Summary

Recent years have witnessed dynamic changes in the financial services industry. Through growth, mergers, and acquisitions, coupled with regulatory reevaluation of acceptable activities, financial institutions in different financial sectors are increasingly competing directly for the same business by offering similar products and undertaking similar activities. Advances in financial theory and technology have enabled firms to understand, measure, and manage the financial risks they face in their business activities far more effectively than in the past. As companies have improved their internal measurement of risk, regulators have responded by reexamining their capital regulations that require firms to hold minimum levels of capital as a buffer against unexpected losses. Some regulators have already developed capital standards that attempt to better correlate required regulatory capital with the actual risks that firms face in their activities, while other regulators are considering similar changes. This report is intended to inform Congress and others of both regulatory capital requirements and financial firms' approaches to risk measurement. GAO describes, for the banking, securities, futures, and life insurance sectors, (1) 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.

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.