiring agreement by two-thirds of the FDIC Board, two-thirds of the Fed Board, and the Secretary of the Treasury “in consultation with the President.”
  - Since the 1990s, the Fed’s Large Complex Banking Organization program assigns dedicated examiner teams and focuses on continuous risk-management policies.

### Consolidated supervision and its scope
- Consolidated supervision consensus: enterprise-level supervision of financial conglomerates supplements legal compartmentalization to address cross-cutting legal, reputational, and operational risks.
- Historical statutory extensions:
  - BHC Act of 1956 introduced group-level supervision of BHCs.
  - Financial Institutions Reform, Recovery, and Enforcement Act of 1989 addressed consolidated supervision of thrift holding companies.
  - Gramm–Leach–Bliley Act of 1999 added “umbrella” supervision of financial holding companies.
- Consolidated supervision focuses on “ring-fencing” risks to insured depositories and mandates examiners to ensure holding companies and affiliates do not pose unacceptable risks to depositories.

### Systemic-risk focus: investment banks and GSEs
- Group-level supervision of the “big five” investment banks emphasizes systemic risk; CSE program (launched in 2004) addresses systemic risks from principal dealers in OTC derivatives, leading clearing firms, originators of securitized assets, and providers of financing to originators and buyers.
- The “big two” housing GSEs:
  - Largest U.S. mortgage investors with significant prepayment risk hedging operations in the OTC interest rate swaption market.
  - Agency charters and contingent Treasury credit lines create presumption of U.S. government backing, producing low funding costs and incentives to leverage and expand balance sheets.
  - Effective reform argued to require higher capital requirements, legislatively enshrined receivership provisions, and measures to limit size and scope of investments.

### Consumer and investor protection versus prudential oversight
- Consumer and investor protection focuses on disclosure, fairness, and fraud-prevention through conduct-of-business rules, distinct from prudential oversight.
- Key statutes and rules:
  - Truth in Lending Act (TILA) of 1968: disclosure requirements for lenders to households.
  - Exchange Act of 1934 net capital rule for registered broker-dealers: protect consumers and enable orderly liquidation if net capital minimums are breached.
  - Insurers: regulated by the states; enforcement often includes private right of action.
- Conduct-of-business approaches differentiate by counterparty sophistication:
  - Retail depositors → rules-based methods preferred.
  - Institutions and high-wealth individuals → principles-based approaches considered appropriate.

### U.S. oversight structure: depository regulators (counts preserved)
- Five independent federal regulators of depositories:
  - The Fed (founded in 1913): umbrella supervisor of financial holding companies (some 650 of them), lead supervisor of BHCs (5,129), and joint primary supervisor of state banks that are Fed members (892) along with the states.
  - The FDIC (created in 1933): joint primary supervisor of state nonmember banks (4,783 including ILCs) and state thrifts (433), back-up supervisor of all other banks and thrifts, and insurer of all banks and thrifts (including branches of foreign banks).
  - The Office of the Comptroller of the Currency (established in 1863): charterer and primary supervisor of national banks (1,705), and primary supervisor of U.S. branches of foreign banks (12).
  - The Office of Thrift Supervision (established in 1989): lead supervisor of thrift holding companies (481), charterer and primary supervisor of federal thrifts (837), and joint primary supervisor of state thrifts (433).
  - The National Credit Union Administration (set up in 1970): chartering authority and supervisor of federal credit unions (5,189), and insurer of all federal and most (3,173) state credit unions.

### Functional regulators and market segmentation
- Functional regulators:
  - SEC: supervises the five CSEs on a consolidated basis under its “alternative net capital rule,” enforces investor protection for some 5,100 other broker-dealers under its original net capital rule.
  - Office of Federal Housing Enterprise Oversight: supervises the “big two” housing GSEs.
  - Insurance: regulated exclusively by the states.
  - The Fed writes TILA regulations for all lending to households and shares enforcement with other federal regulators, the Federal Trade Commission, and states.
  - Securities vs. futures markets: securities regulated by SEC, the states, NASD, and exchanges; futures regulated by Commodity Futures Trading Commission, the states, the National Futures Association, and exchanges.

### Safety-and-soundness tools and coordination mechanisms
- Supervisory tools and rulemaking:
  - Interagency “guidances”, interagency rulemaking (e.g., Basel packages), public comment processes, and finalization.
  - Discretion limited by prompt corrective action provisions of FDICIA with mandatory interventions once capital thresholds are breached.
- Institutional coordination:
  - Federal Financial Institutions Examination Council (FFIEC) proposes principles, standards, and reporting forms.
  - Coordination with states via FFIEC State Liaison Committee.
  - Coordination with functional regulators through the Fed’s authorities over financial holding companies, BHCs, and the Large Complex Banking Organization program.

### Differences between prudential and conduct examinations
- Safety-and-soundness examinations: prudential supervisors, preemptive, flexible.
- Conduct-of-business examinations: focus on compliance, enforcement, and ex post punishment; SEC is on a learning curve relative to bank, thrift, and credit union agencies.

### Emerging challenges: originate-to-distribute model and changing risk landscape
- Originate-to-distribute shifts credit risk from the core to the periphery, which may:
  - Support soundness by dispersing risks, but
  - Exacerbate information asymmetries and create a “principal-agent problem” where originators embed more risk than investors expect.
- Consequences and incentives:
  - Amplification of procyclicality in lending standards.
  - Liquidity and counterparty risk become focal points.
  - Originators face early payment default risk, reputational risk, and “warehousing risk” (some CDOs reportedly taking up to 120 days to assemble).
  - Generous fee structures and investor remoteness can incentivize continued risk-taking.
- Underwriting and risk-layering:
  - “Risk-layering” practices grew sharply in 2005–06 (adjustable-rate, interest-only, low-documentation, multiple-lien combinations).
  - Similar cycles observed in leveraged loan markets with “covenant-lite” loans.
- Workout flexibility constraints in multi-class CDOs:
  - Creditworthiness of tranches depends on stacked seniority/subordination; restructuring can be like removing bottom dominos.
  - In an estimated one-third of CDO structures outstanding, servicers are barred by indenture from restructuring more than 5 percent of the assets in the pool.
- Ratings dependency and conflicts:
  - Raters may act as active participants in CDO transactions; growth in rating and consultancy fees increases incentives to facilitate issuance.
  - Credit Rating Agency Reform Act of 2006 introduces modest checks on conflicts.
  - Basel IA capital rule for depositories could cement agencies’ role as “delegated regulators.”
  - Policy remedies suggested: promote rating competition and encourage more investor due diligence.

### Regulatory responses and debates: capital, Basel implementation, and philosophy
- Regulators emphasize the “three pillars”: capital, origination skills, and diversification, with strong attention to capital.
- Basel II implementation:
  - Intended to enhance risk-sensitivity for the largest internationally active banks and address counterparty credit risk.
  - Compromise elements: retention of the minimum “leverage ratio”; a “parallel run” in 2008; “transitional floors” in 2009–11 capping capital reductions at 5 percent per year (relative to Basel I requirements); and a “holistic review” at the end of the transition.
  - Basel IA package (held up) could discipline mortgage lending via more “granular” capital treatment by loan-to-value ratios.
- Regulatory philosophy tensions:
  - Regulators argue the largest commercial and investment banks are inside the supervisory net, so scope extension risks creating moral hazard.
  - Expanded information-gathering may have limited actionable value and could create false comfort.

### Hedge funds and indirect regulatory approaches
- Fed’s stance:
  - Hedge funds are important liquidity providers; direct restraints on fund size and leverage are resisted.
  - Preferred indirect approach: constrain risks via the large commercial and investment banks that act as prime brokers and counterparties.
  - Key measures: ensure core institutions conduct vigorous stress tests of net, marked-to-market exposures to individual hedge funds; maintain conservative netting and margining for initial and daily collateral.

### IV–VI: Innovation, systemic implications, and reform options (selected highlights)
- Innovation and macroeconomic benefits:
  - Financial innovation increased credit availability financed increasingly by foreign savings; attracted external capital signals foreign investors’ revealed preference for U.S. private debt securities.
  - Innovation facilitated lending to new borrowers.
- Risk transfer and market discipline:
  - New markets dispersed credit risk from regulated core to periphery; conduits facilitated broader credit extension; cycles of excess and panic persist but markets can self-correct.
- Effective leverage and off-balance-sheet expansion:
  - Products like CDO first-loss tranches and index-based CDSs allow investors to assume leverage-like exposures without traditional borrowing, creating “effective leverage.”
  - Off-balance-sheet commitments make accounting statements less complete reflections of activities.
- Fed’s view on macro policy responses:
  - Systemic events in market-based systems may involve price fluctuations and abrupt liquidity changes that can be countered by macroeconomic policy instruments more readily than depository-based crises.
  - Supplying additional liquidity and reducing borrowing costs can ameliorate market events with less potential to increase moral hazard than widespread discount window lending.
  - Market-intermediated finance requires living with less control and knowledge than when banks were dominant.
- Supervision priorities and periodic review:
  - Risk-focused supervision of a small number of systemically important institutions and ensuring rapid market clearing are critical.
  - Periodic review of the multiple-agency model is legitimate; political feasibility and interagency coordination are key constraints.
- Specific organizational proposals and adjustments:
  - Reforms likely to emphasize organizational detail and incremental refinements to reduce transition risks.
  - Questions raised about whether the Fed enjoys sufficiently broad oversight authorities given apex responsibility for financial stability.
  - Location of the CSE program at the SEC is questioned; one study proposal: transfer the CSE program from the SEC to the Fed and merge it into BHC supervision to improve consistency and access to information.
  - H.R. 698 (Industrial Bank Holding Company Act of 2007) proposes new ILC treatment; proposals include amending the BHC Act to remove ILC exceptions.
  - Other menu options include housing GSE reform bills and prior proposals to merge the SEC and the Commodity Futures Trading Commission.
- Political constraints:
  - Achieving consensus in Congress is likely the greatest challenge; “a regulator is only as powerful as those it regulates.”

*Source: _wp07195 - References (PDF content provided).*

### References..............................................................................................................

### _wp07195 - References..............................................................................................................

### I. INTRODUCTION
- The rapid evolution of the U.S. financial sector is creating new challenges for the regulatory structure.
- With large financial institutions increasingly distributing loans to investors rather than holding them, the share of financial sector assets owned by insured depositories has fallen from around half in 1980 to under one-quarter in 2006 (Figure 1).
- As complexity of instruments and trades has multiplied, the portal through which the Federal Reserve views and influences financial markets on a day-to-day basis has, in one respect, halved in size.
- The paper's structure:
  - Section II: surveys the financial landscape, separating a highly regulated, multi-business “core” from a lightly regulated, more specialized “periphery”;
  - Section III: explains the U.S. regulatory philosophy and structure, with its focus on core institutions and its jurisdictional complexity;
  - Section IV: highlights certain new challenges;
  - Section V: draws out broad policy implications;
  - Section VI: concludes by tabling and discussing one specific streamlining measure.

### II. TOPOGRAPHY OF THE SYSTEM
- Technological change and mass-production techniques in finance have enabled large financial firms to use IT, complex modeling, and legal structures to create a growing array of securities with diverse risk profiles.
- Consumer credit scoring facilitates automated approval of housing, consumer, and student loans; these loans, alongside more heterogeneous business and commercial real estate loans, are increasingly bundled as securities.
- Waves of securitization have spread from mortgages to other asset classes (Figure 2).
- Special purpose vehicles / ABS pools:
  - Referred to as asset-backed security (ABS) pools, these pass-through structures serve as “obligors,” issuing debt backed by cash flows on the assets they own.
  - With assets enjoying legal safe-harbor from any previous owner’s bankruptcy, the creditworthiness of each ABS issued is a function of two, and only two, factors: the quality of the assets in the pool, and the capital structure (Moody’s Investors Service, 2007, and Standard & Poor’s, 2007a,b).
  - ABS pools can transform “junk” assets into investment-grade liabilities, widening investor bases to include pension funds and foreign central banks via CDO structuring.
- Credit enhancement techniques in CDOs include:
  - credit “wraps” (guarantees or insurance);
  - “excess spread” (lower interest rates on liabilities than on pooled assets);
  - “over-collateralization” (lower volumes of liabilities than of assets);
  - payment “waterfalls” (seniority/subordination hierarchies).
- Tranche structure outcomes: typically an ‘AAA’-rated tranche, a speculative-grade “equity” tranche with “embedded leverage,” and a “mezzanine” tranche between.
- Hedge funds:
  - Are key providers of liquidity and major contributors to trading volume, particularly in higher-risk segments, central to price discovery (FitchRatings, 2007).
  - Are generally well-equipped to cope with instrument complexity, including CDOs composed of ABSs, other CDOs (creating “CDO2s” and “CDO3s”), or CDSs (creating “synthetic” CDOs).
- Ratings dependency:
  - More complexity entails more ratings dependency; CDO tranches often provide more yield than identically rated single-name securities.
  - Securitization is fostering greater reliance on ratings by less sophisticated investors—especially at higher rating levels (BIS, 2005b), increasing responsibility on a small group of private rating agencies.
- Core vs. Periphery (Figure 3):
  - The core consists of institutions for which market discipline is relatively weak and those considered systemically important:
    - all federally insured depositories (7,380 commercial banks, 1,270 thrifts, and 8,362 credit unions),
    - the government-sponsored enterprises (GSEs) active in mortgage securitization and investment (Fannie Mae and Freddie Mac),
    - the largest broker-dealers (organized into the “big five” investment banking groups).
    - This core now holds less than one-third of total financial sector assets.
  - The periphery consists of all other financial entities:
    - small broker-dealers and all insurance companies, finance companies, mortgage companies, funding corporations, and private capital pools (pension funds, mutual funds, real estate investment trusts, ABS pools, hedge funds, and private equity funds).
    - The periphery’s role as a holder and originator of financial assets has grown, with ABS pools, mutual funds, and hedge/private equity funds leading the expansion in asset holdings, and mortgage brokers and hedge/private equity funds leading originations.
  - System totals indicated in Figure 3: $57 trillion = 430% of U.S. GDP =118% of world GDP.
- Heterogeneity within the core:
  - The 20 largest bank holding companies (BHCs) account for some two-thirds of BHC assets and dominate retail origination (residential mortgages and consumer loans) often involving specialized, largely unregulated nonbank lenders within group structures.
  - Thousands of regional and community banks focus on niche business—small-scale commercial real estate and business lending—relying on local knowledge and generally retaining most loans they make.
- Originate-to-distribute model and income structure:
  - Large core institutions originate many loans explicitly for securitization and sale and purchase pipelines of loans from other originators; large investment banks also purchase loans for bundling and gain market share in syndication.
  - Servicing rights on pooled loans are typically retained by commercial banks, with servicing fees exceeding bundling fees at the largest BHCs.
  - Result: revenue diversification through growing noninterest income, cushioning tight net interest margins and supporting profitability, capital ratios, and market-based solvency metrics (Bhatia, 2006).
- The periphery as shock-absorber:
  - Specialized periphery institutions come and go without wider notice; examples include hedge funds and the monoline mortgage origination industry that accounted for more than half of subprime originations in 2005–06 and bore early payment default problems isolated within that segment (Kiff and Mills, 2007).
  - The periphery can be a natural repository for credit risk from the core (Kroszner, 2007; Kuritzkes, Schuermann, and Weiner, 2003).
  - Examples of complementary roles:
    - Insurers sell CDSs to diversify event-based exposures;
    - Pension funds are far less leveraged than commercial banks;
    - Yield-hungry hedge funds buy CDO equity and sell protection against speculative-grade credit risks.
- Risk management transformation in the core:
  - Liquidity risk and counterparty credit risk have increased in importance as loan books are actively managed and institutions decide between selling loans or retaining them and hedging via CDSs.
  - Both strategies depend on continuous liquidity in markets not yet tested by a “tail event.”
  - CDS purchases and prime brokerage services require understanding exposures to and creditworthiness of periphery entities that may furnish limited information, increasing emphasis on collateral.
- Group structures straddle core and periphery:
  - Large BHCs vary from “bank centric” to “broker-dealer centric.”
  - The “big five” investment bank holding companies engage in securities broker-dealing, prime broking, securitization, syndication, financing to bank and nonbank loan originators, and own deposit-taking subsidiaries known as industrial loan companies (ILCs), a type of state-chartered, FDIC-insured commercial bank.

### III. REGULATORY PHILOSOPHY AND STRUCTURE
- U.S. regulatory philosophy (as enunciated by the Fed) holds that supervising the entire system is neither feasible nor desirable, for reasons including:
  - avoiding “halo effects” from federal supervision;
  - avoiding cramping innovation;
  - practicality given system complexity and international mobility of many institutions (Bernanke, 2007a,c).
- Two tests for safety-and-soundness oversight:
  - Presence of moral hazard:
    - Applies to all commercial banks, thrifts, and credit unions because insured depositors have “little or no incentive to evaluate the risk-taking of their bank” (Bernanke, 2007a).
    - Applies to the “big two” housing GSEs because of the belief that the U.S. government will back these institutions under almost any circumstances (Bernanke, 2007b).
  - Systemic importance:
    - Refers to “very large commercial and investment banks” that “may not fully account for risks to general financial stability,” and to preventing failures of risk management by a sufficient number of smaller institutions that would threaten system health (Bernanke, 2007c).
- Prudential supervision applies only to the “core,” with reliance on market discipline elsewhere (Kohn, 2007a):
  - Examination authorities extend to all federally insured depositories (and their holding companies and group affiliates, except in some ILC cases), the “big five” investment banking groups, and the housing GSEs.
  - Even in the core, regulators emphasize a “hybrid system that supplements direct regulation with a substantial amount of market discipline” (Bernanke, 2007a) and supervision “designed to limit—not eliminate—the risk of failure” (Greenspan, 2005a).
- Prudential oversight tools:
  - Emphasis on capital, receivership, and disclosure requirements.
  - Capital serves as loss-absorption and assurance that shareholders have skin in the game; capital requirements are linked to risk-taking.
  - Credible, automatic wind-up provisions, prompt corrective action, and least-cost resolution requirements (for depositories) were introduced through the FDIC Improvement Act (FDICIA) of 1991.
  - Disclosure addressed through an extensive system of consumer protection.
- Special treatment for “too-large/complex-to-fail” institutions:
  - FDICIA includes a “systemic risk exception” to its least-cost resolution requirement.
  - Market discipline remains important due to uninsured noncore liabilities and capital as marginal funding sources for large BHCs and main sources for large investment banking groups (Bernanke, 2007b).
  - Two safeguards:
    - The systemic risk exception in FDICIA requires agreement by two-thirds of the FDIC Board, two-thirds of the Fed Board, and the Secretary of the Treasury “in consultation with the President” (Eisenbeis, Frame, and Wall, 2004).
    - Since the 1990s, the Fed’s Large Complex Banking Organization program focuses on continuous risk-management policies and assigns a dedicated examiner team to each institution in the program (DeFerrari and Palmer, 2001).

*Italic: Source: _wp07195 - References (PDF content provided).

### 19.      Supervisory powers have progressively been extended to the owners and affiliates of

### 19.      Supervisory powers have progressively been extended to the owners and affiliates of

### Consolidated supervision and its scope
- Consolidated supervision reflects a consensus that financial conglomerates need supervision at the enterprise level, addressing cross-cutting legal, reputational, and operational risks as a supplement to legal compartmentalization.
- Historical statutory extensions:
  - BHC Act of 1956 introduced group-level supervision of BHCs.
  - Financial Institutions Reform, Recovery, and Enforcement Act of 1989 addressed consolidated supervision of thrift holding companies.
  - Gramm–Leach–Bliley Act of 1999 added “umbrella” supervision of financial holding companies (expanded-scope BHCs).
- Consolidated supervision of financial holding companies, BHCs, and thrift holding companies focuses on “ring-fencing” risks to insured depositories and emphasizes “risk-focus,” mandating examiners to ensure holding companies and affiliates do not pose unacceptable risks to depositories.

### Systemic-risk focus: investment banks and GSEs
- Group-level supervision of the “big five” investment banks emphasizes systemic risk rather than protection of deposit-taking ILCs; motivated in part by an E.U. Directive requiring consolidated supervision in the European Economic Area and leading to the Consolidated Supervised Entity (CSE) program launched in 2004.
- CSE program emphasis: systemic risks posed by a small number of institutions that are principal dealers in over-the-counter derivatives markets, leading clearing firms for exchange-traded derivatives, originate securitized assets, and provide financing to other originators and buyers of assets (including buyers of the riskiest tranches).
- The “big two” housing GSEs:
  - Remain the largest U.S. mortgage investors with prepayment risk hedging operations dominant in the over-the-counter interest rate swaption market.
  - Agency charters (including contingent credit lines from the Treasury) create a widely held presumption of U.S. government backing, producing low and relatively risk-insensitive funding costs and incentives to leverage and expand balance sheets.
  - Effective GSE reform is argued to require a package deal: higher capital requirements, legislatively enshrined receivership provisions, and measures to limit the size and scope of their investments.

### Consumer and investor protection versus prudential oversight
- Consumer and investor protection emphasize disclosure, fairness, and fraud-prevention through conduct-of-business rules to underpin market discipline, distinct from prudential oversight.
- Key statutes and rules:
  - Truth in Lending Act (TILA) of 1968 imposes disclosure requirements (and certain prohibitions) on lenders to households “to assist in shopping for credit.”
  - Exchange Act of 1934 net capital rule for registered broker-dealers “to protect consumers and other market participants from broker-dealer failures and to enable those firms that fall below the minimum net capital requirement to liquidate in an orderly fashion.”
  - Insurers face state-level regulations; enforcement often includes private right of action (lawsuits, including class actions), requiring meticulous rulemaking to avoid “paralysis by litigation.”
- Conduct-of-business approaches differentiate by counterparty sophistication:
  - Retail depositors: seen to lack time and resources to gather information → rules-based methods preferred.
  - Institutions and high-wealth individuals: considered “well equipped to assess” risks → principles-based approaches (e.g., safe-harbor under Rule 144A) are considered appropriate.

### U.S. oversight structure: depository regulators (counts preserved)
- The U.S. oversight structure includes five independent federal regulators of depositories (Government Accountability Office (GAO), 2004):
  - The Fed (founded in 1913): umbrella supervisor of financial holding companies (some 650 of them), lead supervisor of BHCs (5,129), and joint primary supervisor of state banks that are Fed members (892) along with the states.
  - The FDIC (created in 1933): joint primary supervisor of state nonmember banks (4,783 including ILCs) and state thrifts (433), back-up supervisor of all other banks and thrifts, and insurer of all banks and thrifts (including branches of foreign banks).
  - The Office of the Comptroller of the Currency (established in 1863): charterer and primary supervisor of national banks (1,705), and primary supervisor of U.S. branches of foreign banks (12).
  - The Office of Thrift Supervision (established in 1989): lead supervisor of thrift holding companies (481), charterer and primary supervisor of federal thrifts (837), and joint primary supervisor of state thrifts (433).
  - The National Credit Union Administration (set up in 1970): chartering authority and supervisor of federal credit unions (5,189), and insurer of all federal and most (3,173) state credit unions.

### Functional regulators and market segmentation
- Functional regulators with important roles:
  - Securities and Exchange Commission (SEC): supervises the five CSEs on a consolidated basis under its “alternative net capital rule,” enforces investor protection for some 5,100 other broker-dealers under its original net capital rule.
  - Office of Federal Housing Enterprise Oversight: supervises the “big two” housing GSEs.
  - Insurance industry: regulated exclusively by the states.
  - The Fed writes TILA regulations for all lending to households and shares enforcement with other federal regulators, the Federal Trade Commission, and states.
  - Securities vs. futures markets: SEC, the states, NASD, and exchanges regulate securities; Commodity Futures Trading Commission, the states, the National Futures Association, and exchanges regulate futures.

### Safety-and-soundness tools and coordination mechanisms
- Supervisory tools:
  - Five federal depository agencies (and occasionally the SEC) issue interagency “guidances” applied flexibly under examination authorities.
  - Regulators adopt rules (e.g., the Basel packages under review) that “prescribe and proscribe” specific actions.
  - Promulgation occurs via interagency consensus-building, proposal, public comment, modification, and finalization.
  - Discretion is limited by prompt corrective action provisions of FDICIA, with mandatory interventions once certain capital thresholds are breached.
- Institutional coordination:
  - Federal Financial Institutions Examination Council (FFIEC): five federal regulators of depositories jointly propose principles, standards, and reporting forms.
  - Coordination with states via the FFIEC State Liaison Committee (Conference of State Banking Supervisors, American Council of State Savings Supervisors, National Association of State Credit Union Supervisors).
  - Coordination with functional regulators largely through the Fed’s authorities over financial holding companies and BHCs, and the Large Complex Banking Organization program for joint inspections of nonbank institutions within group structures.

### Differences between prudential and conduct examinations
- Safety-and-soundness examinations: prudential supervisors, preemptive, with considerable flexibility.
- Conduct-of-business examinations: focus on compliance, enforcement, and ex post punishment; SEC is on a learning curve relative to bank, thrift, and credit union agencies with substantial prudential experience.

### Emerging challenges: originate-to-distribute model and changing risk landscape
- Originate-to-distribute shifts credit risk from systemically important core to atomized periphery, which could support soundness but may exacerbate information asymmetries and a new “principal-agent problem” leading originators to embed more risks than investors expect.
- Consequences include amplification of procyclicality in lending standards, changing (not eliminating) core risks, with liquidity risk and counterparty risk becoming focal points.
- Underwriting standards may be weakening due to incentives:
  - Originators face early payment default risk, reputational risk, and “warehousing risk” (pipelines of loans pending packaging; some CDOs reportedly taking up to 120 days to assemble).
  - Generous fee structures and investor remoteness create incentives to persist with risk-taking.
  - Rating agency models stipulate minimum asset standards, but originators may satisfy them in letter rather than spirit, focusing on “observables” at the expense of due diligence.
- New securitization techniques may encourage lending in riskier niches:
  - “Risk-layering” practices grew sharply in 2005–06 (adjustable-rate, interest-only, low-documentation, multiple-lien combinations).
  - A similar cycle may be occurring in the leveraged loan market with proliferation of “covenant-lite” loans (IMF, 2007).
- Workout flexibility is limited in multi-class CDOs:
  - Creditworthiness and ratings of tranches rest on stacked seniority/subordination; modifying nonperforming assets can be like removing bottom dominos.
  - In an estimated one-third of CDO structures outstanding, servicers are barred by indenture from restructuring more than 5 percent of the assets in the pool, regardless of whether cooperative solutions are least-cost (UBS, 2007).
- Ratings dependency is increasing:
  - Raters in complex CDO transactions may be active participants rather than arm’s-length assessors.
  - Growth in rating (and consultancy) fees increases raters’ incentives to facilitate CDO issuance.
  - Credit Rating Agency Reform Act of 2006 introduces modest checks on agency conflicts of interest.
  - Basel IA capital rule for depositories could cement agencies’ role as “delegated regulators.”
  - Policy remedies include promoting greater rating competition and encouraging more due diligence by investors; the industry is often considered a “natural oligopoly.”
- Competition from the periphery pressures core institutions:
  - Senior loan officers cite increasing competition from nonbanks as a driver of easing credit standards (Fed, 2007a,b).
  - An interagency guidance proposed in early 2006 was reported by several large banks to have had “little effect” on their commercial real estate lending (Fed, 2007a).
  - The question arises whether “regulatory intensity” must increase to maintain a given level of risk-taking in the core.

### Regulatory responses and debates: capital, Basel implementation, and philosophy
- Regulators stress the “three pillars” of bank soundness: capital, origination skills, and diversification, with capital receiving particular attention.
- Basel II implementation aims to enhance risk-sensitivity of regulatory capital at the largest, internationally active banks and addresses counterparty credit risk (including advanced exposure-at-default modeling techniques).
- Basel IA package could discipline mortgage lending standards through more “granular” capital treatment of mortgages based on loan-to-value ratios.
- Delays and interagency negotiation illustrate how multiple overlapping agencies can slow responses:
  - Compromise on Basel II included retention of the minimum “leverage ratio” (tier-1 capital to total assets); a “parallel run” in 2008; “transitional floors” in 2009–11 capping capital reductions at 5 percent per year (relative to Basel I requirements); and a “holistic review” at the end of the transition period.
  - Basel IA was held up in the process; subprime lending standards deteriorated in the interim.
- Regulatory philosophy points by the Fed:
  - Regulators believe they can substantially influence the system because the largest commercial and investment banks are inside the supervisory net.
  - Extending supervisory powers to new categories could create moral hazard by singling out institutions or markets as critical to stability.
  - Expanded information-gathering efforts may be of limited actionable value and could create a false sense of comfort among market participants.

### Hedge funds and indirect regulatory approaches
- The Fed views the hedge fund industry as an important provider of liquidity and innovative trading strategies but resists direct restraints on size and leverage of individual funds.
- Preferred approach: apply constraints indirectly via large commercial and investment banks that serve as hedge funds’ major counterparties (prime brokerage), focusing on:
  - Ensuring core institutions conduct vigorous stress tests of net, marked-to-market exposures to individual hedge funds.
  - Maintaining conservative netting arrangements and “margining” policies for initial and daily collateral.

*Source: IMF staff report excerpt (chapter/section provided).*

### 40.      The U.S. financial sector has demonstrated a tremendous capacity for innovation,

### 40.      The U.S. financial sector has demonstrated a tremendous capacity for innovation,

### Innovation and macroeconomic benefits
- The U.S. financial sector’s creative abilities have produced a steady stream of new financial products and services, supporting a widening of domestic credit availability financed increasingly by foreign savings.
- The relative ease of attracting external capital represents a revealed preference by foreign investors for U.S. private debt securities (Balakrishnan, Bayoumi, and Tulin, 2007).
- Innovation has facilitated lending to new, previously excluded borrowers, rather than simply increasing lending to existing borrowers (Weinberg, 1995).

### Risk transfer, core-periphery dynamics, and market discipline
- New risk transfer markets have dispersed credit risk from a regulated core—where moral hazard is concentrated—to a periphery where market discipline is the chief restraint on risk-taking.
- The conduit mechanism has facilitated broader credit extension.
- Cycles of excess and panic persist (the subprime boom-bust is cited as a recent example), but markets have demonstrated capacity for self-correction.

### Prudential oversight and the changing nature of leverage
- Market forces and selective application of safety-and-soundness oversight have been central to innovation; the Fed has served a guardian role against more dirigiste regulatory approaches.
- Financial innovations such as first-loss tranches of CDOs and index-based CDSs permit investors to assume leverage-like exposures without traditional borrowing, creating “effective leverage” as a combination of traditional “financial leverage” and “embedded leverage” (FitchRatings, 2007).
- Expansion of off-balance sheet commitments has made accounting statements increasingly incomplete reflections of complex financial institutions’ activity.
- More discriminating pricing of a wide range of risks has produced richer market information; surveillance practices have adapted, with the Fed monitoring a broad range of price-based indicators (Nelson and Perli, 2005).

### Uncertainties, liquidity risk, and the Fed’s view on macro policy responses
- As the highly regulated core has contracted in relative size, regulators’ ability to influence or view the entire system has diminished.
- With trading activities gaining prominence and liquidity in new markets untested comprehensively, concerns exist that strong financial sector profits may mask large contingent losses in major disturbances (Knight, 2007).
- The Fed has discussed the role of monetary policy in such scenarios (Kohn, 2007a). Key points noted by the Fed:
  - “Systemic events in market-based financial systems are perhaps more likely to involve price fluctuations and abrupt changes in market liquidity than are systemic events in depository-based financial systems. But ... such events can more readily be countered by macroeconomic policy instruments than could old-fashioned crises of depository intermediation.”
  - “Supplying additional liquidity and reducing borrowing costs can greatly ameliorate the effects of market events on the economy, and those types of macroeconomic interventions will carry less potential for increasing moral hazard than would the discount window lending that was a prominent feature of crisis management when depositories funded more credit.”
  - “Market intermediated finance also requires us to live with less control and less knowledge than we had when banks were dominant. Greater uncertainty about where risks are lodged is the flip side of better dispersion of those risks, especially to less regulated sectors, and of more resilience of the whole system.”

### Supervision priorities and systemic importance
- Risk-focused supervision of a small number of systemically important institutions and measures to ensure rapid market clearing are increasingly critical.
- The largest BHCs and investment banking groups are central to financial stability because:
  - Issues at any one such entity could cascade across the system.
  - These firms serve as “regulators by proxy,” policing risk-taking in the periphery.
- Extending direct prudential supervision to hedge funds may be infeasible and undesirable; instead, indirect oversight through BHCs and CSEs requires continuous vigilance.
- Ensuring efficient functioning of payment and settlement systems is important to support smooth liquidity flows.

### Periodic review of the regulatory structure and potential reforms
- Periodic review of the U.S. multiple-agency regulatory model is legitimate given stakes and systemic changes.
- The U.S. multiple-agency model offers firms choice in supervision (e.g., charter “flipping”), and there is little evidence centralized structures deliver more effective supervisory procedures (De Nicoló, Hayward, and Bhatia, 2004). However, the model raises issues of consistency across markets and institutions and requires careful interagency coordination to prevent risks from slipping between the cracks.

### Specific organizational proposals and regulatory adjustments
- Reforms are likely to focus on organizational detail rather than scope of supervisory activity; principles for reforms include simplifying initiatives and favoring incremental refinements to reduce transition risks (Paulson, 2006).
- With the Fed bearing apex responsibility for U.S. financial stability, questions arise about whether the Fed enjoys sufficiently broad oversight authorities; the Fed’s role in supervision of financial holding companies and BHCs is argued to be sacrosanct (Goodhart, 2000).
- The location of the CSE program at the SEC is questioned given that the “big five” investment banking groups bear systemic importance and own insured depositories:
  - H.R. 698, the Industrial Bank Holding Company Act of 2007 (pending before the Congress), proposes to make new ILCs subject to broader prohibitions on mixing banking and commerce and to bring their parents and affiliates into the federal supervisory net by amending the FDIC Act to create a new “industrial bank holding company” category under FDIC consolidated supervision.
  - The Fed suggests consistency and simplicity would be better served by amending the BHC Act to remove exceptions for ILCs (Kohn, 2007b).
  - H.R. 698 proposes grandfathering existing ILC-owning holding companies (including the “big five” CSEs); absent grandfathering, owners of ILCs could be required to divest or become BHCs under the Fed’s consolidated supervisory authority.
  - The still-new CSE program is not specifically geared to risks a group structure may pose to insured depositories but emphasizes systemic risks posed by large complex entities; CSE oversight shares synergies with the Fed’s BHC oversight yet sits at the traditionally enforcement-oriented SEC.
  - One organizational reform suggested for further study: transfer of the CSE program from the SEC to the Fed and merge it into BHC supervision to improve regulatory consistency (for example, CSEs currently face a different variant of Basel II than depositories) and to enhance the Fed’s direct access to information and ability to influence the behavior of five systemically important institutions.
  - The GAO (2004) weighed rationalizing regulators along functional lines (the “twin peaks” model); a “twin peaks-lite” quid pro quo could consider transferring TILA rulemaking responsibilities from the Fed to the SEC, leveraging the SEC’s consumer protection expertise.

### Additional reform options and political constraints
- A menu of proposals exists beyond functional reorganization, including various housing GSE reform bills and prior proposals to merge the SEC and the Commodity Futures Trading Commission.
- Achieving political consensus may be the greatest challenge; Congress will deliberate initiatives to adapt the U.S. regulatory system, mindful that “a regulator is only as powerful as those it regulates.”

*Source: _wp07195 - 40.      The U.S. financial sector has demonstrated a tremendous capacity for innovation,*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07195.pdf_