GAO Report Proposes Framework for Monitoring Financial Emerging Risks and Regulatory Responses

The Government Accountability Office (“GAO”) issued a report titled “Lessons Learned and a Framework for Monitoring Emerging Risks and Regulatory Response.” The report outlines a framework the GAO will use to monitor regulators’ efforts to identify and respond to emerging risks to the banking system.

The GAO reviewed its prior studies and those of federal banking regulators, the regulators’ inspectors general, and academics that evaluated regulators’ efforts to identify and respond to risks that led to bank failures in past crises.  In its review, the GAO determined that there are a number of regulatory lessons to be learned from previous banking-related crises including the importance of:

  • early and forceful action by bank management;
  • forward-looking assessments of emerging risk; and
  • emerging risks in the context of a broader financial system.

The GAO Report outlines a framework for monitoring regulators’ efforts to identify and respond to emerging risks to the banking system. The framework has two strategic goals: (i) to monitor known emerging risks to the safety and soundness of the banking system; and (ii) to monitor regulatory responses to these risks, including detecting trends in regulatory responses that might signal a weakening of regulatory oversight.

Part one of the two-part framework incorporates quantitative information in the form of financial indicators that can track and analyze emerging risks and qualitative sources of information on emerging risks – such as regulatory reports and industry and academic studies. The second part of the framework monitors regulatory responses to emerging risks, such as agency guidance, aiming to flag issues for further review where the effectiveness of the regulatory responses may not be clear or questions have arisen as to whether these measures have mitigated risk.

Lofchie Comment: Apparently, no one informed the GAO that the “official” cause of the recent financial crisis was derivatives entered into by institutions outside of the control of the banking regulators. The report (at pp. 14-15) seems to assume that the major cause of the financial crisis was a boom in mortgage-lending, followed by a bust. Indeed, the GAO discussion of the causes of the financial crisis is closer to the dissent published by Peter Wallison as part of the Financial Crisis Inquiry Commission’s report than the official assumed view of the majority. The GAO’s report also criticizes the failure of the bank regulators to respond to known weaknesses in the banks that they regulated before the 2007-2009 financial crisis.

Notwithstanding these assumptions, a good part of the implicit conclusion of the report is that the bank regulators want, and should have, more regulatory authority over non-banks. See, for example (at page 2), where the banking regulators complain about the fact that “shadow banking activities largely were not subject to consistent and effective regulatory oversight.” To put this argument differently, any failure by a federal regulator in the exercise of its power should be attributed to a great extent to the fact that it has insufficient power.

Perhaps there is some truth to this; but we should nonetheless be wary of an economic system where the banking regulators control banks and non-banks alike.  Non-banks should be entitled to risk failure by default.