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Working Paper Series

The Consolidation of Financial Market
Regulation: Pros, Cons, and Implications
for the United States

WP 09-08

Sabrina R. Pellerin
Federal Reserve Bank of Richmond
John R. Walter
Federal Reserve Bank of Richmond
Patricia E. Wescott
Federal Reserve Bank of Richmond

This paper can be downloaded without charge from:
http://www.richmondfed.org/publications/

The Consolidation of Financial Market Regulation: Pros,
Cons, and Implications for the United States*

Sabrina R. Pellerin, John R. Walter, and Patricia E. Wescott
Federal Reserve Bank of Richmond

May 2009
Working Paper No. 09-08

Abstract
The U.S. financial system has changed significantly over the last several decades without any major
structural changes to the decentralized financial regulatory system, despite numerous proposals. In the past
decade, many countries have chosen to consolidate their regulators into a newly formed “single regulator”
or have significantly reduced the number of existing regulators in order to form a regulatory structure that
more closely mirrors the current financial system – one that is increasingly dominated by large financial
conglomerates. This paper reviews the advantages and disadvantages of regulatory consolidation, explores
the effects of consolidation on regulators’ incentives, and evaluates which entity is best suited for this role
– whether it be a newly created entity or an existing one, such as a central bank. Additionally, this paper
reviews the transitions to consolidated regulation that took place in the U.K., Germany, Japan and Australia
and finds that despite significant consolidation, complex systems with multiple entities remain. These
countries removed most regulatory authority from their central banks, yet there may be reasons not to make
such a change.

JEL classifications: L51, G28
Keywords: Regulatory reform, financial regulatory consolidation

The authors would like to thank Brian R. Gaines, Borys Grochulski, Sam E. Henly,
Edward S. Prescott, and Juan M. Sanchez for helpful comments. The views expressed in
this article are those of the authors and do not necessarily reflect those of the Federal
Reserve Bank of Richmond or the Federal Reserve System.

E-mails: Sabrina.Pellerin@rich.frb.org, John.Walter@rich.frb.org,
Patricia.Wescott@rich.frb.org.

1. Introduction
During the summer of 2008, the House Financial Services Committee held hearings to
consider proposals for restructuring financial regulation in the United States (U.S.
Congress 2008). A Treasury Department proposal, released in March 2008, had a
prominent role in the hearings. The Treasury proposal would consolidate by shrinking the
number of financial regulators from the current six (plus banking and insurance
regulators in most of the 50 states) to three: a prudential supervisor – responsible for
assessing the riskiness of all financial institutions that have government backing, a
consumer protection supervisor, and a market stability supervisor. Many other countries
have either adopted consolidated financial regulation or are considering doing so.
Four goals appear most frequently in the financial regulation consolidation
literature: 1) take advantage of economies of scale made possible by the consolidation of
regulatory agencies; 2) eliminate the apparent overlaps and duplication that are found in a
decentralized regulatory structure; 3) improve accountability and transparency of
financial regulation; and 4) better adapt the regulatory structure to the increased
prevalence of conglomerates in the financial industry. 1 These goals are difficult to
achieve in a decentralized regulatory structure because of regulator incentives,
contracting, and communication obstacles inherent in such a structure. Beyond the four
goals found in the consolidation literature, an added motivation for modifying the U.S.
regulatory structure arose during the period of severe market instability that began in
2007. That motivation is the desire to create a regulator that focuses heavily on market
stability and systemic risk.
1

Economies of scale result when fewer resources are employed per unit of output as firm (or agency) size
grows.

While a consolidated regulator seems better able to achieve these four goals,
countries that have consolidated their regulatory apparatus have spread decision-making
authority among several agencies, thus undermining, to some degree, the potential
benefits of consolidation. The desire to vest authority with more than one agency appears
to be motivated by an interest in ensuring that an array of viewpoints temper regulatory
decision-making so that financial regulation decisions, given their far-reaching
consequences, are not mistakenly applied or abused.
Further, regulatory consolidation, as frequently practiced in those countries that
have consolidated, presents a conflict between, on the one hand, achieving the goals of
consolidation, and on the other hand, the effective execution of the lender of last resort
function (LOLR – whereby a government entity, normally the central bank, stands ready
to make loans to solvent but illiquid financial institutions). Under the consolidated model,
the central bank is often outside of the consolidated regulatory and supervisory entity so
does not have the thorough, day-to-day financial information that is beneficial when
deciding whether to provide loans to troubled institutions in its LOLR role. This central
bank outsider role is a potential weakness of the typical consolidated regulatory structure.
One solution is to make the central bank the consolidated regulator; however, this poses
difficulties of its own.
There are several questions to consider before consolidating regulatory agencies
in the United States. What drives financial regulation and how is it currently practiced in
the U.S.? The Treasury proposal is the latest in a long history of consolidation proposals.
What did some of these earlier proposals advocate and how does the Treasury proposal
differ? What are the typical arguments for and against consolidation, what role do

regulator incentives play in these arguments, and how have other countries proceeded?
What are the features of the conflict between consolidation and effective execution of the
LOLR function?

2. Why the Government Regulates Financial Firms
Government agencies regulate (establish rules by which firms operate) and supervise
(review the actions of firms to ensure rules are followed) financial firms to prevent such
firms from abusing the taxpayer-provided safety net. The safety net consists primarily of
bank access to deposit insurance and loans to banks from the central bank – i.e., the
Federal Reserve in the United States. In periods of financial turmoil, the Federal Reserve
or the Treasury can expand the safety net. For example, in March 2008 the Federal
Reserve began lending to securities dealers and in September 2008 the Treasury
guaranteed the repayment of investments made in money market mutual funds. As a
result of the safety net, financial firms have a tendency to undertake riskier actions than
they would without the net, leaving taxpayers vulnerable. Three justifications are often
provided for the safety net: to protect against bank runs, to minimize systemic risk, and to
allow small dollar savers to avoid costly efforts spent evaluating financial institution
health.
To protect taxpayers from losses, legislators require certain government agencies
to regulate and supervise financial firm risk-taking – so-called safety and soundness
regulation. These agencies are called on to compel financial firms to take certain riskreducing actions when their perceived riskiness rises above prescribed levels.

Additionally, legislators require agencies to assume a consumer and investor
protection role, ensuring that consumers are protected against unscrupulous behavior by
financial firms and that firms reveal trustworthy accounting information so that investors
can make informed decisions.

Safety and Soundness Regulation
Banks and the Safety Net Because banks can offer their customers government-insured
deposits and can borrow from the Federal Reserve, they have access to funds regardless
of their level of risk. While other creditors would deny funds to a highly risky bank, an
insured depositor cares little about the level of riskiness of his bank since he is protected
from loss. Absent active supervision, loans from the Federal Reserve might also provide
funds to highly risky banks.
In certain circumstances, banks have a strongly perverse incentive to take
excessive risk with taxpayer-guaranteed funds. This incentive results from the oftdiscussed moral hazard problem related to deposit insurance. Depositors are protected
from loss by government-provided insurance. As a result they ignore bank riskiness when
deciding in which banks to hold deposits. Banks, in turn, undertake riskier investments
than they would if there were no deposit insurance because they know there is no
depositor-imposed penalty for doing so.
For banks with high levels of owners’ equity, the danger of excessive risk taking
is limited because shareholders monitor and prevent undue risk-taking by bank
management to protect their equity investment in the bank. However, for a troubled bank
that has suffered losses depleting its capital, possibly to the point that the bank is likely to

fail, owners and bank management both have a perverse appetite for risk. They will wish
to undertake highly risky investments; investments with a large payoff if successful – socalled gambles on redemption. If the investment is successful, the bank can be saved
from failure, and if it fails, shareholders and management are no worse off given that the
bank was likely to fail anyway. Insured depositors are happy to provide funding for these
risky endeavors, but by doing so they are exposing taxpayers to greater risk of loss.
Because these incentives are misaligned, regulators must monitor banks closely
and take swift action when they determine that a bank’s capital is falling toward zero.
Such measures typically include limitations on activities or investments that are
unusually risky – gambles on redemption. In addition, because measuring bank capital is
notoriously difficult, regulators impose risk-limiting restrictions on all banks. Regulators
never know with certainty whether a bank’s capital is strong or weak; consequently, as
pre-emptive measures, they prohibit all banks from undertakings that are known to be
unusually risky. By doing so, they hope to remove access to gambles on redemption for
those banks in which capital has fallen unbeknownst to regulators. Examples of such preemptive measures include limits on the size of loans made to a single borrower and
restrictions on banks’ ability to invest in stock, which is typically riskier than loans and
bonds.
Ultimately, supervisors close a bank once capital falls to zero in order to limit the
strong incentive bank owners and managers have to undertake risky investments when
they no longer have equity to lose. In the United States the prompt-corrective action
(PCA) requirements laid out in the Federal Deposit Insurance Corporation Improvement

Act of 1991 (FDICIA) require that banks with no capital be closed and that limitations be
imposed on the actions of banks with declining capital.
FDICIA also places strict limits on Federal Reserve loans when a bank’s capital is
weak. The danger here is that Fed loans might substitute for uninsured deposits, thus
increasing taxpayer losses. Specifically, uninsured depositors might become aware of a
bank’s troubles and begin to withdraw funds. Assuming that it is unable to quickly raise
new insured deposits to replace withdrawals, the bank would likely come to the Federal
Reserve asking for loans to prevent the bank from having to rapidly sell assets at a loss. If
the Fed grants a loan and the borrowing bank ultimately fails, then uninsured depositors
have escaped losses, imposing losses on the FDIC and possibly taxpayers. The Fed is
protected from loss since it lends against collateral.
Because of the danger Fed lending can pose, the Fed must ensure that banks to
which it makes loans have strong capital. As noted earlier, determining the level of a
bank’s capital is complex and its capital level can change. For these reasons the Fed must
closely supervise the borrowing bank both before making the loan and throughout the
duration of the loan.

Nonbanks and the Safety Net Access to deposit insurance and Fed loans provides a clear
reason for supervising banks. Yet, nonbanks do not routinely have such access, so other
factors must explain the safety and soundness supervision nonbanks often receive. Two
such factors seem most important. First, nonbank financial firms are frequently affiliated
(part of the same holding company) with banks, and losses suffered by a nonbank can
transfer from one affiliate to others – including bank affiliates. Second, nonbanks, and

especially nonbank financial firms, have, at times, been granted safety net access,
specifically in the form of the opportunity to borrow from the Federal Reserve. As a
result of nonbank safety net access, the moral hazard problem discussed earlier for banks
can distort nonbank incentives as well, explaining the desire to supervise nonbank
riskiness.
Nonbank financial firms are often owned by holding companies that include
banks. For example, the major U.S. securities firms are in holding companies that include
banks. Likewise, major insurance companies are also part of holding companies with
banking subsidiaries. Such affiliation between bank and nonbank provides two dangers as
discussed in Walter (1996, p. 29-36). First, assets of the bank are likely to be called on to
cover losses suffered by the nonbank affiliate. A holding company may find this a
valuable strategy if the reputation of the overall firm can be damaged by the failure of a
nonbank subsidiary, and the reputational cost can exceed the cost of shifting bank assets
to the nonbank. In such a case, the chance of a bank’s failure will increase and thus put
the deposit insurance fund at risk, which justifies efforts to control risk in nonbank
affiliates of banks.
There is an additional danger of bank affiliation with a nonbank not driven by the
holding company’s avoidance of reputational damage but instead by a desire of a holding
company to minimize its loss by passing it off to taxpayers. If a nonbank suffers a loss
that is smaller than the equity of the nonbank but larger than the equity of a bank affiliate,
the holding company might gain by shifting the loss to the bank. The shift will result in
the failure of the bank, so that the holding company loses the value of the bank’s equity,
but this is smaller than the total loss that would have been incurred if it had been left in

the larger nonbank. The amount of the loss which exceeds the bank’s equity is suffered
by the bank’s creditors and the FDIC.
Legislators have designed laws that are meant to prevent asset and loss shifts.
Examples include rules found in Sections 23A and 23B of the Federal Reserve Act that
limit the size of transactions between banks and their nonbank affiliates. Yet supervisors
do not expect these rules to be perfect, so nonbank supervision is a valuable supplement
to the rules.
In some cases, nonbanks have also been granted access to loans from the Fed. For
instance, beginning in March 2008 certain large securities dealers were allowed to
borrow from the Fed. To protect itself from lending to a weak borrower, the Fed
reviewed the financial health of the securities dealers to determine their soundness, in
effect acting as a supervisor for these borrowers. 2

Why The Government Provides a Safety Net Given the difficulties of supervising entities
protected by the government safety net, one must wonder why the safety net exists.
Observers provide three explanations.
Bank runs One such explanation is offered by Diamond and Dybvig (1983), who
argue that the provision of deposit insurance offers an efficient solution to a problem that
arises when banks offer demand deposits. Individuals and businesses find great value in
the ability to withdraw deposits on demand because they cannot predict when they might
face a sudden need for funds. Banks offer deposits that can be withdrawn on demand,
meeting this desire for demand deposits, while holding assets, i.e. loans, with longer

The Fed had likewise extended a large number of loans to nonbanks during the 1930s and 1940s
(Schwartz 1992, p. 61)

maturities. By providing demand deposits, banks can make loans at lower interest rates
than firms that do not offer demand deposits. But, the provision of demand deposits
leaves banks subject to runs, when all depositors suddenly decide to withdraw them at
once. The danger of runs undercuts the benefit gained by offering demand deposits. A
financially sound bank may suffer a bank run based simply on fear that a large number of
customers will withdraw deposits rapidly, depleting the bank’s liquid assets. One solution
is for the government to provide deposit insurance, eliminating the danger of runs.
Diamond and Dybvig view the government provision of deposit insurance as a low-cost
means of protecting against runs while still allowing banks to provide the benefits of
demand deposits. The availability of lender of last resort loans may also stem runs.
Systemic Risk Alternatively, observers argue that if the government failed to
intervene to protect the liability holders of a large, troubled institution, including a
nonbank institution, the financial difficulties of that institution might spread more widely
(see Bernanke 2008, p. 2). This is often referred to as the systemic risk justification for
the safety net (i.e., an individual institution’s problems lead to a banking- or financialsystem-wide problem – thus the name systemic). Intervention is more likely to flow to
financial than to non-financial firms because of the interconnectedness of financial firms.
For example, the list of creditors of a large financial institution typically includes other
large financial institutions. Therefore, the failure of one financial institution may well
lead to problems at others, or at least a reduction in lending by the institutions which are
exposed to the failed institution. An instance of this occurred when Lehman Brothers’
September 2008 bankruptcy led to large withdrawals from mutual funds, especially from
those with significant holdings of Lehman commercial paper.

Reduced lending by firms directly exposed to a failed firm can produce problems
for other financial firms. Financial firms’ balance sheets often contain significant
maturity mismatches – long-term assets funded by short-term liabilities. As a result, firms
that normally borrow from an institution that reduced lending because of its exposure to a
failed firm will be forced to seek other sources of funding to continue to fund its longterm assets. If many firms are exposed to the failed firm, then the supply of funds will
decline, interest rates will rise, and sales of assets at fire-sale prices may result. Reduced
lending by other institutions will tend to exacerbate weak economic conditions that often
accompany the failure of a large financial institution. In such circumstances,
policymakers are highly likely to provide financial aid to a large troubled institution.
Because of this tendency, supervisors have reason to monitor the risk-taking of large
financial institutions.
Small Savers Third, without deposit insurance, all investors and savers would
find it necessary to review the financial health of any bank with which they hold deposits
(Dewatripont and Tirole 1994, p. 29-45). Given that retail customers of small banks
number in the thousands and in the tens of millions for the largest banks, if each
individual retail customer were to evaluate the health of his or her bank, the effort would
be exceedingly costly and duplicative. Further, most customers are unlikely to possess the
skills needed to perform such analyses.
Rather than performing their own evaluations, individuals might instead rely on
credit rating services. Unfortunately, such services are likely to produce a less-thanoptimal amount of information. Because services will be unable to strictly limit access to
their ratings information to individuals who have paid for access, few firms will find it

profitable to generate such information (i.e., a free-rider problem will lead to too little
information being produced). Alternatively, financial institutions that receive the credit
ratings could be charged fees by the ratings company, but this creates a conflict of
interest. Specifically, a financial institution would have a strong incentive to illicitly
influence the ratings company to inflate its score. Deposit insurance, coupled with a
government agency monitoring bank risk, offers a solution to the small savers’ costly
evaluation problem.

Consumer and Investor Protection Regulation
Financial firm regulators often provide another type of supervision and regulation
intended to ensure that (1) products offered to consumers are beneficial and that (2)
financial firms provide their investors with truthful and complete accounting information
about the firm’s financial strength or about the characteristics of investments.
The Truth in Lending and Truth in Savings Acts are examples of legislation
meant to protect consumers when dealing with financial institutions. Both require
financial institutions to offer consumers clear disclosures of the terms of transactions.
The regulation that implements the Truth in Lending Act, for example, provides that
financial institutions must disclose interest rates that are being charged, ensures that
borrowers have the right to cancel the loan for several days after initially agreeing to it,
and prohibits certain lender actions that are considered likely to be harmful to the
consumer. Similarly, the Truth in Savings Act’s implementing regulation requires that
deposit interest rates be disclosed in a set manner, allowing consumers to more easily
compare rates among various institutions.

The Securities and Exchange Act of 1934, among other things, established the
Securities and Exchange Commission (SEC) to require that financial firms provide
accurate and complete information. The SEC has the authority to bring civil actions
against firms, especially financial firms, that offer false or misleading information about
investments, engage in insider trading, or commit accounting fraud (U.S. Securities and
Exchange Commission 2008). Broadly, the SEC is meant to ensure that investors are
provided with a fair picture of the risks and returns offered by investments they might be
considering. The SEC does not, in general, attempt to limit the risk-taking behavior of
firms, instead focusing efforts toward requiring that investors are aware of the risks.

3. Regulatory Oversight
Current U.S. Regulatory System – A Variety of Players
The United States’ regulatory structure for financial institutions has remained largely
unchanged since the 1930s even though the financial environment has undergone many
fundamental changes. Specifically, banks, investment banks, and insurance companies
have been supervised by the same players. 3 One prominent feature of financial services
regulation in the United States is the large number of agencies involved.
Regulatory oversight in the United States is complex, especially compared to that of
other countries (as explored in Section 6). In the United States, depending on charter
type, four federal agencies, as well as state agencies, oversee banking and thrift
institutions (Table 1 lists regulators and their functions). Credit unions are regulated by

Since the 1930s, there have been changes to the agencies responsible for regulating and supervising credit
unions and thrifts. The current regulator and supervisor of credit unions, the National Credit Union
Administration, was created in 1970 when credit unions gained federal deposit insurance. The Office of
Thrift Supervision, which supervises and regulates state-chartered savings institutions, was created in 1989.

one federal agency, the Office of Thrift Supervision (OTS), and state agencies. Securities
firms are also regulated at the federal and state level in addition to oversight by selfregulatory organizations (SROs). The Commodity Futures Trading Commission (CFTC)
regulates futures and options activities. Meanwhile, the insurance industry is regulated
mainly at the state level.
States typically maintain depository and insurance commissions that examine
depositories, along with federal agencies, and supervise and regulate insurance
companies. This sharing of supervisory responsibility for depositories varies by
institution type, but for example, in the case of state member banks, the Federal Reserve
and state agencies typically either alternate or conduct joint examinations. The states and
the Federal Reserve share their findings with one another so that duplication is limited, at
least to some degree. The FDIC and states are responsible for the supervision of statechartered nonmember banks. All of these agencies communicate by sharing examination
documents and through other means. Common training and communication is
encouraged for all federal banking agencies and representative bodies for state
supervisory agencies in the Federal Financial Institutions Examination Council (FFIEC).
The FFIEC develops uniform supervisory practices and promotes these practices through
shared training programs. 4
The complexity of the U.S. regulatory apparatus has caused observers to question its
efficiency, and is one of the primary reasons that the Treasury Department proposed
reforms. One example of an apparent inefficiency lies in the difficulty of maintaining
strong communication links among the different supervisors responsible for the various
entities in one holding company. (Communication is important because, as discussed
4

See http://www.ffiec.gov/ for a description of the FFIEC’s role in the U.S. financial regulatory system.

earlier, losses in one subsidiary can endanger others.) For instance, consider Bank
Holding Company (BHC) X which has two subsidiary institutions, Bank A and Securities
Company B. Four different regulators could be present in such a scenario. BHC X is
regulated by the Federal Reserve, while its bank subsidiary, Bank A (a state, nonmember
bank), is regulated by the FDIC as well as by the state banking agency. Although the
FDIC and the state would both regulate Bank A, the Federal Reserve still maintains
umbrella oversight, meaning that direct and open communication between the FDIC, the
state, and the Fed must be present to ensure the safety and soundness of the banking
institution as well as that of the BHC. In addition, Securities Company B, another
subsidiary of BHC X, is regulated by the Securities and Exchange Commission (SEC).
(See Figure 1 for an illustrative depiction of a bank holding company, which includes an
even broader scope of activities and regulators.)
Communication is especially vital for information exchange among supervisors when
dealing with a troubled bank. Some observers argue that problems arose in 1999 when
communication gaps between the OCC and FDIC hindered a coordinated supervisory
approach in a bank failure. The OCC originally denied the FDIC’s request to participate
in an OCC examination of a bank that later failed. However, the OCC reversed its
decision in time for the FDIC to participate in the examination. Had the OCC not
reversed course, the FDIC might have been unable to collect information and offer
input. 5 John Hawke, Jr., Comptroller of the Currency, in February 2000 testimony before
the U.S. House Committee on Banking and Financial Services regarding the bank failure,
noted

The examination was of First National Bank of Keystone, Keystone, West Virginia, a bank that failed in
1999.

“[the] importance of keeping the FDIC fully informed about serious
concerns that we [the OCC] may have about any national bank and of
maintaining mutually supportive working relationships between our [OCC
and the FDIC] two agencies at all levels. We [the OCC’s staff] have just
reiterated to our supervisory staff the desirability of inviting FDIC
participation in our examinations when deterioration in a bank's condition
gives rise to concerns about the potential impact of that particular
institution on the deposit insurance fund, even if the FDIC has made no
request for participation” (Hawke 2000).

Table 1 U.S. Financial Regulators
Regulator
Securities and Exchange
Commission
Federal Reserve System

Date
Function
Established
1934
Regulates securities markets.
1913

Federal Deposit Insurance
Corporation

1933

Office of the Comptroller of
the Currency
Office of Thrift Supervision

1863

National Credit Union
Administration
Commodity Futures Trading
Commission
Federal Housing Finance
Agency
States

1970

Regulates bank holding companies and Fed member state
chartered banks.
Regulates state chartered banks that are not members of
the Federal Reserve. FDIC is also the back-up supervisor
for all insured depository institutions.
Regulates all national banks and supervises the federal
branches and agencies of foreign banks in the US.
Regulates state-chartered savings associations and their
holding companies.
Regulates federally chartered credit unions.

1974

Regulates commodity futures and option markets.

2008

Regulates Fannie Mae, Freddie Mac, and the Federal
Home Loan Banks.
Regulate insurance companies, banks and credit unions.

1989

Figure 1 Regulation of a Hypothetical Bank Holding Company

Source: Bothwell, James L. 1996. “Bank Oversight: Fundamental Principles for Modernizing the U.S.
Structure.” Figure updated slightly to reflect changes since 1996.

Integration of US Financial Firms
Starting in the 1980s, the financial services industry began moving toward an integration
that had not been present before. Specifically, banking firms began to include securities
subsidiaries following a 1987 order by the Board of Governors of the Federal Reserve
System allowing bank holding companies to offer securities services to a limited extent
(Walter 1996, p. 25-28). As discussed later, the growth of financial conglomerates—in
this case, conglomerates that combine a bank and a securities company in one holding
company—is a motivation for consolidating regulators.
The Gramm-Leach-Bliley Act (GLBA) of 1999 authorized combinations of
securities and banking firms within one holding company, thus removing the limitation
set on such combinations by the 1987 Board of Governors rule. The Act also allowed the
affiliation of insurance firms and banks. The GLBA designated the Federal Reserve the
umbrella supervisor of those banking companies that exercise expanded powers.
Umbrella oversight means responsibility for monitoring the soundness of the holding
17

company and for ensuring that nonbank losses are not shifted to bank affiliates. Under
GLBA rules the Fed does not typically supervise the nonbanking affiliates. Securities
subsidiaries are typically supervised by the SEC and insurance subsidiaries by state
insurance commissioners. These supervisors are to share information with the Federal
Reserve so that it can perform its umbrella responsibilities. In the GLBA, legislators
chose to follow a functional regulation model, whereby supervisors are assigned based
on function. For example, the function of securities dealing is supervised by a supervisor
that specializes in securities dealing, the SEC.
Beyond the evolution toward consolidation, driven by the 1987 Board of
Governors ruling and the GLBA, events related to the mortgage market-related financial
turmoil that began in 2007 produced additional movement, if perhaps temporary, toward
regulatory consolidation. Specifically, during 2008 a group of securities dealers came
under Federal Reserve supervisory scrutiny for the first time in recent history.
In March 2008 the Federal Reserve began lending to primary dealers, that is,
securities dealers with which the Federal Reserve regularly conducts securities
transactions. While normally the Fed lends only to depository institutions, it has the
authority to broaden its lending to entities outside of depositories during times of severe
financial stress. The Fed determined that such stress existed in March 2008 and therefore
began lending to securities firms under a program the Fed called its Primary Dealer
Credit Facility. To ensure that such lending did not subject the Federal Reserve to
unacceptable risk, the Federal Reserve began reviewing the financial health of some of
these borrowers. Primary dealers that were affiliated with commercial banking
organizations were already subject to some supervision by a banking regulator, so they

did not receive new scrutiny from the Federal Reserve. In contrast, several primary
dealers were not affiliated with banks and became subject to onsite visits from Federal
Reserve staff (Bernanke 2008). Therefore, perhaps for the short-term, some additional
supervisory authority was concentrated in one supervisory agency – the Federal Reserve
– beyond its traditional supervisory focus on banks and bank holding companies.

4. Proposals to Consolidate U.S. Regulation
Over the last 35 years, several proposals have been advanced to consolidate the U.S.
financial regulatory system. In most cases the proposals’ objectives are to increase
efficiency and reduce duplication in the nation’s financial regulatory system, lowering the
cost and burden of regulation. To date, the proposals have not led to the enactment of
legislation. In March 2008, the Treasury Department offered a consolidation proposal
which builds on the work of the earlier proposals.

Early Consolidation Proposals
Hunt Commission Report One of the earliest regulatory consolidation plans is found in
the Report of the President’s Commission on Financial Structure and Regulation,
popularly known as the Hunt Commission Report, after the commission’s chair Reed O.
Hunt (Helfer 1996, Appendix A). The Hunt Commission Report, released in 1971, was
formed, in part, to examine a decline in lending by depository institutions in the 1960s.
This decline was precipitated by caps on interest rates depositories were allowed to pay
on deposits, commonly referred to as Regulation Q interest rate ceilings. When rising
inflation pushed up market interest rates in the late 1960s, depositories were unable to

gather new deposits because their deposit interest rates were capped below market rates.
As a result they were forced to limit lending.
While much of the commission’s work was focused in other directions, it also
proposed changes to the regulatory structure for banks. It recommended that depository
institution regulation and supervision be vested in two agencies – reduced from five.
The commission proposed that one agency, the Office of the Administrator of
State Banks (OASB), regulate and supervise all state-chartered depositories, including
banks and thrifts (i.e., savings banks and savings and loans), taking away responsibility
from three agencies – the FDIC, the Fed and the Federal Home Loan Bank Board. The
change would mean that the FDIC and the Federal Reserve would lose oversight for
state-chartered banks, while the Federal Home Loan Bank Board, at that time the
regulator of most thrifts, would lose oversight responsibility for state-chartered thrifts.
The commission plan would, however, allow banking agencies created by states to
continue their traditional regulatory and supervisory roles, supplementing oversight by
the OASB.
The commission also would rename the Office of the Comptroller of the Currency
(supervisor and regulator of federally chartered banks, i.e., national banks) and move the
agency outside of the Treasury Department. The new regulator would become the Office
of the National Bank Administrator (ONBA). Beyond responsibility for national banks,
the ONBA would have responsibility for federally chartered thrifts.
The goal of these changes was two-fold. First, it was intended to produce a more
efficient and uniform regulatory apparatus. Second, it was intended to more completely

focus the Federal Reserve on monetary policy, bank holding company supervision, and
international finance responsibilities (U.S. Treasury 2008, p. 197-98).

The 1984 Task Group Blueprint The Task Group on Regulation of Financial Services
was created by President Reagan in 1982. Its goal was to recommend regulatory changes
that would improve the efficiency of financial services regulation and lower regulatory
costs (U.S. Treasury 2008, p. 199 – 201). In 1984, the group produced a report entitled
Blue Print for Reform: Report of the Task Group on Regulation of Financial Services.
The task group’s blueprint called for several consolidating changes. First it
planned to end the FDIC’s regulatory and supervisory authority. Also, the OCC’s
oversight of nationally chartered banks would be assumed by a new agency, the Federal
Banking Agency (Helfer, 1996, Appendix A). State-chartered banks would be overseen
by either the Federal Reserve, or a state supervisory agency passing a certification test.
Last, bank holding company supervision would generally be performed by the regulator
responsible for the primary bank in the holding company. The Federal Reserve would
retain its regulatory power over only the largest holding companies, those containing
significant international operations, and foreign-owned banking entities. This change was
meant to reduce overlapping supervisory responsibilities. Because the Federal Reserve
supervises bank holding companies, it may inspect (examine) their subsidiaries that are
already overseen by other regulators. However, the effective extent of the overlap is
currently limited because examination of a holding company’s bank subsidiaries is
largely left to other supervisory agencies (unless the bank happens to be a state member
bank, which the Fed is responsible for supervising).

1991 Treasury Proposal Based on a study requirement in the Financial Institutions
Reform, Recovery, and Enforcement Act of 1989, the Treasury produced a report meant
to suggest changes that could strengthen federal deposit insurance (U.S. Treasury 2008,
p. 202-204). The Treasury named the study Modernizing the Financial System:
Recommendations for Safer, More Competitive Banks. In addition to recommendations
concerning the deposit insurance system, the study proposed consolidating the financial
regulatory system to enhance efficiency by reducing “duplicative” and “fragmented”
supervision. This proposal, building on the 1984 blueprint, called for only two banking
supervisors, the new Federal Banking Agency (FBA) and the Federal Reserve. The
Federal Reserve would be responsible for state-chartered banks and associated holding
companies, and the FBA would be responsible for all other bank, bank holding company,
and thrift supervision. Under this proposal the FDIC would be responsible only for
deposit insurance.

March 2008 Treasury Blueprint
Concerned that a fragmented financial regulatory structure placed U.S. financial
institutions at a disadvantage relative to foreign counterparts, the Treasury Department
produced a proposal to reform the U.S. regulatory system. The proposal was entitled
Blueprint for a Modernized Financial Regulatory Structure and was released in March
2008. The proposal is meant to create more uniform supervision of similar activities
across different providers (i.e., regardless of whether a similar product is provided by a
bank, a thrift, or an insurance company, its production is supervised similarly), reducing

duplication of effort and trimming costs of regulation and supervision for government
agencies as well as for regulated institutions. Additionally, the proposal was influenced
by serious financial market difficulties emanating from troubles that began in the
subprime mortgage market in 2007.
The authors of the 2008 Blueprint proposed what they viewed as “optimal”
recommendations for regulatory restructuring, along with short-term and intermediate
term changes. The optimal recommendations called for replacing all financial regulators
with three entities: a prudential regulator, a business conduct regulator, and a market
stability regulator.
In broad terms, the prudential regulator would be responsible for supervising all
financial firms having government-provided insurance protection. This group includes
depository institutions – because of their access to federal deposit insurance – and
insurance companies – because of state-government-provided guarantee funds. The goal
of the prudential regulator is to ensure that these financial firms do not take excessive
risks. Currently, this role is performed by a number of banking agencies including the
FDIC, the OCC, the OTS, the Federal Reserve, state banking supervisory agencies, and
state insurance supervisors. The Blueprint would have only one agency performing this
prudential supervisory role for all banks and insurance companies.
The business conduct regulator envisioned by the authors of the Blueprint is
largely focused on consumer protection. It is charged with ensuring that consumers are
provided adequate disclosures and that products are neither deceptive nor offered in a
discriminatory manner.

While the 2008 Blueprint does not specify particular agencies as the prudential or
business conduct regulators, it does name the Federal Reserve as the market stability
regulator. The role of this regulator is to “limit spillover effects” from troubles in one
firm or one sector, i.e., to reduce systemic risk (U.S. Treasury 2008, p. 146). Presumably,
the authors of the proposal view the Federal Reserve as suited to this role because of the
Fed’s ability to make loans to illiquid institutions via its role as the lender of last resort.
In addition to lending to institutions facing financial difficulties, the market stability
regulator is to take regulatory actions to limit or prohibit market developments that might
contribute to market turmoil. The market stability regulator, in general, is not focused on
problems at individual institutions unless they might spill over more widely.

5. The Pros and Cons of Consolidating
If the United States were to adopt the consolidated regulatory structure proposed in the
Treasury Blueprint, it would be joining a widespread trend toward consolidation. While
the specific reasons countries consolidate vary, several key arguments emerge in
discussions: adapting to the increasing emergence of financial conglomerates, taking
advantage of economies of scale, reducing or eliminating regulatory overlap and
duplication, improving accountability of supervisors, and enhancing regulator and
rulemaking transparency.
Unfortunately, discussions of motivations provide little analysis of regulatory
incentives. Nevertheless, these incentives seem fundamental to questions about whether
consolidation is likely to be beneficial. Organizational economics has identified
conditions – related to organizational incentives – under which a centralized

(consolidated) organizational structure can be expected to produce superior outcomes to a
decentralized structure, and vice versa. Some discussion of these incentives is included in
the following paragraphs.

Pro: Consolidated Structure is Better Suited to Financial Conglomerate Regulation
Financial industry trends have led to large, complex firms offering a wide range of
financial products regulated by multiple supervisory institutions. This complexity
manifests itself in the United States and the rest of the world through the increased
emergence of financial conglomerates, defined as companies providing services in at
least two of the primary financial products – banking, securities, and insurance (see Table
2). The desire to adapt regulatory structures to a marketplace containing a growing
number of consolidated financial institutions is the leading reason for the move to
consolidated supervision. For example, in 2003 the World Bank surveyed 15 countries
choosing to integrate their financial regulatory structures and found that the number one
motivation was the need to more effectively supervise a financial system that was shifting
toward conglomerates. 6,7

Table 2 The market share (%) of financial conglomerates in 1990 and 2001
in each sector, across the 15 World Bank-surveyed countries
1990
2001
53
71
Banking
54
63
Securities
41
70
Insurance
Source: De Luna-Martinez and Rose (2003). 8
6

Surveyed countries were Australia, Canada, Denmark, Estonia, Hungary, Iceland, Korea, Latvia,
Luxembourg, Malta, Mexico, Norway, Singapore, Sweden and the United Kingdom.
7
Briault (1999), Calomiris and Litan (2000), as well as Goodhart et al., (1998) argue that a consolidated
financial regulatory system is more efficient than a decentralized one when faced with the emergence of
financial conglomerates.
8
See footnote 6.

As discussed in Section 2, because financial conglomerates may combine bank,
securities, and insurance subsidiaries in one holding company, losses in one entity type
(say, the subsidiary securities firm) can endanger another entity (say, the subsidiary
bank). For instance, if BHC X has subsidiaries that include Bank A and Securities
Company B, it is possible that risky behavior that results in losses on the part of
Securities Company B may result in spillover losses to Bank A (in the absence of
perfectly effective firewalls), or reputational damage, leading to the potential lack of
confidence in Bank A. Bank A’s regulator may not have foreseen such risks, and thus
may not have taken adequate measures to prevent the loss.
In addition, separate specialized supervisors may not have a strong incentive to
concern themselves with the danger that losses in subsidiaries they supervise might lead
to problems in other subsidiaries. Their incentive will be weak because they face limited
repercussions for difficulties that might arise in affiliates that they do not supervise even
when brought on by problems that spread from an entity that they do supervise. (This is a
typical externality problem, whereby the actions – or lack of actions – of one party can
harm another party). Hence, separate supervisors may invest too few resources in
protecting against losses that might spread. Therefore, effective financial supervision
should address whether “there are risks arising within the group as a whole that are not
adequately addressed by any of the specialist prudential supervisory agencies that
undertake their work on a solo basis” (Goodhart, et al. 1998, p.148).
Similarly, with separate supervisors, there may even be disincentives to share
information. Turf wars between the supervisors may cause supervisory employees to be

reticent to share. By sharing information, a bank supervisor, for example, may help a
securities supervisor discover a problem. However, if the bank supervisor withholds
information and allows the problem to remain undiscovered until it grows, the securities
supervisor is likely to be severely embarrassed by its failure to discover the problem
earlier. If the bank supervisor can benefit from the securities supervisor’s embarrassment,
perhaps by being granted, by legislators, an enlarged supervisory domain, information
will likely not be shared. 9
By consolidating supervisory agencies, theses incentive problems can be
overcome. A single supervisory agency, which is held responsible for losses throughout
the financial conglomerate, will have the incentive to invest sufficient resources in
guarding against losses that might spread across entities within the conglomerate.
Even assuming that no incentive problems were present, communications between
supervisors is likely to be simpler within one consolidated entity than across different
supervisory organizations. Separate organizations will have differing cultures and
policies so that communication between them can more easily become confused than can
communication within one organization.

Pro: Economies of Scale
Another benefit of regulatory consolidation is that it can lead to economies of scale.
Economies of scale result when fewer resources are employed per unit of output as firm
(or agency) size grows. For instance, subject matter experts, such as one specializing in
credit default swaps, may be underutilized if working for a specialized regulatory

See Garicano and Posner (2005), p. 161-63, for a discussion of the turf-war driven disincentive for
information sharing among separate agencies.

institution. Whereas, under a consolidated structure, a single regulatory institution could
use one subject matter expert for all sectors, banking, securities, and insurance. Given
that banks, securities firms, and insurance companies all have at least some similar
products today, they all need some of the same types of specialist examiners (e.g. experts
on credit default swaps). A consolidated supervisor can share costs of indivisible
resources. Decentralized supervisors are unlikely to share resources across institutional
lines because it is costly to establish labor contracts between separate agencies. Such
contracts, which must specify agency employee actions across a wide range of
circumstances, are prohibitively expensive to develop. Outsourcing is another option but
may be infeasible for financial supervisors because supervision generates a great deal of
confidential information that is difficult to protect when not held internally. The prospect
of maximizing economies of scale and scope in regulation was considered to be the
second most significant rationale for those countries surveyed by the World Bank in 2003
that chose to consolidate.

Pro: Reduced Overlap and Duplication
The complex institutional structure of decentralized regulatory systems, whereby
supervision is organized around specialized agencies, has arguably led to a significant
amount of overlap and duplication in regulatory efforts, thus reducing efficiency and
effectiveness as well as increasing costs. For instance, in the United States, securities
subsidiaries of financial holding companies are primarily supervised by the SEC,
however the Federal Reserve has some supervisory responsibility as umbrella supervisor.
Under GLBA, the Federal Reserve generally must rely on SEC findings regarding

activities of a securities subsidiary. However, to be well-informed about the financial
condition of the holding company, the Federal Reserve must have staff who are very
familiar with securities operations in order to interpret SEC findings. In the absence of
highly effective (and therefore, costly) coordination between overlapping regulatory
authorities, the potential for inconsistent actions and procedures may result in
inefficiencies by delaying issue resolution or arriving at conflicting rulings. Moreover,
financial institutions may be visited by different regulators and therefore need to dedicate
time to educating multiple supervisors about the same activity within the firm.
Duplication could be avoided, in a decentralized supervisory environment, by clearly
dividing up responsibilities among the various supervisors. However, doing so requires
not only careful coordination, but also the ability of supervisors to convince one another
that they will watch for risks that will flow into other entities. Developing this level of
trust between institutions is difficult, for instance, because of the incentives discussed in
the previous section, making consolidation an attractive alternative. Thus, placing a
single entity in charge of supervision and regulation for all financial institutions may
offer the least cost regulatory structure.

Pro: Accountability and Transparency
In a decentralized supervisory system with multiple agencies reviewing the financial
condition of one entity, legislators may have difficulty determining which agency is at
fault when a financial institution fails. As a result, agencies may have a reduced incentive
to guard against risk, knowing that blame will be dispersed. Consolidation allows the

government to overcome this difficulty by making one agency accountable for all
problems – giving this agency correct incentives.
Additionally, with a single regulator rather than multiple regulators, the regulatory
environment can be more transparent, and as a result learning and disseminating rules
may be less costly. With one regulator, financial institutions will spend less time
determining whether a new product being considered will be acceptable to the regulator,
therefore lowering the cost of financial products. Reports will have a consistent structure,
simplifying investor comparisons between multiple institutions. Further, consumers can
more easily locate information about an institution with which they conduct business, or
more broadly about the set of rules that apply to various financial institutions. All of these
benefits from greater transparency that a single supervisor offers lower the cost of
providing financial services and thus enhance public welfare.

Con: Lack of regulatory competition
In order to fully achieve the benefits discussed above, supervisory consolidation would
need to be complete – meaning the creation of one supervisor with authority for all
supervisory and regulatory decisions across all types of financial institutions. However,
there are costs associated with creating a single regulator since it would lack competitors
– other regulatory agencies – and therefore have greater opportunity to engage in selfserving behavior to the detriment of efficiency.
For example, this single entity might have an incentive to be excessively strict.
Regulators often face significant criticism when institutions that they regulate fail. Yet
they receive few benefits when institutions undertake beneficial, but risky, innovation

aimed at offering superior products or becoming more efficient. As a result, regulators
have a strong incentive to err on the side of excessive strictness and will be likely to
restrict risky innovations. This incentive is contained to some extent in a decentralized
structure in which some competition may exist between regulators. 10
Beyond restrictions on innovative, but risky, products, one might expect a single
regulator to charge higher fees to enhance regulatory income. Additionally, a single
dominating regulator would be likely to adopt a narrow, one-size-fits-all regulatory
approach, since such an approach would likely be simpler to enforce but will be
unsuitable in a diverse financial marketplace.
If self-serving regulatory incentives are to be prevented, legislators will almost
certainly establish checks on regulatory practice that will tend to undercut the advantages
– discussed earlier – of consolidation. Typically, such checks have included various
means of sharing regulatory or supervisory decision-making authority. In the United
States the multiple regulatory agencies, such as the Treasury, the Federal Reserve, and
the FDIC, often are required by law to make regulatory decisions jointly. In a
consolidated environment, with only one regulatory agency, that agency is likely to share
authority with the Treasury and the central bank, a common practice in those countries
that have adopted a consolidated model (discussed below).

Con: Fewer new ideas
10

Llewellyn (2005) argues that competition between regulators can result in a race to the bottom in which
an institution devises a business model that allows it to come under the regulatory auspices of the most
liberal regulator. Resources spent on this restructuring process, from society’s point of view, are wasted.
Similarly, when regulators compete with one another to attract or keep regulated entities, they will have an
incentive to give in to demands made for liberal treatment, i.e., they are likely to be “captured” by the
institutions they regulate. Regulations that might have large net benefits but are costly for the regulated
industry will not be implemented.

The multiple regulatory agencies in a decentralized system are likely to produce a range
of considered opinions on the most important regulatory questions the system faces,
perhaps as many opinions as there are regulators. Competition among regulatory agencies
for legislator or financial institution support (often viewed negatively as a power struggle
between regulators) will drive idea generation. In contrast, a single regulator, because of
its need to speak with one voice, will tend to identify and adopt one view.
The dual banking system in the United States whereby bank founders can choose
between a federal or state charter and thereby choose between various regulators, is often
thought to create an environment that fosters experimentation with new financial
products and delivery systems that, if successful, might be more widely adopted
(Ferguson 1998). An important example of this type of state experimentation leading to
later nationwide adoption occurred in the early 1970s when regulators in New England
allowed thrifts in that region to pay interest on checking accounts. This innovation
ultimately was an important contributor to the elimination of the nationwide prohibition
of the payment of interest on checking accounts and was later followed by the removal of
restrictions on bank deposit interest rates by the Depository Institutions Deregulation and
Monetary Control Act of 1980 (Varvel and Walter 1982, p. 5). Without the opportunity
provided by some states to experiment with the payment of interest on checking accounts,
it seems likely that wide-ranging restrictions on interest rates might have survived longer.
Thoroughgoing consolidation, for example as envisioned in the Treasury blueprint, would
likely do away with this level of choice and experimentation with only one charter and
one prudential supervisor for all insured financial institutions.

In a stable financial environment, the generation of competing ideas is
unnecessary. In such a situation, a centralized regulator may be preferable. Yet in a
dynamic financial environment the idea-generation component of a decentralized
regulatory scheme will be important and valuable (Garicano and Posner 2005, p. 153159).

Con: Lack of specialization
The combination of all regulatory functions within a single institution may result in a lack
of sector-specific regulatory skills, whereby agency staff possess intimate knowledge
tailored to a certain sector. Despite the increasing emergence of financial conglomerates
worldwide, with many conglomerates sharing a similar set of products, it is not
necessarily the case that all institutions have converged on a common financial
conglomerate model. For instance, an insurance company that has started to expand
services to include areas of banking and securities is likely to remain focused
predominantly on its core insurance business, and thus may benefit more from a regulator
that has specialized knowledge in insurance (Goodhart, et al. 1998). If the single
regulator were set up with divisions that address sector-specific issues, it is not obvious
that supervisors within the same organization with sector-specific responsibilities would
effectively communicate and coordinate efforts more efficiently than they would in a
decentralized setting.

Con: Loss of scope economies between consumer and safety supervision

The Treasury blueprint as well as the consolidated supervisory system adopted by
Australia separate consumer protection supervision from safety and soundness
supervision. But separating these two functions may mean a loss of scope economies. 11
Scope economies are present when the production of one product, within the same entity,
lowers the cost of producing another product. In the U.S. at least, consumer protection
law enforcement in depository institutions is conducted via regular on-site examinations
in which examiners review depositories for violations of consumer laws.
Consumer protection examinations have their origin in, and are modeled after,
bank safety and soundness examinations. As discussed earlier, in a safety and soundness
examination, examiners from a federal banking agency investigate a bank’s riskiness and
financial health. The agencies examine every bank periodically. The examinations
include an on-site analysis of the bank’s management, its policies and procedures, and its
key financial factors. Additionally, examiners verify that a bank is complying with
banking laws and regulations. Because of this responsibility, examiners gained
responsibility for verifying compliance with the consumer protection laws when these
were passed in the United States in the 1960s and 1970s. Between 1976 and 1980, the
depository institution regulatory agencies established “consumer compliance”
examinations separate from safety and soundness examinations because performing both
consumer law compliance and safety and soundness tasks within the same examination
was too burdensome (Walter 1995, p. 69-70).
While separate staffs typically perform consumer examinations during separate
exams these individuals are typically part of the same departments and are often trained

Economies of scope may be generated when regulatory entities are consolidated if doing so simplifies the
transfer of information gleaned in an examination of one line to another.

together so that they each have some familiarity with the other’s responsibilities. Safety
and soundness examiners can discover consumer compliance-related information during
their examinations, and consumer examiners will at times uncover safety-related
information. As a result, it seems likely that economies of scope exist when these two
types of compliance are produced together. By remaining closely tied to one another in
the same departments, this information is more likely to be shared.

Con: Adjustment and organizational costs
While economies of scale can be utilized once all enabling legislation is in place and the
regulatory agency has become fully consolidated, this process of achieving complete
integration can be lengthy and costly. For instance, Japan’s consolidated regulator, the
FSA, underwent several reforms between 1998 and 2000 before assuming its current
responsibilities as an integrated financial services regulator. Observers discuss numerous
adjustment costs likely to arise when shifting regulatory and supervisory activities from
multiple agencies to one agency. A few of the more significant costs include: developing
a uniform compensation scheme; restructuring IT systems and compliance manuals;
training staff for new responsibilities; reorganizing management structures; and costs
borne by financial institutions as they adapt to the new regulatory regime (HM Treasury
1997). As demonstrated by Japan, the transition period during which the new regulatory
framework is constructed is long. During this time, multiple supervisory institutions
continue to operate, resulting in increased regulatory costs. Even in the United Kingdom,
where integration took place relatively quickly – in a so-called “big bang” – the transition

was fairly lengthy. For example, the FSA reported to two separate boards for
approximately two years (Taylor and Flemming 1999).
One possible means of lowering transition costs is to simply grant all regulatory
responsibility to one existing financial regulator rather than creating a whole new entity.
Since, in many countries, central banks are the primary bank regulator and typically also
act as the LOLR, they are an obvious choice (see Table 4). However, central banks have
traditionally not been involved in the insurance and securities sectors and thus lack
expertise in these areas. Additionally, there are potential conflicts of interest that should
be considered when vesting all regulatory power with the central bank, as will be
discussed in Section 7.
Perhaps because of the lack of insurance and securities expertise among central
bank staffs and because of potential conflicts of interest, many countries, such as those
discussed in the next section, have chosen to create a new regulatory institution to
conduct financial services regulation. However, a single regulator must be structured
such that it is free of political influence. Otherwise, legislators can be expected to
influence the regulatory agency to achieve short-term political goals. For example, the
regulator might be encouraged to provide forbearance for troubled institutions when
legislators face pressure from their constituents who represent the troubled entities or the
regions in which those entities operate. Observers note that such forbearance was
widespread during the U.S. savings and loan crisis of the 1980s.
One means of reining in this potential to inappropriately respond to political
pressure is to enact legislation that ties the hands of the regulatory agency. Following the
savings and loan crisis, legislation was enacted which was meant to limit the choices of

depository institution regulators when dealing with a troubled institution. The legislation
established rules that required regulators to take specified actions, most importantly to
close a troubled institution in the most serious cases as its financial health declined.
Nevertheless, rules are difficult to write to cover all situations in which regulators
might have an incentive to inappropriately respond to political pressures. Instead broader
measures must be established to separate a financial supervisor from political influence.
One important measure intended to insulate a regulator from the dangers of
political pressure is to provide the regulator with a source of income outside of the very
politically charged legislative budget process. For instance, the Federal Reserve generates
operating income from asset holdings. Additionally, during the debate surrounding
legislative consideration of reforms aimed at strengthening the housing GSEs (Fannie
Mae, Freddie Mac, and the Federal Home Loan Bank System), there was ample
discussion of possible means of providing an adequate source of income, separate from
the political process (Lockhart 2006, p. 3). Ultimately, income for the new regulator
created by the 2008 legislation is derived from fees paid by the entities it regulates and is
not subject to the legislative appropriation process. Beyond an independent source of
income, other structural arrangements, such as a managing board comprised of a majority
of nongovernmental members, are meant to ensure freedom from political influence.
If the newly formed regulatory entity is created such that it is free of political
influence, additional structural arrangements must be put in place that ensure the
institution is accountable for its actions. Some accountability mechanisms include:
transparency (clarity of entities’ mandates, objectives, rules, responsibilities, and
procedures), appointment procedures of senior staff, integrity of board staff and

procedures to monitor this function, effective communication and consultation
procedures, as well as intervention and disciplinary procedures in place to address
misconduct or poor decisions made by the regulatory institution (Llewellyn 2006).
Without effective accountability mechanisms, a purely independent institution
may have the incentive to act in its own self-interest and, without competitors, make
regulatory choices that are overly strict or narrow. These tendencies can be constrained
by dispersing power through a system of checks and balances, but doing so undermines
some of the previously discussed benefits of consolidation. Ensuring the accountability of
an independent regulatory agency while also structuring it so that it is free of political
influence requires a complex balancing act. Thus, establishing a single independent
regulator with the correct incentives to carry out regulation efficiently can be a
complicated and costly feat.
As will be discussed in the next section, many countries that are typically thought
of as having adopted a single regulator model have formed multipart structures geared
toward ensuring the single regulator has ample oversight to prevent the abuse of wide
supervisory authority and to have more than a single entity involved in maintaining
financial stability. Thus, many of the countries that will be discussed in the following
section (and included in the single regulator column in Table 3) have dispersed regulatory
power between entities, such as between a supervisory agency and a central bank, and
therefore are less consolidated than the term “single regulator” implies.

6. Consolidation in other Countries

Traditionally, countries have conducted financial regulation and supervision through the
central bank, the ministry of finance or Treasury and various other specialized
supervisory agencies, including self-regulatory organizations (SROs) (Martinez and Rose
2003, p. 3). However, many countries have carried out major financial regulatory reform
by consolidating the roles of these institutions into a centralized regulatory regime and
reducing the role of the central bank in prudential oversight of financial institutions.
Norway was the first nation to adopt a single regulator, but many others followed.
According to a 2003 World Bank Study, approximately 29 percent of countries
worldwide have established a single-regulator for financial services and approximately 30
percent more have significantly consolidated but have not gone as far as a singleregulator to supervise the bank, securities, and insurance sectors (see Table 3). 12

Table 3 Countries with a Single Supervisor, Semi-integrated Supervisory
Agencies and Multiple Supervisors in 2002*

Among the 29 percent of countries that adopted a single-regulator model, many have dispersed
regulatory power among several agencies.

*Sample includes only countries that supervise all the three types of intermediaries (banks, securities firms
and insurers).
Source: De Luna-Martinez and Rose (2003)

The U.S. Treasury’s proposal to modernize the U.S. regulatory structure through
consolidation has increased interest in the rationales and processes of countries that have
consolidated, such as the U.K., Germany, Japan, and Australia. While many countries
have followed this trend, these four countries are especially important because of the size
of their financial systems and their significance in the global financial market. The United
Kingdom, Japan, and Germany have all adopted single-regulatory models, while
Australia has adopted a model with two primary regulators. However, the notion of a
single regulator can be misleading. Although a significant amount of consolidation has
taken place in these countries, the newly formed single-regulatory entity does not act
alone in its efforts to provide financial stability through supervision and regulation of
financial institutions. Each of these countries, with the exception of Japan, fashioned a
variety of forms of checks and balances. Significant coordination occurs between the
newly established integrated regulator, the central bank, and other branches of
government. In addition, these single-regulatory institutions contain various divisions that
have complexities of their own.
While this section reviews the structural transformations occurring in these
countries’ financial regulatory systems, it will not assess the success or failure of these
newly implemented systems because they have been in place for a relatively short period
and assessing causes of problems in dynamic financial systems is complicated. While, for
example, some observers have blamed depositor turmoil associated with the demise of
Northern Rock in England on failures of the consolidated supervisory system and
especially on the fact that the central bank was largely left out of supervision, the report

from the House of Commons Treasury Committee spread blame more widely. That report
maintained that an amalgamation of contributing factors were present, such as the lack of
a deposit insurance system as well as a failure of communication between the supervisory
agency, the central bank, and the Treasury. (House of Commons Treasury Committee
2008, p. 3-4). Countries which adopted consolidated structures did so under varying
financial conditions and structures, and all operate in various legal and political
environments. Thus, to compare outcomes across countries would require an exceedingly
detailed analysis, which is beyond the scope of this article.

The U.K.’s Financial Services Authority (FSA)
The United Kingdom offers a useful example when considering the possibility of
consolidation in the United States because the United States and the United Kingdom
share similar economic and financial systems (such as both containing top international
financial markets). During the 1990s, both countries were interested in reforming their
complicated regulatory structures, yet the U.S. maintained a decentralized regulatory
structure while the United Kingdom changed significantly. Specifically, the United
Kingdom eliminated nine independent regulatory agencies and replaced them with a
single regulatory entity. Prior to regulatory consolidation, regulatory and supervisory
authority for the United Kingdom’s banking sector was long held by the Bank of
England, the U.K.’s central bank.
The first step in a series of reforms was to transfer all direct regulation and
supervision responsibilities from the Bank of England (BOE) to the Securities Investment
Board (SIB) in 1997. Next, plans were developed to establish the Financial Services

Authority (FSA), a single regulatory entity to oversee supervision and regulation for all
financial activity in the United Kingdom. The FSA did not assume full power until 2001
under the Financial Services Markets Act of 2000. At this point, all regulatory and
supervisory responsibilities, previously conducted by the SIB and nine self-regulatory
organizations (SROs), became the responsibility of the FSA. Thereafter, the FSA’s new
role combined prudential and consumer protection regulation for banking, securities,
investment management, and insurance services in one regulatory body. Although the
FSA was created as a single agency to accomplish the goals of regulation, the agency
itself is comprised of three directorates responsible for 1) consumer and investment
protection, 2) prudential standards, and 3) enforcement and risk assessment. The FSA
alone is responsible for all the regulatory and supervisory functions performed in the U.S.
by federal and state banking agencies, the SEC, SROs, the Commodity Futures Trading
Commission, and insurance commissions.
The United Kingdom created the Tripartite Authority as an oversight entity with
representatives from the Treasury, the BOE, and the FSA to act as a coordinating body
and to balance the power of the FSA. The Tripartite Authority is responsible for ensuring
clear accountability, transparency, minimizing duplication of efforts, and exchanging
information between entities. Each entity’s respective obligations are outlined in a
memorandum of understanding (MOU). 13
In the U.S. Treasury’s blueprint, consumer protection and prudential regulation
would be conducted by two newly formed agencies, leaving the central bank solely with
financial stability responsibility. The BOE performs a similar role in the U.K. The BOE’s

See: http://www.hm-treasury.gov.UK/Documents/Financial_Services/Regulating_Financial_Services/
fin_rfs_mou.cfm to access a copy of the MOU.

role in ensuring financial stability, as laid out in the MOU, includes acting in the markets
to address liquidity problems (i.e. making loans to illiquid institutions), overseeing
payment systems, and utilizing information uncovered through its role in the payments
system and in monetary policy to act as advisor to the FSA on issues concerning overall
financial stability. As part of its financial stability role, the BOE is the lender-of-last
resort. However, if taxpayer funds are at risk, the BOE must consult with the Treasury
prior to lending.

Japan’s Financial Services Authority
Japan’s transition to a single regulator was more dramatic than in many other countries
because the Ministry of Finance (MOF) held significant regulatory power prior to reform.
While some supervisory functions were held by the Bank of Japan (BOJ), the Ministry of
International Trade and Industry (MITI), and various SROs, the Minister of Finance was
responsible for the majority of financial regulation including banking supervision and
regulation. 14
In 1998 Japan established the Financial Supervisory Agency (FSA-old) under the
Financial Reconstruction Commission (formed the same year) as the principle
enforcement regulator of the financial services industry. This agency, created to improve
supervisory functions and rehabilitate the financial sector, removed banking and
securities regulation functions from the Ministry of Finance (MOF). In 2000, the FSA-old
was further refined, replacing the MOF as the entity responsible for writing financial
market regulation, and was renamed the Financial Service Authority (FSA). The newly

Japanese SROs included Japanese Securities Dealers Association, Commodity Futures Association,
Investment Trust Association, and Japanese Securities Investment Advisors Association.

formed “single regulator”, the FSA, is structurally under Japan’s Cabinet Office and is
independent from the MOF. The primary responsibilities of the FSA are to ensure the
stability of the financial system; protect depositors, securities investors and insurance
policyholders; inspect and supervise private sector financial institutions; and conduct
surveillance of securities transactions.
While the FSA is considered a single regulator for financial services, its authority
is not as comprehensive as that of other unified regulators, such as the FSA in the U.K.
For instance, the BOJ retains supervisory responsibility for banks, while the
responsibility for oversight of the securities sector lies with the Securities and Exchange
Surveillance Commission (SESC), similar to the SEC in the U.S. 15 In addition, according
to an IMF study, the MOF continues to be an influence in financial regulation, preventing
the FSA from exercising independent regulatory authority (International Monetary Fund
2003). Unlike the single regulators in other countries, the FSA does not have a board
overseeing its operations and thus lacks the layer of separation from political influence
such a board offers. The IMF study also notes an absence of formal communications
between the FSA and the BOJ, preventing information exchange between the parties that
could potentially enhance supervisory efficiency. Even in the highly decentralized
regulatory environment of the United States, there are formal communication structures
between regulatory agencies through, for example, the FFIEC.

Germany’s BaFin
In the years leading up to reform, banking supervision in Germany was carried out by an
autonomous federal agency, BaKred (Federal Bank Supervisory Office), which shared
15

While SESC is structurally under the FSA, it still operates as a legally independent enforcement agency.

responsibilities with Germany’s central bank, the Bundesbank. This contrasts with many
other countries such as the United Kingdom, which concentrated bank supervisory power
in the central bank prior to reform. The Bundesbank conducted bank examinations,
whereas the BaKred was responsible for determining regulatory policy. In March of 2002
legislation was enacted that consolidated Germany’s regulatory agencies for banking,
securities (regulated by BaWe, the Federal Supervisory Office for Securities Trading),
and insurance (BaV, the Federal Supervisory Office for Insurance Enterprises) into a
single federal regulatory entity, BaFin (Schüler 2004). BaFin is an independent federal
administrative agency under the MOF’s supervision. The authority over decisions with
respect to the supervision of credit institutions, investment firms, and other financial
organizations, previously conducted by the BaKred, were now a part of BaFin’s new
responsibilities.
BaFin’s organizational structure consists of regulatory bodies responsible for both
sector-specific and cross-sectoral supervision. The sector-specific structural aspect differs
from the U.K. and Japan, which are functionally organized. Rather, BaFin consists of
three directorates that deal with sector-specific regulation and thus perform the roles of
the former three independent supervisory offices: BaKred, BaV, and BaWe. In addition
to these specialized directorates, BaFin also consists of three cross-sectoral departments
that handle matters that are not sector-specific and may affect all directorates, including
issues involving financial conglomerates, money laundering, prosecution of illegal
financial transactions, and consumer protection. With effective coordination and
cooperation between the directorates, sector-specific, and cross-sectoral issues could be
addressed by one institutional body. BaFin also encompasses an administrative council

and advisory board. 16 These groups oversee BaFin’s management and advise BaFin on
matters concerning supervisory practices, laying the groundwork for a more accountable
and transparent regulatory system.
Germany’s central bank, the Bundesbank, expressed great interest in becoming
the sole bank supervisor when consolidation legislation was debated. Despite the
Bundesbank’s efforts, it lacked the support from the Länder (state governments of
Germany) and lost bank supervisory authority in the consolidation. However, because of
the Bundesbank’s experienced staff and insights into the financial system, the Parliament
established an agreement between the BaFin and the Bundesbank under which the
Bundesbank would retain an important, but reduced, supervisory role in the financial
system. In order to prevent duplication of work and keep costs minimized, the
Bundesbank and BaFin have divided tasks between themselves: BaFin writes regulations,
and the Bundesbank, which is independent from BaFin, carries out day-to-day
supervision (evaluating documents, reports, annual accounts and auditors’ reports
submitted by the institutions as well as banking operations audits – i.e., examinations).
Cooperation between them is required by the Banking Act and is outlined in a
memorandum of understanding signed by each party. 17 Germany’s Bundesbank stands
out from the majority of other single-regulatory models because it has greater
involvement in bank supervision. These retained examination responsibilities may be
useful to the Bundesbank when deciding whether to grant aid to troubled banks.

Members from the government and Parliament, representatives of financial institutions, and academics
are among those representing these groups.
17
See:
http://www.bafin.de/cln_109/nn_721606/SharedDocs/Veroeffentlichungen/EN/BaFin/Internationales/Gem
einsameStandpunkte/mou__021031__en.html

Australia’s “Twin Peaks” Model
The U.S. Treasury’s proposed “objectives-based” optimal regulatory structure, including
a market stability regulator, a prudential financial regulator, and a consumer protection
regulator, is very similar in structure to Australia’s “twin peaks” model of financial
regulation. As Australian financial markets became more globally integrated, financial
deregulation occurred throughout the 1980s and 1990s, and the number of financial
conglomerates grew, so the idea of reconstructing the financial regulatory system became
an issue of interest. In 1996 the Wallis Committee, chaired by Australian businessman
Stan Wallis, was created to prepare a comprehensive review of the financial system and
make recommendations for modifying the regulatory apparatus.
Later known as the Wallis Inquiry, the committee concluded that given the
changed financial environment, establishing two independent regulators – each
responsible for one primary regulatory objective – would result in the most efficient and
effective regulatory system. Australia adopted the Wallis Plan producing the “Twin
Peaks” model of regulation, comprised of two separate regulatory agencies; one
specializing in prudential supervision, the Australian Prudential Regulation Authority
(APRA), and the other focusing on consumer and investor protection, the Australian
Securities and Investments Commission (ASIC). The APRA is responsible for prudential
supervision of deposit-taking institutions (banks, building societies, and credit unions),
insurance, and pension funds (called superannuation funds in Australia). 18,19 In addition
to supervising these institutions, the APRA is also responsible for developing

Building societies are financial institutions, owned by members that offer banking and other financial
services but specialize in mortgage lending (similar to mutual savings banks in the United States).
19
Employers in Australia are required by law to pay a proportion of employee earnings into
superannuation funds, which are then held in trust until the employee retires.

administrative practices and procedures to achieve goals of financial strength and
efficiency. Unlike the structure of single regulators of the other countries discussed,
Australia’s regulatory structure is designed with two independent regulators that operate
along functional rather than sectoral lines. However, like the single-regulatory models,
the APRA and ASIC coordinate their regulatory efforts with the central bank and the
Treasury.
The Reserve Bank of Australia (RBA) lost direct supervisory authority over
individual banking institutions to the APRA but retained responsibility for maintaining
financial stability, including providing liquidity support. In addition, the RBA has a
regulatory role in the payments system and continues its role in conducting monetary
policy (RBA 1998). The three regulatory agencies (APRA, ASIC, and RBA) are all
members, along with the Treasury, of the Council of Financial Regulators, which is a
coordinating body comprised of members from each agency and chaired by the RBA.
The Council’s role is to provide a high level forum for the coordination and cooperation
of the members. It holds no specific regulatory function separate from those of the
individual members. 20 This system resembles that of the FFIEC in the United States,
functioning as a coordinating unit between financial supervisory actors.

7. Central Banks and Regulatory Consolidation
Traditionally, central banks have played a major role in bank supervision, as shown in the
previous section. Government agencies that are separate from the central bank typically
supervise securities and insurance sectors. As banking firms began to offer securities and
20

See http://www.rba.gov.au/FinancialSystemStability/AustralianRegulatoryFramework/cfr.html for a
detailed description of the council and a list of its members.

to some extent insurance products, as securities and insurance companies started to offer
banking products, and as financial conglomerates developed, countries reassessed their
financial regulatory systems. Included in this reassessment was a review of the central
banks’ role in regulation and supervision. Ultimately, in many nations, the regulatory
role of central banks was reduced or eliminated. The Treasury blueprint’s proposal to
remove supervisory functions from the Federal Reserve is therefore not unique. But why
might one wish to consolidate regulation outside of the central bank? And what are the
downsides to removing regulation from the central bank?
Table 4 Location of Bank Supervision Function

Source: Milo 2007, p.15

Reasons to Move Regulation Outside of the Central Bank
Observers note three predominant reasons for preferring to have regulation outside of the
central bank (see, for example Calomiris and Litan, 2000, p. 303 – 308). Two of these
reasons involve a conflict of interest between central banks’ macroeconomic
responsibilities and its supervisory responsibilities. The third involves the possibility of
damage to the central bank’s reputation, and therefore independence, resulting from
problems at its supervised institutions.
First, a central bank with regulatory and supervisory authority will, at times, have
an incentive to loosen monetary policy – meaning reduce market interest rates since
monetary policy is normally conducted through interest rate changes – to protect troubled
institutions it supervises from failure. Observers maintain that this conflict can lead the
central bank to allow higher inflation rates than may be optimal. Often average maturities
of assets are longer than maturities of liabilities on bank balance sheets. As a result, bank
earnings will tend to increase when interest rates decline. If a central bank is answerable
for problems at its supervised banks, it may view a small or short-lived reduction in
interest rates as an acceptable means of avoiding the criticism it might face if its
supervised banks begin to fail.
Di Noia and Di Giorgio (1999) performed empirical analysis on the link between
the inflation performance of OECD countries and whether the central bank is also a bank
regulator. While the results are not overwhelming, they find that the inflation rate is
higher and more volatile in countries in which the responsibility for banking supervision
is entirely with the central bank.

Second, a central bank that is also a bank supervisor may choose to loosen its
supervisory reins when doing so might avoid macroeconomic troubles. Calomiris and
Litan (2000) argue that an example of this behavior occurred in the 1980s when banks
were not required to write down their developing country debt because they feared that
doing so would weaken banks, which in turn would have wide macroeconomic
consequences. Presumably the consequences would occur when these banks reduced
lending in response to their write-downs.
Third, when one of its supervised institutions fails, a central bank may suffer
reputational damage. In turn, legislators may lose confidence in the central bank and
begin to attempt to intervene in its monetary policy decisions, undercutting independence
and perhaps introducing an inflation bias.

Keep Regulation in the Central Bank?
In contrast, there is one oft-stated reason to keep the central bank as a bank regulator:
without day-to-day examination responsibility, the central bank will have difficulty
making prudent lender-of-last-resort (LOLR) lending decisions. Central banks typically
allow certain institutions to borrow funds, typically on a short-term basis, to cover
liquidity shortages. For example, a bank facing deposit withdrawals that exceed the
bank’s easily marketable (liquid) assets will be forced to sell other assets. Since bank
assets are often difficult for outsiders to value, rapid sales of these assets are likely to
generate losses for the bank. To allow banks to overcome this “fire sale” problem, central
banks provide access to LOLR loans.

LOLR loans are frequently made to institutions with uncertain futures. The
decision is likely to be controversial and subject the decision maker to close political and
public scrutiny. If the central bank incorrectly decides not to lend to an institution that is
healthy but has a short-term liquidity problem, that bank may fail. Such a decision may
mean that valuable resources will be wasted reorganizing the failed bank. Alternatively, if
the central bank incorrectly decides to lend to an institution that is unhealthy and the bank
ultimately fails, then uninsured depositors have escaped losses, leaving these losses to
instead be borne by the deposit insurer or taxpayers. Further, if the central bank
frequently lends to unhealthy banks, banks will be more willing to make risky
investments knowing that the LOLR is likely to come to their aid.
Given the dangers of incorrect LOLR decisions, the decision maker will require
careful counsel from a knowledgeable staff. This kind of knowledge is likely to be gained
only by individuals who are involved in day-to-day examination of institutions. Further,
the decision maker is likely to get the best input from staff that report directly to the
decision maker so that poor decisions are punished and good decisions rewarded.
Consequently, the combination of the need for day-to-day knowledge and for proper
incentives for providing good information argues in favor of keeping regulatory
responsibility with the entity that provides LOLR loans, typically the central bank.
Still, there are alternatives to vesting the central bank with supervisory powers.
First, if the LOLR lending decision is left with a supervisor outside of the central bank
and all consequences for wrong decisions rest with that supervisor, then the best decision
possible is likely to transpire. For example, if the separate supervisory agency were
required to determine whether a loan is to be made by the central bank, the central bank is

required to abide by this decision, and the supervisor is held solely responsible to
legislators for bad decisions, then the central bank could be safely left out of supervision.
Likewise, if the LOLR’s authority to lend rested with an entity outside of the
central bank, there would be no reason for vesting supervisory powers with the central
bank. In this case, concerns with conflicts of interest would then argue for separating
supervision from the central bank. In the U.S., for example, the FDIC has the authority to
make LOLR loans, but given the FDIC’s fairly small reserves ($45 billion as of June
2008, Federal Deposit Insurance Corporation 2008, p. 15) the FDIC would likely be
unable to act as a strong LOLR. Therefore the only entity currently capable of replacing
the Fed as LOLR is the Treasury, unless another agency were granted the authority to
issue large amounts of government-backed debt or to borrow directly from the Treasury.
If supervisory authority and LOLR authority were combined at the Treasury, the funds
would be available to make LOLR loans, and the incentives would be properly situated to
ensure that the LOLR decisions were appropriate.

8. Conclusion
The growth of financial conglomerates around the world has led a number of countries to
consolidate their financial regulatory agencies. The United States is facing this same
situation, leading some policymakers to propose regulatory consolidation for the United
States. While the exact regulatory structure adopted varies greatly from country to
country, the move from multiple regulatory agencies to one or two agencies seems
motivated by the desire to achieve a fairly consistent list of efficiencies. Regulator

incentives make achieving these efficiencies difficult without shrinking the number of
regulatory agencies.
One question U.S. policymakers will confront if they investigate the possibility of
consolidating regulation is to what degree should regulators be consolidated? Moving to
one entity with the authority to make all regulatory decisions may well achieve the
communication efficiency goals of consolidation. But vesting one agency with all
regulatory authority may also raise concerns that the single regulator will adopt strategies
that raise the regulatory costs imposed on financial firms. Most countries have dispersed
regulatory authority among several agencies.
A second question likely to be important if the U.S. considers consolidation is
how the LOLR function is to be performed. Prominent countries that have moved to a
more consolidated regulatory structure have typically left the central bank with LOLR
authority but without regulatory and supervisory responsibilities. While some observers
have noted dangers from combining in one entity supervisory and central bank
responsibilities, there are strong disadvantages from doing otherwise. The information
gathered by performing day-to-day supervisory activities is vital to the decision makers
who are responsible for LOLR lending. This information is vital because LOLR loans
frequently are made to firms for which creditworthiness is difficult to measure. While a
supervisor that is separate from the LOLR could ideally transfer this information to
decision-makers at the central bank, in reality such information transfers are likely to be
problematic.
Therefore, there are strong tensions between achieving the benefits of
consolidation and preventing the costs that might arise from a lack of competition when

there is only one regulator. Further, the question of how to ensure that appropriate LOLR
decisions are made in a consolidated environment seems especially thorny. It is no
wonder that the United States has approached consolidation so many times over the last
40 years without ever moving forward.

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