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GAO Issues Report on Regulatory Changes – A Great History Lesson, but Most Ideas Come up Short

     By Fulcrum Inquiry Damages, Appraisal, Accounting & Economics Expert Witnesses

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The GAO just issued a report that will likely to assist the Obama administration’s changes to the U.S. financial regulatory system. We summarize the GAO’s description of the regulatory problem, and their ideas of what to do about these problems. Although the report is correct on many fronts, the good ideas are lost in other Pollyannaish, obvious, and banal thoughts that are not worth the ink spilled.
In January, the Government Accountability Office (GAO) issued a report entitled “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System”. The report is likely to assist the discussion of increased regulation that the Obama administration and its friendly Congress will be implementing.

The report starts with a stark description of our current situation, as follows:

“The current U.S. financial regulatory system has relied on a fragmented and complex arrangement of federal and state regulators—put into place over the past 150 years—that has not kept pace with major developments in financial markets and products in recent decades. As the nation finds itself in the midst of one of the worst financial crises ever, the regulatory system increasingly appears to be ill-suited to meet the nation’s needs in the 21st century. Today, responsibilities for overseeing the financial services industry are shared among almost a dozen federal banking, securities, futures, and other regulatory agencies, numerous self-regulatory organizations, and hundreds of state financial regulatory agencies. Much of this structure has developed as the result of statutory and regulatory changes that were often implemented in response to financial crises or significant developments in the financial services sector. For example, the Federal Reserve System was created in 1913 in response to financial panics and instability around the turn of the century, and much of the remaining structure for bank and securities regulation was created as the result of the Great Depression turmoil of the 1920s and 1930s.”

However, when presenting details and recommendations, the report primarily limits itself to an interesting primer of the current situation. Most of the report’s conclusions end up being obvious and Pollyannaish. The GAO thereby missed an opportunity to be as helpful as possible. In contrast, the Bush administration’s suggestions for a new regulatory framework made more specific and useful suggestions.

What caused the current problems

The GAO identified the following sources of mistakes and “holes” in the current regulatory setup:

1. Regulators struggled, and often failed, to address systemic risks presented by large and interconnected financial conglomerates serving banking, securities, and insurance. While these entities increased significantly in recent years, none of the regulators are tasked with assessing and controlling the related risks posed across the entire financial system.

2. Regulators struggled, and often failed, to address problems caused by less-regulated market participants, such as non-bank mortgage lenders, hedge funds, and credit rating agencies.

3. Regulators struggled, and often failed, to address problems caused by new and complex investment products. Consumers face difficulty understanding new and increasingly complex retail mortgage and credit products. An important example is that regulators failed to adequately oversee the sale of mortgage products that posed risks to consumers and the stability of the financial system.

4. Accounting standard setters face growing challenges to ensure that accounting and audit standards respond to market developments, and in addressing challenges arising from the global convergence of accounting and auditing standards.

5. Despite the increasingly global aspects of financial markets, the current fragmented U.S. regulatory structure complicates efforts to coordinate with international regulators.

The GAO’s Solutions

With these problems in mind, the following is our summary of the GOA’s suggestions as to how to evaluate and craft financial regulatory reform. The following list combines related GAO suggestions in a way that we think the GOA should have done itself, and adds our comments.

1. A regulatory system should have goals that are clearly articulated and relevant, so that regulators can effectively conduct activities to implement their missions. – This is a bit silly. Elsewhere in the report, the GAO clearly lays out the regulatory objectives. When added together, the objectives are a bit numerous, although not unclear or contradictory. Regulators know what they were tasked to do in the numerous failures that the GOA observes. The problems are the other items described elsewhere.

2. The regulatory system should be appropriately comprehensive, flexible, and adaptable. – The GAO report provides numerous examples where those who would otherwise be regulated successfully took measures to avoid the regulation. These non-regulated activities need to be brought under the regulatory umbrella. The regulatory authority should be sufficiently broad to (i) avoid clever “work-arounds” by those attempting to avoid the rules, and (ii) allow regulation of new types of transactions not previously contemplated when the authority was first granted.

3. The broad authority described in the preceding point needs to be implemented by regulators with independence, prominence, authority, and accountability. - Although the GAO failed to say it directly, some of the problems the GAO noted were caused by regulators who were content with defining and implementing their responsibilities too narrowly.

4. Protect consumers from themselves – The GAO believes that the regulatory scheme needs increased focus on consumer and investor protection that provides market participants with disclosures, sales practice standards, and suitability requirements that will prevent them from making bad decisions. The GAO’s examples on this point generally involve consumers who make stupid decisions after getting information that they chose to ignore. Although the GAO desires additional disclosure, no level of disclosure will prevent stupidity by those who will not read whatever is made available to them. Accordingly, the GAO would have been better off describing this challenge directly, and recommending that troubling sales practices be outlawed.

5. The GAO wasted entirely too much ink on platitudes that everyone could agree upon, but which lacked any practical implementation guidance or useful recommendations. We should all be relieved that the GAO thinks regulation should be:

a. Efficient, effective, and consistent – The GAO provides no specifics here, other than this is a desired objective.

b. Minimizing regulatory burden - Of course, all of the other GAO suggestions will increase regulatory burden, but the GAO failed to discuss these difficult trade-offs.

c. Minimize negative competitive outcomes – The GAO provides no description of what this even means, much less how this objective is to occur

d. Not cost much, and decrease loss exposure to taxpayers – Again, no specifics.

6. Although highlighting accounting’s role in a sound regulatory system, the GAO failed to provide any suggestions as to how to do better. The GAO incorrectly blamed more complex transactions. The parties entering into the transactions understood what was happening, and so did (or should have) the accountants and auditors. The real problem is not the complexity of transactions that require accounting, but the accountants’ desire to have cookbook rules to tell them precisely what needs to be done. Once cookbook rules exist, the accountants and auditors attempt to slavishly follow the recipe, even when the underlying transactions are designed to fit into existing rules and purposefully avoid a fair presentation of the real economics of the transactions. When faced with this situation, the accountants and auditors need to not shrink back into the cookbook, but use already-known principles to identify the correct answer. State otherwise, the real problem is that the accountants and auditors failed to cry foul when they knew (or certainly should have known) that the accounting was not being true to the economics of the transaction. To understand this issue more, see principles-based accounting.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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