A Government Accountability Office review of the watchdogs including the Federal Reserve and the Securities and Exchange Commission said the agencies found “numerous weaknesses” in the management of risks. Regulators shunned “forceful actions” because the firms reported “strong” finances and pledged to change their practices, the GAO said in a 35-page report, requested by Democratic U.S. Senator Jack Reed of Rhode Island.

“Regulators acknowledged that in some cases they had not fully appreciated the extent of these weaknesses until the financial crisis occurred,” the report said. “Regulators also acknowledged that they relied heavily on management representations of risks.”

U.S. financial companies including Bear Stearns Cos.,Washington Mutual Inc. and Wachovia Corp. failed or were forced to find a buyer as a collapsing subprime mortgage market led businesses worldwide to report more than $1.2 trillion in writedowns and credit losses since 2007. Congress is beginning the biggest overhaul of financial regulation since the Great Depression to prevent future meltdowns.

Reed, who leads a Senate subcommittee on securities, insurance and investment, will hold a hearing today to examine oversight of risk management by the Fed, SEC, the Office of Thrift Supervision and the Office of the Comptroller of the Currency.

‘Red Flags’

Lawmakers have chided the bank regulators for failing to prevent mortgage underwriting practices that contributed to the financial crisis. SEC Inspector General H. David Kotz said in a September report that his agency failed to respond to “red flags” at Bear Stearns such as its “high leverage” and over- concentration in mortgage securities before the company collapsed a year ago.

The GAO said regulators knew financial companies had “significant shortcomings,” including an inability to monitor risks across their entire businesses. Still, some watchdogs gave firms “satisfactory assessments until the financial crisis occurred,” the government watchdog said.

Spokesmen for the Fed, SEC and OTS had no comment on the GAO’s findings. OCC spokesmen Kevin Mukri and Robert Garsson didn’t return telephone calls or e-mails requesting comment.

SEC Chairman

Regulators appointed by President Barack Obama have echoed the GAO: “Regulators lost their skepticism and thought that market discipline was what was really necessary,” SEC Chairman Mary Schapiro, who took over the agency in January, told Congress March 11. Regulators assumed “nobody would take a foolish economic risk that might put the franchise in danger.”

In one instance, the GAO said an unidentified regulator told a company’s board in 2006 that “senior managers” weren’t adequately monitoring “financial reporting, risk appetite and internal audit functions.”

While the regulator continued to find the same weaknesses in subsequent examinations, it didn’t force the company to resolve the shortcomings until the credit crunch. The regulator justified its actions by saying it felt the company had “sufficient capital and the ability to raise more,” the GAO said.

The government watchdog also said that some regulators relied on management’s assessment of risk, especially in “emerging areas” such as the subprime-mortgage market. Agencies became “less comfortable” with management representations after banks stopped lending to each other in late 2007, the GAO said.

The GAO said regulators may have been hindered because no single agency evaluates risks across banks and securities firms that may threaten the financial system. In some instances, regulators scrutinize risk in a different way than companies mange it internally. As a result, agencies may have a “limited view” of what a firm is up to, the GAO said.

Lawmakers including House Financial Services Committee Chairman Barney Frank have endorsed establishing a so-called systemic-risk regulator to examine threats to economy stability across the financial sector. Such an agency would scrutinize banks, insurers, hedge funds and private-equity firms.

SOURCE: Bloomberg