A Government Accountability Office report Wednesday urged regulators to evaluate whether new Basel II reforms will truly fix the capital inadequacies highlighted by the crisis.

The 130-page report addressed findings that the industry's overreliance on leverage — and the subsequent deleveraging by financial institutions — were significant contributing factors to the financial turmoil.

The study said the crisis demonstrated shortcomings in the agencies' reining in of leverage, questioned whether U.S. regulations to implement the international Basel II reforms were an adequate improvement and recommended that a new proposed systemic-risk regulator be specifically tasked with limiting leverage.

"The crisis highlighted past concerns about the approach to be taken under Basel II, … such as the ability of banks' models to adequately measure risks for regulatory capital purposes and the regulators' ability to oversee them," the GAO said.

"Federal financial regulators have not formally assessed the extent to which Basel II reforms proposed by U.S. and international regulators may address these concerns. Such an assessment is critical to ensure that Basel II reforms, particularly those that would increase reliance on complex risk models for determining capital needs, do not exacerbate regulatory limitations revealed by the crisis."

Even though large institutions complied with baseline capital requirements leading up to the crisis, those standards were not enough to mitigate the risks posed by certain mortgage-related assets, the watchdog agency said.

"As a result, a number of these institutions did not hold capital commensurate with their risks and some lacked adequate capital or liquidity to withstand the market stresses of the crisis, the GAO said.

In addition to shortfalls in limiting leverage before the crisis, the GAO said the regulatory structure also failed to prevent the industry's problems from worsening once institutions — trying to deleverage — quickly sold off assets, potentially depressing market prices.

"The crisis illustrated how the existing regulatory framework, along with other factors, might have contributed to cyclical leverage trends that potentially exacerbated the current crisis," the report said.

"For example, minimum regulatory capital requirements may not provide adequate incentives for banks to build loss-absorbing capital buffers in benign markets when it is relatively less expensive to do so. When market conditions deteriorated, minimum capital requirements became binding for many institutions that lacked adequate buffers to absorb losses and faced sudden pressures to deleverage."

The report recommended that as Congress debates tasking an agency — such as the Federal Reserve Board — with overseeing systemic risk, the regulator specifically be charged with "monitoring systemwide leverage and evaluating options to limit procyclical leverage trends."

Even though the U.S. banking agencies finalized their Basel II rule in 2007, the crisis has reinforced concerns among observers, and some regulators, that the measures may not be enough. Concerns have included that the regulation focuses too much on banks' using their own internal models to gauge capital adequacy. Indeed, the regulation itself called for a study two years after the rule was finalized. (Large institutions have until April 2011 to fully comply).

The GAO said regulators in general had responded positively to the report's recommendation that they reassess the rule.

"We strongly endorse the report's recommendation that the regulators undertake a fundamental review of Basel II to assess whether that new framework would adequately address concerns about the use of banks' internal models for determining regulatory capital requirements," Federal Deposit Insurance Corp. Chairman Sheila Bair, who had raised the most concern among the regulators, said in a July 9 letter included in the report.

"In addition to requiring insufficient capital as revealed by the crisis, the advanced approaches of Basel II embody a degree of regulatory deference to banks that is concerning."

In a similar letter, Comptroller of the Currency John Dugan concurred, saying his agency "agrees that recent events have highlighted certain weaknesses in our regulatory framework — both Basel I-based and Basel II."

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