fcic_final_report_full--267 COMMISSION CONCLUSIONS ON CHAPTER 13 The Commission concludes that the shadow banking system was permitted to grow to rival the commercial banking system with inadequate supervision and regulation. That system was very fragile due to high leverage, short-term funding, risky assets, inadequate liquidity, and the lack of a federal backstop. When the mortgage market collapsed and financial firms began to abandon the commercial paper and repo lending markets, some institutions depending on them for fund- ing their operations failed or, later in the crisis, had to be rescued. These markets and other interconnections created contagion, as the crisis spread even to mar- kets and firms that had little or no direct exposure to the mortgage market. In addition, regulation and supervision of traditional banking had been weak- ened significantly, allowing commercial banks and thrifts to operate with fewer constraints and to engage in a wider range of financial activities, including activi- ties in the shadow banking system. The financial sector, which grew enormously in the years leading up to the fi- nancial crisis, wielded great political power to weaken institutional supervision and market regulation of both the shadow banking system and the traditional banking system. This deregulation made the financial system especially vulnera- ble to the financial crisis and exacerbated its effects. fcic_final_report_full--47 Traditional and Shadow Banking Systems The funding available through the shadow banking system grew sharply in the 2000s, exceeding the traditional banking system in the years before the crisis. IN TRILLIONS OF DOLLARS $15 12 9 6 $13.0 Traditional Banking $8.5 Shadow Banking 3 0 1980 1985 1990 1995 2000 2005 2010 NOTE: Shadow banking funding includes commercial paper and other short-term borrowing (bankers acceptances), repo, net securities loaned, liabilities of asset-backed securities issuers, and money market mutual fund assets. SOURCE: Federal Reserve Flow of Funds Report Figure . Figure . shows that during the s the shadow banking system steadily gained ground on the traditional banking sector—and actually surpassed the bank- ing sector for a brief time after . Banks argued that their problems stemmed from the Glass-Steagall Act. Glass- Steagall strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the s, when banks sold highly speculative securities to depositors. In , Congress also imposed new regulatory requirements on banks owned by holding companies, in order to prevent a holding company from endan- gering any of its deposit-taking banks. Bank supervisors monitored banks’ leverage—their assets relative to equity— because excessive leverage endangered a bank. Leverage, used by nearly every finan- cial institution, amplifies returns. For example, if an investor uses  of his own money to purchase a security that increases in value by , he earns . However, if he borrows another  and invests  times as much (,), the same  in- crease in value yields a profit of , double his out-of-pocket investment. If the investment sours, though, leverage magnifies the loss just as much. A decline of  costs the unleveraged investor , leaving him with , but wipes out the leveraged investor’s . An investor buying assets worth  times his capital has a leverage ratio of :, with the numbers representing the total money invested compared to the money the investor has committed to the deal. fcic_final_report_full--437 The dangerous imprecision of the term “shadow banking” Part II of the majority’s report begins with an extensive discussion of the failures of the “shadow banking system,” which it defines as a “financial institutions and activi- ties that in some respects parallel banking activities but are subject to less regulation than commercial banks.” The majority’s report suggests that the shadow banking sys- tem was a cause of the financial crisis. “Shadow banking” is a term used to represent a collection of different financial in- stitutions, instruments, and issues within the financial system. Indeed, “shadow banking” can refer to any financial activity that transforms short-term borrowing into long-term lending without a government backstop. This term can therefore in- clude financial instruments and institutions as diverse as: • The tri-party repo market; • Structured Investment Vehicles and other off-balance-sheet entities used to in- crease leverage; • Fannie Mae and Freddie Mac; • Credit default swaps; and • Hedge funds, monoline insurers, commercial paper, money market mutual funds, and investment banks. As discussed in other parts of this paper, some of these items were important causes of the crisis. No matter what their individual roles in causing or contributing to the crisis, however, they are undoubtedly different. It is a mistake to group these is- sues and problems together. Each should be considered on its merits, rather than painting a poorly defined swath of the financial sector with a common brush of “too little regulation.” BIG BANK BETS AND WHY BANKS FAILED The story so far involves significant lost housing wealth and diminished values of se- curities financing those homes. Yet even larger past wealth losses did not bring the global financial system to its knees. The key differences in this case were leverage and risk concentration. Highly correlated housing risk was concentrated in large and highly leveraged financial institutions in the United States and much of Europe. This leverage magnified the effect of a housing loss on a financial institution’s capital re- serve, and the concentration meant these losses occurred in parallel. fcic_final_report_full--257 COMMISSION CONCLUSIONS ON CHAPTER 12 The Commission concludes that entities such as Bear Stearns’s hedge funds and AIG Financial Products that had significant subprime exposure were affected by the collapse of the housing bubble first, creating financial pressures on their par- ent companies. The commercial paper and repo markets—two key components of the shadow banking lending markets—quickly reflected the impact of the housing bubble collapse because of the decline in collateral asset values and con- cern about financial firms’ subprime exposure. fcic_final_report_full--552 Public Hearing on the Shadow Banking System, Dirksen Senate Office Building, Room , Washington DC, Day , May ,  Session : Investment Banks and the Shadow Banking System Paul Friedman, Former Senior Managing Director, Bear Stearns Samuel Molinaro Jr., Former Chief Financial Officer and Chief Operating Officer, Bear Stearns Warren Spector, Former President and Co-chief Operating Officer, Bear Stearns Session : Investment Banks and the Shadow Banking System James E. Cayne, Former Chairman and Chief Executive Officer, Bear Stearns Alan D. Schwartz, Former Chief Executive Officer, Bear Stearns Session : SEC Regulation of Investment Banks Charles Christopher Cox, Former Chairman, U.S. Securities and Exchange Commission William H. Donaldson, Former Chairman, U.S. Securities and Exchange Commission H. David Kotz, Inspector General, U.S. Securities and Exchange Commission Erik R. Sirri, Former Director Division of Trading & Markets, U.S. Securities and Exchange Commission Public Hearing on the Shadow Banking System, Dirksen Senate Office Building, Room , Washington DC, Day , May ,  Session : Perspective on the Shadow Banking System Henry M. Paulson Jr., Former Secretary, U.S. Department of the Treasury Session : Perspective on the Shadow Banking System Timothy F. Geithner, Secretary, U.S. Department of the Treasury; Former President, Federal Reserve Bank of New York Session : Institutions Participating in the Shadow Banking System Michael A. Neal, Vice Chairman, General Electric; Chairman and Chief Executive Officer, GE Capital Mark S. Barber, Vice President and Deputy Treasurer, GE Capital Paul A. McCulley, Managing Director, PIMCO Steven R. Meier, Chief Investment Officer, State Street Public Hearing on Credibility of Credit Ratings, the Investment Decisions Made Based on Those Ratings, and the Financial Crisis, The New School Arnhold Hall, Theresa Lang Community & Student Center,  West th Street, nd Floor, New York, NY, June ,  Session : The Ratings Process Eric Kolchinsky, Former Team Managing Director, US Derivatives, Moody’s Investors Service Jay Siegel, Former Team Managing Director, Moody’s Investors Service Nicolas S. Weill, Group Managing Director, Moody’s Investors Service Gary Witt, Former Team Managing Director, US Derivatives, Moody’s Investors Service Session : Credit Ratings and the Financial Crisis Warren E. Buffett, Chairman and Chief Executive Officer, Berkshire Hathaway Raymond W. McDaniel, Chairman and Chief Executive Officer, Moody’s Corporation Session : The Credit Rating Agency Business Model Brian M. Clarkson, Former President and Chief Operating Officer, Moody’s Investors Service (written testimony only due to a medical emergency) Mark Froeba, Former Senior Vice President, US Derivatives, Moody’s Investors Service Richard Michalek, Former Vice President/Senior Credit Officer, Moody’s Investors Service 549 fcic_final_report_full--612 Chapter 16 1. David Wong, interview by FCIC, October 15, 2010. 2. Josh Fineman and Yalman Onaran, “Lehman’s Fuld Says ‘Worst Is Behind Us’ in Crisis (Update3), Bloomberg, April 15, 2008. 3. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 28. 4. Viral V. Acharya and T. Sabri Öncü, “The Dodd-Frank Wall Street Reform and Consumer Protec- tion Act and a Little Known Corner of Wall Street: The Repo Market,” Regulating Wall Street, July 16, 2010. 5. Sandie O’Connor, JP Morgan, interview by FCIC, March 4, 2010. 6. Jamie Dimon, interview by FCIC, October 20, 2010. 7. Adam Copeland, Antoine Martin, Michael Walker, “The Tri-Party Repo Market Before the 2010 Reforms,” FRBNY Staff Report No. 477, November 2010, p. 24. 8. Steven Meier, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 276. 9. William Dudley, interview by FCIC, October 15, 2010. 10. Darryll Hendricks, interview by FCIC, August 6, 2010. 11. James Cayne, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session 2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 168. 12. Seth Carpenter, interview by FCIC, September 20, 2010. 13. Federal Reserve, “Regulatory Reform: Primary Dealer Credit Facility (PCDF),” Usage of Federal Reserve Credit and Liquidity Facilities, data available at www.federalreserve.gov/newsevents/ reform_pdcf.htm. 14. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11 Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 4:1396–98; quotation, 1396 (hereafter cited as Valukas; available at http://lehmanreport.jenner.com/). 15. William Dudley, email to Chairman, June 17, 2008. 16. Dimon, interview. 17. Ibid. 18. Hendricks, interview. 19. Lucinda Brickler, email to Patrick Parkinson, July 11, 2008; Lucinda Brickler et al., memorandum to Timothy Geithner, July 11, 2008. 20. The $200 billion figure is noted in Patrick Parkinson, email to Ben Bernanke et al., July 20, 2008. 21. Brickler et al., memorandum, p. 1. 22. Patrick Parkinson, email to Lucinda Brickler, July 11, 2008. 23. Patrick Parkinson, email to Ben Bernanke et al., July 20, 2008. 24. Ibid. 609 25. Based on chart in Federal Reserve Bank of New York, Developing Metrics for the Four Largest Secu- rities Firms, August 2008, p. 5. 26. Ibid. 27. Tobias Adrian, Christopher Burke, and James McAndrews, “The Federal Reserve’s Primary Dealer Credit Facility,” Federal Reserve Bank of New York, Current Issues in Economics and Finance 15, no. 4 (August 2009): 2. 28. Erik Sirri, interview by FCIC, April 9, 2010, p. 3. 29. Fed Chair Ben Bernanke, “Lessons from the Failure of Lehman Brothers,” testimony before the fcic_final_report_full--355 COMMISSION CONCLUSIONS ON CHAPTER 18 The Commission concludes the financial crisis reached cataclysmic proportions with the collapse of Lehman Brothers. Lehman’s collapse demonstrated weaknesses that also contributed to the failures or near failures of the other four large investment banks: inadequate regulatory oversight, risky trading activities (including securitization and over-the-counter (OTC) derivatives dealing), enormous leverage, and reliance on short-term fund- ing. While investment banks tended to be initially more vulnerable, commercial banks suffered from many of the same weaknesses, including their involvement in the shadow banking system, and ultimately many suffered major losses, requiring government rescue. Lehman, like other large OTC derivatives dealers, experienced runs on its de- rivatives operations that played a role in its failure. Its massive derivatives posi- tions greatly complicated its bankruptcy, and the impact of its bankruptcy through interconnections with derivatives counterparties and other financial in- stitutions contributed significantly to the severity and depth of the financial crisis. Lehman’s failure resulted in part from significant problems in its corporate governance, including risk management, exacerbated by compensation to its ex- ecutives and traders that was based predominantly on short-term profits. Federal government officials decided not to rescue Lehman for a variety of reasons, including the lack of a private firm willing and able to acquire it, uncer- tainty about Lehman’s potential losses, concerns about moral hazard and political reaction, and erroneous assumptions that Lehman’s failure would have a manage- able impact on the financial system because market participants had anticipated it. After the fact, they justified their decision by stating that the Federal Reserve did not have legal authority to rescue Lehman. The inconsistency of federal government decisions in not rescuing Lehman af- ter having rescued Bear Stearns and the GSEs, and immediately before rescuing AIG, added to uncertainty and panic in the financial markets. fcic_final_report_full--48 In , bank supervisors established the first formal minimum capital standards, which mandated that capital—the amount by which assets exceed debt and other lia- bilities—should be at least  of assets for most banks. Capital, in general, reflects the value of shareholders’ investment in the bank, which bears the first risk of any po- tential losses. By comparison, Wall Street investment banks could employ far greater leverage, unhindered by oversight of their safety and soundness or by capital requirements outside of their broker-dealer subsidiaries, which were subject to a net capital rule. The main shadow banking participants—the money market funds and the invest- ment banks that sponsored many of them—were not subject to the same supervision as banks and thrifts. The money in the shadow banking markets came not from fed- erally insured depositors but principally from investors (in the case of money market funds) or commercial paper and repo markets (in the case of investment banks). Both money market funds and securities firms were regulated by the Securities and Exchange Commission. But the SEC, created in , was supposed to supervise the securities markets to protect investors. It was charged with ensuring that issuers of securities disclosed sufficient information for investors, and it required firms that bought, sold, and brokered transactions in securities to comply with procedural re- strictions such as keeping customers’ funds in separate accounts. Historically, the SEC did not focus on the safety and soundness of securities firms, although it did im- pose capital requirements on broker-dealers designed to protect their clients. Meanwhile, since deposit insurance did not cover such instruments as money market mutual funds, the government was not on the hook. There was little concern about a run. In theory, the investors had knowingly risked their money. If an invest- ment lost value, it lost value. If a firm failed, it failed. As a result, money market funds had no capital or leverage standards. “There was no regulation,” former Fed chair- man Paul Volcker told the Financial Crisis Inquiry Commission. “It was kind of a free ride.”  The funds had to follow only regulations restricting the type of securities in which they could invest, the duration of those securities, and the diversification of their portfolios. These requirements were supposed to ensure that investors’ shares would not diminish in value and would be available anytime—important reassur- ances, but not the same as FDIC insurance. The only protection against losses was the implicit guarantee of sponsors like Merrill Lynch with reputations to protect. Increasingly, the traditional world of banks and thrifts was ill-equipped to keep up with the parallel world of the Wall Street firms. The new shadow banks had few constraints on raising and investing money. Commercial banks were at a disadvan- tage and in danger of losing their dominant position. Their bind was labeled “disin- termediation,” and many critics of the financial regulatory system concluded that policy makers, all the way back to the Depression, had trapped depository institu- tions in this unprofitable straitjacket not only by capping the interest rates they could pay depositors and imposing capital requirements but also by preventing the institu- tions from competing against the investment banks (and their money market mutual funds). Moreover, critics argued, the regulatory constraints on industries across the entire economy discouraged competition and restricted innovation, and the financial sector was a prime example of such a hampered industry. fcic_final_report_full--42 SHADOW BANKING CONTENTS Commercial paper and repos: “Unfettered markets” ...........................................  The savings and loan crisis: “They put a lot of pressure on their regulators” ...........................................................................  The financial crisis of  and  was not a single event but a series of crises that rippled through the financial system and, ultimately, the economy. Distress in one area of the financial markets led to failures in other areas by way of interconnections and vulnerabilities that bankers, government officials, and others had missed or dis- missed. When subprime and other risky mortgages—issued during a housing bubble that many experts failed to identify, and whose consequences were not understood— began to default at unexpected rates, a once-obscure market for complex investment securities backed by those mortgages abruptly failed. When the contagion spread, in- vestors panicked—and the danger inherent in the whole system became manifest. Fi- nancial markets teetered on the edge, and brand-name financial institutions were left bankrupt or dependent on the taxpayers for survival. Federal Reserve Chairman Ben Bernanke now acknowledges that he missed the systemic risks. “Prospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis,” Bernanke told the Commission. “Rather, the system’s vulnerabilities, together with gaps in the government’s crisis-re- sponse toolkit, were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.”  This part of our report explores the origins of risks as they developed in the finan- cial system over recent decades. It is a fascinating story with profound conse- quences—a complex history that could yield its own report. Instead, we focus on four key developments that helped shape the events that shook our financial markets and economy. Detailed books could be written about each of them; we stick to the essen- tials for understanding our specific concern, which is the recent crisis. First, we describe the phenomenal growth of the shadow banking system—the investment banks, most prominently, but also other financial institutions—that freely operated in capital markets beyond the reach of the regulatory apparatus that had been put in place in the wake of the crash of  and the Great Depression.  CHRG-111shrg50814--153 Mr. Bernanke," Well, I think the Fed was a very active and conscientious regulator. It did identify a lot of the problems. Along with our other fellow regulators, we identified issues with non-traditional mortgages, with commercial real estate, with leveraged lending and other things. But what nobody did was understand how big and powerful this credit boom and the ensuing credit collapse was going to be, and routine supervision was just insufficient to deal with the size of this crisis. So clearly, going forward, we need to think much more broadly, more macroprudentially, about the whole system and think about what we need to do to make sure that the system as a whole doesn't get subjected to this kind of broad-based crisis in the future. Senator Shelby. Does that include insurance, too, because insurance has been regulated under the McCarran-Ferguson Act by the States, but then you had AIG, which caused systemic stress, to say the least, to our banking system, and they were regulated primarily by the New York State Insurance Commission. " Mr. Bernanke," AIG had a Financial Products Division which was very lightly regulated and was the source of a great deal of systemic trouble. So I think that we do need to have broader-based coverage, more even coverage, more even playing field, to make sure that there aren't--as our system evolves, that there aren't markets and products and approaches that get out of the line of vision of the regulators, and that was a problem we had in the last few years. Senator Shelby. Thank you, Mr. Chairman. " fcic_final_report_full--484 Thus, about 27 percent of Bear’s readily available sources of funding consisted of PMBS that became unusable for repo financing when the PMBS market disappeared. The loss of this source of liquidity put the firm in serious jeopardy; rumors swept the market about Bear’s condition, and clients began withdrawing funds. Bear’s offi cers told the Commission that the firm was profitable in its first 2008 quarter—the quarter in which it failed; ironically they also told the Commission’s staff that they had moved Bear’s short term funding from commercial paper to MBS because they believed that collateral-backed funding would be more stable. In the week beginning March 10, 2008, according to the FCIC staff report, Bear had over $18 billion in cash reserves, but by March 13 the liquidity pool had fallen to $2 billion. 51 It was clear that Bear—solvent and profitable or not—could not survive a run that was fueled by fear and uncertainty about its liquidity and the possibility of its insolvency. Parenthetically, it should be noted that the Commission’s staff focused on Bear because the Commission’s majority apparently believed that the business model of investment banks, which relied on relatively high leverage and repo or other short term financing, was inherently unstable. The need to rescue Bear was thought to be evidence of this fact. Clearly, the five independent investment banks—Bear, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs—were badly damaged in the financial crisis. Only two of them remain independent firms, and those two are now regulated as bank holding companies by the Federal Reserve. Nevertheless, it is not clear that the investment banks fared any worse than the much more heavily regulated commercial banks—or Fannie and Freddie which were also regulated more stringently than the investment banks but not as stringently as banks. The investment banks did not pass the test created by the mortgage meltdown and the subsequent financial crisis, but neither did a large number of insured banks— IndyMac, Washington Mutual (WaMu) and Wachovia, to name the largest—that were much more heavily regulated and, in addition, offered insured deposits and had access to the Fed’s discount window if they needed emergency funds to deal with runs. The view of the Commission majority, that investment banks—as part of the so-called “shadow banking system”—were special contributors to the financial crisis, seems misplaced for this reason. They are better classified not as contributors to the financial crisis but as victims of the panic that ensued after the housing bubble and the PMBS market collapsed. Bear went down because the delinquencies and failures of an unprecedentedly large number of NTMs caused the collapse of the PMBS market; this destroyed the 50 51 FCIC, “Investigative Findings on Bear Stearns (Preliminary Draft),” April 29, 2010, p.16. Id., p.45. 479 usefulness of AAA-rated PMBS as assets that Bear and others relied on for both capital and liquidity, and thus raised questions about the firm’s ability to meet its obligations. Investment banks like Bear Stearns were not commercial banks; instead of using short term deposits to hold long term assets—the hallmark of a bank— their business model relied on short-term funding to carry the short term assets of a trading business. Contrary to the views of the Commission majority, there is nothing inherently wrong with that business model, but it could not survive an unprecedented financial panic as severe as that which followed the collapse in value of an asset class as large and as liquid as AAA-rated subprime PMBS. fcic_final_report_full--45 These funds differed from bank and thrift deposits in one important respect: they were not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher interest rates, and the stature of the funds’ sponsors reassured them. The fund sponsors implicitly promised to maintain the full  net asset value of a share. The funds would not “break the buck,” in Wall Street terms. Even without FDIC insur- ance, then, depositors considered these funds almost as safe as deposits in a bank or thrift. Business boomed, and so was born a key player in the shadow banking indus- try, the less-regulated market for capital that was growing up beside the traditional banking system. Assets in money market mutual funds jumped from  billion in  to more than  billion in  and . trillion by .  To maintain their edge over the insured banks and thrifts, the money market funds needed safe, high-quality assets to invest in, and they quickly developed an ap- petite for two booming markets: the “commercial paper” and “repo” markets. Through these instruments, Merrill Lynch, Morgan Stanley, and other Wall Street in- vestment banks could broker and provide (for a fee) short-term financing to large corporations. Commercial paper was unsecured corporate debt—meaning that it was backed not by a pledge of collateral but only by the corporation’s promise to pay. These loans were cheaper because they were short-term—for less than nine months, sometimes as short as two weeks and, eventually, as short as one day; the borrowers usually “rolled them over” when the loan came due, and then again and again. Be- cause only financially stable corporations were able to issue commercial paper, it was considered a very safe investment; companies such as General Electric and IBM, in- vestors believed, would always be good for the money. Corporations had been issuing commercial paper to raise money since the beginning of the century, but the practice grew much more popular in the s. This market, though, underwent a crisis that demonstrated that capital markets, too, were vulnerable to runs. Yet that crisis actually strengthened the market. In , the Penn Central Transportation Company, the sixth-largest nonfinancial corpora- tion in the U.S., filed for bankruptcy with  million in commercial paper out- standing. The railroad’s default caused investors to worry about the broader commercial paper market; holders of that paper—the lenders—refused to roll over their loans to other corporate borrowers. The commercial paper market virtually shut down. In response, the Federal Reserve supported the commercial banks with almost  million in emergency loans and with interest rate cuts.  The Fed’s ac- tions enabled the banks, in turn, to lend to corporations so that they could pay off their commercial paper. After the Penn Central crisis, the issuers of commercial pa- per—the borrowers—typically set up standby lines of credit with major banks to en- able them to pay off their debts should there be another shock. These moves reas- sured investors that commercial paper was a safe investment. CHRG-111hhrg48867--211 Mr. Silvers," Congressman, covering the shadow markets and giving full jurisdiction to the relevant regulators to regulate those activities, meaning to the extent that shadow markets are really credit-granting functions; the bank regulators, to the extent that they are really in the securities markets; the securities regulators. That is a critical thing to do here. And, secondly, to create a consumer protection agency so that we put an end to giving that function to agencies that don't want to do it. " fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  CHRG-111shrg56376--22 Mr. Bowman," I would agree with some of the disadvantages that have been pointed out. I think the other question that we would have is the form that the current system holds, a multiple of regulators, really the cause of the issue we are dealing with today? And I would suggest that, in fact, the principal cause, as the Administration says in its proposal--high-cost loans, only 6 percent of the high-cost loans provided American consumers were provided by depository institutions that were regulated under the current system; 94 percent were provided by the so-called ``shadow banking regulator.'' That is why we would suggest the focus really should be on filling the regulatory gaps that exist today and that really need to be filled. " fcic_final_report_full--611 March 10, 2008. 53. Matthew Eichner, email to Brian Peters, March 11, 2008. 54. David Fettig, “The History of a Powerful Paragraph,” Federal Reserve Bank of Minneapolis, June 2008. 55. James Embersit, email to Deborah Bailey, March 3, 2008. 56. In response to the FCIC’s interrogatories, JP Morgan produced a list of all payments Bear Stearns made to or received from OTC derivatives counterparties from March 10, 2008, through March 14, 2008. The spreadsheet was created in September 2008 by Bear Stearns in response to a request by the SEC Divi- sion of Trading and Markets. The large volume of novations away from Bear Stearns during the week of March 10, 2008 and the previous week was confirmed by the New York Federal Reserve and Interna- tional Swaps and Derivatives Association. (New York Federal Reserve personnel, interview by FCIC; ISDA personnel, interviews by FCIC, May 13 and 27, 2010). 57. Brian Peters, email to Matthew Eichner, March 11, 2008. 58. Stuart Smith, email to Bear Stearns, March 11, 2008; Marvin Woolard, email Stuart Smith et al., March 11, 2008; Kyle Bass, interview by FCIC, April 30, 2010. 59. Bass, interview. 60. Debby LaMoy, email to Faina Epshteyn, March 12, 2008; Faina Epshteyn, email to Debby LaMoy, March 12, 2008. 61. Marvin Woolard, email to Stuart Smith et al., March 12, 2008. 62. CNBC video, Schwartz and CNBC’s David Faber, original air date March 12, 2008. 63. Yalman Onaran, “Bear Stearns Investor Lewis May Increase His Stake,” Bloomberg News, March 11, 2008. 64. Matthew Eichner, email to Erik Sirri, Robert Colby, and Michael Macchiaroli, March 12, 2008. 65. Minutes of Special Meeting of Bear Stearns Board of Directors, March 13, 2008, pp. 1–2. 66. Upton, interview. 67. Matthew Eichner, email to Erik Sirri, Robert Colby, and Michael Macchiaroli, March 12, 2008. 68. Alan Schwartz, interview by FCIC; Matthew Eichner, email to Erik Sirri, Robert Colby, and Michael Macchiaroli, March 13, 2008. 69. Upton, interview. 70. Minutes of Special Meeting of Bear Stearns Board of Directors, March 13, 2008 (“[Schwartz] said there had been seventeen billion dollars in cash with a two billion eight hundred million dollar backstop, unsecured line. The Board was told that twelve to fifteen billion dollars had gone out of TBSCI in the last two days and that TBSCI had received a billion dollars in margin calls”). 71. Upton, interview; Goebel, Gaffney, and Lind, interview; Steven Meier, interview by FCIC, March 15, 2010; Michael Macchiaroli, interview by FCIC, April 13, 2010. 72. Christopher Cox, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1, session 3: SEC Regulation of Investment Banks, May 5, 2010, p. 6. 73. Timeline Regarding Bear Stearns Companies Inc., April 3, 2008, produced by SEC. 74. Jamie Dimon, interview by FCIC, October 20, 2010. 75. Alan Schwartz, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session 2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 167; Schwartz, inter- view. 76. Schwartz., interview. 77. Ibid.; Molinaro, interview; Alix, interview. 78. John Chrin, interview by FCIC, April 28, 2010. 79. Dimon, interview by FCIC, October 20, 2010; minutes of Special Meeting of Bear Stearns Board of Directors, March 16, 2008. 80. Federal Reserve, “Report Pursuant to Section 129 of the Emergency Economic Stabilization Act of 2008: Loan to Facilitate the Acquisition of The Bear Stearns Companies, Inc. by JP Morgan & Co.,” pp. 1, 4; Ernst & Young, “Project LLC: Summary of Findings and Observations Report,” June 26, 2008, p. 10. 81. Contrary to what is stated in the board minutes (Special Meeting of Bear Stearns Board of Direc- tors, March 16, 2008, p. 5), when FCIC staff interviewed Schwartz he said that the $2 a share price came from JP Morgan, not Paulson. Schwartz also told staff that because Bear did not receive “a lot of compet- ing offers,” it had to accept JP Morgan’s offer of $2 a share. 82. Chrin, interview. 83. Alan Schwartz, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session 2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 142. 84. Macchiaroli, interview. 85. Ben Bernanke, closed-door session with FCIC, November 17, 2009. 86. Ibid. 87. Timothy Geithner, president, Federal Reserve Bank of New York, “Actions by the New York Fed in Response to Liquidity Pressures in Financial Markets,” prepared testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 110th Cong., 2nd sess., April 3, 2008, p. 10. 88. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, pp. 68, 59, 78. FinancialCrisisInquiry--191 We stand ready to assist the commission over the coming year and we look forward to your findings on these matters of utmost importance to America’s families. Thank you very much. CHAIRMAN ANGELIDES: Thanks, Ms. Gordon. Mr. Cloutier? CLOUTIER: Thank you very much. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Rusty Cloutier, and I am pleased to testify today on the current state of the financial crisis and in particular the effect it has had on the small- business lending community. I am president and chief executive officer of MidSouth Bank, a $980 million community bank headquartered in Lafayette, Louisiana, with locations throughout south Louisiana and southeast Texas. I am also the author of the book “Big Bad Banks,” which details how a few megabanks and powerful individuals fueled the current financial and economic crisis. I’m proud to testify today on behalf of the Independent Community Bankers of America and its 5,000 community bank members nationwide. Mr. Chairman, it is difficult to talk about the effects of the financial crisis without speaking to the root cause. Too-big-to-fail institutions and the systemic risks that they pose were the heart of our financial and economic meltdown. Equally responsible were those institutions making up the unregulated shadow banking industry operating just not outside of legal parameters, of the regulatory framework, which made most of the subprime exotic loans and brought the housing markets to its knees. For far too long, these institutions have enjoyed privileges of favorable government treatment, easier access to cheaper funding sources, lower or no compliance cost, and little if any oversight. A little more than a few years ago, a key element of the financial system nearly collapsed due to the failure of these institutions to manage their highly risky activities. fcic_final_report_full--89 In , President Bill Clinton asked regulators to improve banks’ CRA perform- ance while responding to industry complaints that the regulatory review process for compliance was too burdensome and too subjective. In , the Fed, Office of Thrift Supervision (OTS), Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) issued regulations that shifted the regulatory focus from the efforts that banks made to comply with the CRA to their actual re- sults. Regulators and community advocates could now point to objective, observable numbers that measured banks’ compliance with the law. Former comptroller John Dugan told FCIC staff that the impact of the CRA had been lasting, because it encouraged banks to lend to people who in the past might not have had access to credit. He said, “There is a tremendous amount of investment that goes on in inner cities and other places to build things that are quite impressive. . . . And the bankers conversely say, ‘This is proven to be a business where we can make some money; not a lot, but when you factor that in plus the good will that we get from it, it kind of works.’”  Lawrence Lindsey, a former Fed governor who was responsible for the Fed’s Divi- sion of Consumer and Community Affairs, which oversees CRA enforcement, told the FCIC that improved enforcement had given the banks an incentive to invest in technology that would make lending to lower-income borrowers profitable by such means as creating credit scoring models customized to the market. Shadow banks not covered by the CRA would use these same credit scoring models, which could draw on now more substantial historical lending data for their estimates, to under- write loans. “We basically got a cycle going which particularly the shadow banking industry could, using recent historic data, show the default rates on this type of lend- ing were very, very low,” he said.  Indeed, default rates were low during the prosper- ous s, and regulators, bankers, and lenders in the shadow banking system took note of this success. SUBPRIME LENDERS IN TURMOIL: “ADVERSE MARKET CONDITIONS ” Among nonbank mortgage originators, the late s were a turning point. During the market disruption caused by the Russian debt crisis and the Long-Term Capital Management collapse, the markets saw a “flight to quality”—that is, a steep fall in de- mand among investors for risky assets, including subprime securitizations. The rate of subprime mortgage securitization dropped from . in  to . in . Meanwhile, subprime originators saw the interest rate at which they could borrow in credit markets skyrocket. They were caught in a squeeze: borrowing costs increased at the very moment that their revenue stream dried up.  And some were caught holding tranches of subprime securities that turned out to be worth far less than the value they had been assigned. Mortgage lenders that depended on liquidity and short-term funding had imme- diate problems. For example, Southern Pacific Funding (SFC), an Oregon-based sub- prime lender that securitized its loans, reported relatively positive second-quarter results in August . Then, in September, SFC notified investors about “recent ad- verse market conditions” in the securities markets and expressed concern about “the continued viability of securitization in the foreseeable future.”  A week later, SFC filed for bankruptcy protection. Several other nonbank subprime lenders that were also dependent on short-term financing from the capital markets also filed for bank- ruptcy in  and . In the two years following the Russian default crisis,  of the top  subprime lenders declared bankruptcy, ceased operations, or sold out to stronger firms.  CHRG-111shrg56376--5 INSURANCE CORPORATION Ms. Bair. Thank you, Senator Dodd, Ranking Member Shelby, and Members of the Committee. Today you have asked us to address the regulatory consolidation aspects of the Administration's proposal and whether there should be further consolidation. The yardstick for any reform should be whether it deals with the fundamental causes of the current crisis and helps guard against future crises. Measured by that yardstick, we do not believe the case has been made for regulatory consolidation of State and Federal charters. Among the many causes of the current crisis, the ability to choose between a State and Federal charter was not one of them. As a consequence, we see little benefit to regulatory consolidation and the potential for great harm and its disruptive impact and greater risk of regulatory capture and dominance by large banking organizations. The simplicity of a single bank regulator is alluring. However, such proposals have rarely gained traction in the past because prudential supervision of FDIC-insured banks has, in fact, worked well compared to the regulatory structures used for other U.S. financial sectors and to those used overseas. Indeed, this is evidenced by the fact that large swaths of the so-called ``shadow banking sector'' have collapsed back into the healthier insured sector. And U.S. banks, notwithstanding the current problems, entered this crisis with stronger capital positions and less leverage than their international competitors. A significant cause of the crisis was the exploitation of regulatory gaps between banks and the shadow nonbank financial system and virtually no regulation of the over-the-counter derivatives contracts. There were also gaps in consumer protection. To address these problems, we have previously testified in support of a systemic risk council that would help assure coordination and harmonization of prudential standards among all types of financial institutions. And a council would address regulatory arbitrage among the various financial sectors. We also support a new consumer agency to assure strong rules and enforcement of consumer protection across the board. However, we do not see merit or wisdom in consolidating all Federal banking supervision. The risk of weak or misdirected regulation would be exacerbated by a single Federal regulator that embarked on a wrong policy course. Prudent risk management argues strongly against putting all your regulatory and supervisory eggs in one basket. One of the advantages of multiple regulators is that it permits diverse viewpoints to be heard. For example, during the discussion of Basel II, the FDIC voiced deep and strong concerns about the reduction in capital that would have resulted. Under a unified regulator, the advanced approaches of Basel II could have been implemented much more quickly and with fewer safeguards, and banks would have entered this crisis with much lower levels of capital. Also, there is no evidence that shows a single financial regulatory structure was better at avoiding the widespread economic damage of the past 2 years. Despite their single-regulator approach, the financial systems in other countries have all suffered during the crisis. Moreover, a single-regulator approach would have serious consequences for two mainstays of the American financial system: the dual banking system and deposit insurance. The dual banking system and the regulatory competition and diversity that it generates is credited with spurring creativity and innovation in financial products and the organization of financial activities. State-chartered institutions tend to be community-oriented and very close to the small businesses and customers they serve. They provide the funding that supports economic growth and job creation, especially in rural areas. Main Street banks also are sensitive to market discipline because they know they are not too big to fail and that they will be closed if they become insolvent. A unified supervisory approach would inevitably focus on the largest banks to the detriment of community banking. In turn, this could cause more consolidation in the banking industry at a time when efforts are underway to reduce systemic exposure to very large financial institutions and to end ``too big to fail.'' Concentrating examination authority in a single regulator also could hurt bank deposit insurance. The loss of an ongoing and significant supervisory role would greatly diminish the effectiveness of the FDIC's ability to perform a congressional mandate. It would hamper our ability to reduce systemic risk through risk-based premiums and to contain the costs of deposit insurance by identifying, assessing, and taking actions to mitigate risk to the Deposit Insurance Fund. To summarize, the regulatory reforms should focus on eliminating the regulatory gaps I have just outlined. Proposals to create a unified supervisor would undercut the many benefits of our dual banking system and would reduce the effectiveness of deposit insurance, and, most importantly, they would not address the fundamental causes of the current crisis. Thank you. " CHRG-111shrg53176--127 CONSUMER FEDERATION OF AMERICA Ms. Roper. Thank you for the opportunity to testify here today regarding the steps that the Consumer Federation of America believes are necessary to enhance investor protection and improve regulation of the securities market. My written testimony describes a dozen different policies in a dozen different areas. Out of respect for the length of today's hearing, I will confine my oral comments to just two of those, bringing the shadow banking system within the regulatory structure and reforming credit rating agencies. Before I get into the specifics of those issues, however, I would like to spend a brief moment discussing the environment in which this policy review is taking place. For nearly three decades, regulatory policy in this country has been based on a fundamental belief that market discipline and industry self-interest could be relied on to rein in Wall Street excesses. That was the philosophy that made the Fed deaf to warnings about unsustainable subprime mortgage lending. It was the philosophy that convinced an earlier Congress and administration to override efforts to regulate over-the-counter derivatives markets. And it is the philosophy that convinced financial regulators that financial institutions could be relied on to adopt appropriate risk management practices. In short, it was this misguided regulatory philosophy that brought about the current crisis and it is this philosophy that must change if we are to take the steps needed to prevent a recurrence. In talking about regulatory reform, many people have focused on creation of a Systemic Risk Regulator, and that is something CFA supports, although, as others have noted, the devil is in the details. We believe it is at least as important, however, to directly address the risks that got us into the current crisis in the first place, and that includes bringing the shadow banking system within the regulatory structure. Overwhelming evidence suggests that a primary use of the shadow banking system, and indeed a major reason for its existence, is to allow financial institutions to do indirectly what they would not be permitted to do directly in the regulated market. There are numerous examples of this in the recent crisis, including, for example, banks holding toxic assets through special purpose entities for which they would have had to set aside additional capital had they been held on balance sheets, or AIG offering insurance in the form of credit default swaps without any of the protections designed to ensure their ability to pay claims. The main justification for allowing these two systems to operate side by side, one regulated and one unregulated, is that sophisticated investors are capable of protecting their own interests. If that was true in the past, it is certainly not true today, and the rest of us are paying a heavy price for their failure to protect their interests. To be credible, therefore, any regulatory reform proposal must confront the shadow banking system issue head on. This does not mean that all financial activities must be subject to identical regulations, but it does mean that all aspects of the financial system must be subject to regulatory scrutiny. One focus of that regulation should be on protecting against risk that could spill over into the broader economy, but regulation should also apply basic principles of transparency, fair dealing, and accountability to these activities in recognition of two basic lessons of the current crisis: One, protecting investors and consumers contributes to the safety and stability of the financial markets; and two, the sheer complexity of modern financial products has made former measures of investor sophistication obsolete. Complex derivatives and mortgage-backed securities were the poison that contaminated the financial system, but it was their ability to attract high credit ratings that allowed them to penetrate every corner of the market. Given the repeated failure of the credit rating agencies in recent years to provide timely warnings of risk, it is tempting to conclude, as many have done, that the answer to this problem is simply to remove all references to credit ratings from our financial regulations. We are not yet prepared to recommend that step. Instead, we believe a better approach is found in simultaneously reducing, but not eliminating, our reliance on ratings; increasing the accountability of ratings agencies, by removing First Amendment protections that are inconsistent with their legally sanctioned status; and improving regulatory oversight. While we appreciate the steps Congress and this Committee in particular took in 2006 to enhance SEC oversight of ratings agencies, we believe the current crisis demands a more comprehensive response. As I said earlier, these are just two of the issues CFA believes deserve Congressional attention as part of a comprehensive reform plan. Nonetheless, we believe these two steps would go a long way toward reducing systemic risk, particularly combined with additional steps to improve regulatory oversight of systemic risks going forward. Bold plans are needed to match the scope of the crisis we face. CFA looks forward to working with this Commission to craft a reform plan that meets this test and restores investors' faith both in the integrity of our markets and in the effectiveness of our government in protecting their interests. Senator Reed. Thank you very much. " Mr. Tittsworth," STATEMENT OF DAVID G. TITTSWORTH, EXECUTIVE DIRECTOR AND fcic_final_report_full--265 Even high-quality assets that had nothing to do with the mortgage market were declining in value. One SIV marked down a CDO to seven cents on the dollar while it was still rated triple-A.  To raise cash, managers sold assets. But selling high-qual- ity assets into a declining market depressed the prices of these unimpaired securities and pushed down the market values of other SIV portfolios. By the end of November, SIVs still in operation had liquidated  of their portfo- lios, on average.  Sponsors rescued some SIVs. Other SIVs restructured or liquidated; some investors had to wait a year or more to receive payments and, even then, re- couped only some of their money. In the case of Rhinebridge, investors lost  and only gradually received their payments over the next year.  Investors in one SIV, Sigma, lost more than .  As of fall , not a single SIV remained in its original form. The subprime crisis had brought to its knees a historically resilient market in which losses due to subprime mortgage defaults had been, if anything, modest and localized. MONEY FUNDS AND OTHER INVESTORS: “DRINK ING  FROM A FIRE HOSE ” The next dominoes were the money market funds and other funds. Most were spon- sored by investment banks, bank holding companies, or “mutual fund complexes” such as Fidelity, Vanguard, and Federated. Under SEC regulations, money market funds that serve retail investors must keep two sets of accounting books, one reflect- ing the price they paid for securities and the other the fund’s mark-to-market value (the “shadow price,” in market parlance). However, funds do not have to disclose the shadow price unless the fund’s net asset value (NAV) has fallen by . below  (to .) per share. Such a decline in market value is known as “breaking the buck” and generally leads to a fund’s collapse. It can happen, for example, if just  of a fund’s portfolio is in an investment that loses just  of its value. So a fund manager cannot afford big risks. But SIVs were considered very safe investments—they always had been—and were widely held by money market funds. In fall , dozens of money market funds faced losses on SIVs and other asset-backed commercial paper. To prevent their funds from breaking the buck, at least  sponsors, including large banks such as Bank of America, US Bancorp, and SunTrust, purchased SIV assets from their money market funds.  fcic_final_report_full--46 In the s, the commercial paper market jumped more than sevenfold. Then in the s, it grew almost fourfold. Among the largest buyers of commercial paper were the money market mutual funds. It seemed a win-win-win deal: the mutual funds could earn a solid return, stable companies could borrow more cheaply, and Wall Street firms could earn fees for putting the deals together. By , commercial paper had risen to . trillion from less than  billion in .  The second major shadow banking market that grew significantly was the market for repos, or repurchase agreements. Like commercial paper, repos have a long his- tory, but they proliferated quickly in the s. Wall Street securities dealers often sold Treasury bonds with their relatively low returns to banks and other conservative investors, while then investing the cash proceeds of these sales in securities that paid higher interest rates. The dealers agreed to repurchase the Treasuries—often within a day—at a slightly higher price than that for which they sold them. This repo transac- tion—in essence a loan—made it inexpensive and convenient for Wall Street firms to borrow. Because these deals were essentially collateralized loans, the securities deal- ers borrowed nearly the full value of the collateral, minus a small “haircut.” Like com- mercial paper, repos were renewed, or “rolled over,” frequently. For that reason, both forms of borrowing could be considered “hot money”—because lenders could quickly move in and out of these investments in search of the highest returns, they could be a risky source of funding. The repo market, too, had vulnerabilities, but it, too, had emerged from an early crisis stronger than ever. In , two major borrowers, the securities firms Drysdale and Lombard-Wall, defaulted on their repo obligations, creating large losses for lenders. In the ensuing fallout, the Federal Reserve acted as lender of last resort to support a shadow banking market. The Fed loosened the terms on which it lent Treasuries to securities firms, leading to a -fold increase in its securities lending. Following this episode, most repo participants switched to a tri-party arrangement in which a large clearing bank acted as intermediary between borrower and lender, es- sentially protecting the collateral and the funds by putting them in escrow.  This mechanism would have severe consequences in  and . In the s, how- ever, these new procedures stabilized the repo market. The new parallel banking system—with commercial paper and repo providing cheaper financing, and money market funds providing better returns for consumers and institutional investors—had a crucial catch: its popularity came at the expense of the banks and thrifts. Some regulators viewed this development with growing alarm. According to Alan Blinder, the vice chairman of the Federal Reserve from  to , “We were concerned as bank regulators with the eroding competitive position of banks, which of course would threaten ultimately their safety and soundness, due to the competition they were getting from a variety of nonbanks—and these were mainly Wall Street firms, that were taking deposits from them, and getting into the loan business to some extent. So, yeah, it was a concern; you could see a downward trend in the share of banking assets to financial assets.”  CHRG-111hhrg53244--115 Mr. Bernanke," I think you would have had a very good chance of a collapse of the credit system. Even what we did see after the failure of Lehman was, for example, commercial paper rates shot up and availability declined. Many other markets were severely disrupted, including corporate bond markets. So even with the rescue and even with the stabilization that we achieved in October, there was a severe increase in stress in financial markets. My belief is that, if we had not had the money to address the global banking crisis in October, we might very well have had a collapse of the global banking system that would have created a huge problem in financial markets and in the broad economy that might have lasted many years. " CHRG-111shrg51395--33 Mr. Silvers," Good morning, Chairman Dodd and Ranking Member Shelby. Thank you for inviting me here today. Before I begin, I would like to note that in addition to my role as Associate General Counsel of the AFL-CIO, I am the Deputy Chair of the Congressional Oversight Panel created by the Emergency Economic Stabilization Act of 2008 to oversee the TARP. While I will describe in my testimony aspects of the Congressional Oversight Panel's report on regulatory reform, my testimony reflects my views alone and the views of the AFL-CIO unless otherwise noted and is not on behalf of the panel, its staff, or its chair. The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send their children to college, as you noted, Mr. Chairman, in your opening remarks. While the spectacular frauds like the Madoff Ponzi scheme have generated a great deal of publicity, the bigger question is what changes must be made to make our financial system a more reasonable place to invest the hard-earned savings of America's working families. Today, I will address this larger question at three levels: Regulatory architecture, regulating the shadow markets and the challenge of jurisdiction, and certain specific steps Congress and regulators should take to address holes in the investor protection scheme. First, with respect to regulatory architecture, the Congressional Oversight Panel in its special report on regulatory reform observed that addressing issues of systemic risk cannot be a substitute for a robust, comprehensive system of routine financial regulation. Investor protection within this system should be the focus of a single agency within the broader regulatory framework. That agency needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market intermediaries. This has been noted by several of the panelists prior to me. This mission is in natural tension with bank regulators' mission of safeguarding the safety and soundness of the banks they regulate, and that natural tension would apply to a Systemic Risk Regulator that was looking more broadly at safety and soundness issues. Because of these dynamics, effective investor protection requires that any solution to the problem of systemic risk prevention should involve the agency charged with investor protection and not supercede it. I have a more detailed document on issues associated with creating a Systemic Risk Regulator that I will provide the Committee following the hearing. I should just note that in relation to this, it is my belief that more of a group approach to systemic risk regulation rather than designating the Fed as the sole regulator would be preferable. Among the reasons for this are the issues of information sharing and coordination that other panelists raised, but most importantly, the fact that the Federal Reserve in its regulatory role fundamentally works through the regional Fed banks, which are fundamentally self-regulatory in nature. Several of the prior witnesses have mentioned some of the problems with self-regulation on critical issues. Furthermore, a Systemic Risk Regulator, as we have learned through the TARP experience, is likely to have to expend public dollars in extreme circumstances. It is completely inappropriate for that function to be vested in a body that is at all self-regulatory. While the Fed could be changed, its governance could be changed to make it fully a public agency, that would have implications, I believe, for the Fed's independence in its monetary policy role. Now, we have already in the Securities and Exchange Commission a regulator focused on investor protection. Although the Commission has suffered in recent years from diminished jurisdiction and leadership failure, the Commission remains an extraordinary government agency whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective re-regulation of the capital markets. This point flows right into the issue of jurisdiction and the shadow markets. The financial crisis we are currently experiencing is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system where the holes, the shadow markets, grew to dominate the regulated markets. The Congressional Oversight Panel specifically observed that we need to regulate financial products and institutions, in the words of President Obama, ``for what they do and not what they are.'' The Congressional Oversight Panel's report further stated that shadow institutions should be regulated by the same regulators that currently have jurisdiction over their regulated counterparts. So, for example, the SEC should have jurisdiction over derivatives that are written using public debt or equity securities as their underlying asset. At a minimum, the panel stated, hedge funds should also be regulated by the SEC in their role as money managers. There is a larger point here, though. Financial re-regulation will be utterly ineffective if it turns into a series of rifle shots at the particular mechanisms used to evade regulatory structures in earlier boom and bust cycles. What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of Federal securities regulation: Very broad, flexible jurisdiction that allowed the Commission to follow changing financial market practices. If you follow this principle, the SEC should have jurisdiction over anyone over a certain size who manages public securities and over any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC's jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC's leadership, as I gather some of my fellow panelists believe is necessary. Moving on to substantive reforms, beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long-term investors and to the channeling of capital to productive purposes. First, strong boards of publicly traded companies that the public invests in--having strong boards requires meaningful accountability to long-term investors. The AFL-CIO urges Congress to work with the SEC to ensure that long-term investors can nominate and elect psychologically independent directors to company boards through access to the corporate proxy. Second, effective investor protection requires comprehensive executive pay reform involving both disclosure governance and tax policy around two concepts. Equity-linked pay should be held significantly beyond retirement. And two, pay packages as a whole should reflect a rough equality of exposure to downside risk as well as to upside gain. Part of this agenda must be a mechanism for long-term shareholders to advise companies on their executive pay packages in the form of an advisory vote. Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. These cases effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are actual co-conspirators in securities frauds. Now, to address very briefly the international context, the Bush administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That needs to be replaced by a commitment on the part of the Obama administration, the Congress, and the regulators to building a strong global regulatory floor in coordination with the world's other major economies. However, Congress should not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to re-regulate U.S. financial markets and institutions. Obviously, this testimony simply sketches the outline of an approach and notes some key substantive steps for Congress and the administration to take. While I do not speak for the Oversight Panel, I think I am safe in saying that the Panel is honored to have been asked to assist Congress in this effort and is prepared to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL-CIO. Thank you. " fcic_final_report_full--117 The origination and securitization of these mortgages also relied on short-term fi- nancing from the shadow banking system. Unlike banks and thrifts with access to de- posits, investment banks relied more on money market funds and other investors for cash; commercial paper and repo loans were the main sources. With house prices al- ready up  from  to , this flood of money and the securitization appara- tus helped boost home prices another  from the beginning of  until the peak in April —even as homeownership was falling. The biggest gains over this pe- riod were in the “sand states”: places like the Los Angeles suburbs (), Las Vegas (), and Orlando (). FOREIGN INVESTORS: “AN IRRESISTIBLE PROFIT OPPORTUNITY ” From June  through June , the Federal Reserve kept the federal funds rate low at  to stimulate the economy following the  recession. Over the next two years, as deflation fears waned, the Fed gradually raised rates to . in  quarter- point increases. In the view of some, the Fed simply kept rates too low too long. John Taylor, a Stanford economist and former under secretary of treasury for international affairs, blamed the crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC, short-term interest rates would have been much higher, discourag- ing excessive investment in mortgages. “The boom in housing construction starts would have been much more mild, might not even call it a boom, and the bust as well would have been mild,” Taylor said.  Others were more blunt: “Greenspan bailed out the world’s largest equity bubble with the world’s largest real estate bubble,” wrote William A. Fleckenstein, the president of a Seattle-based money management firm.  Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed chairman argue that deciding to purchase a home depends on long-term interest rates on mortgages, not the short-term rates controlled by the Fed, and that short- term and long-term rates had become de-linked. “Between  and , the fed funds rate and the mortgage rate moved in lock-step,” Greenspan said.  When the Fed started to raise rates in , officials expected mortgage rates to rise, too, slow- ing growth. Instead, mortgage rates continued to fall for another year. The construc- tion industry continued to build houses, peaking at an annualized rate of . million starts in January —more than a -year high. As Greenspan told Congress in , this was a “conundrum.”  One theory pointed to foreign money. Developing countries were booming and—vulnerable to financial problems in the past—encouraged strong saving. Investors in these coun- tries placed their savings in apparently safe and high-yield securities in the United States. Fed Chairman Bernanke called it a “global savings glut.”  fcic_final_report_full--632 Survey, fourth-quarter 2008, p. 8. 23. Elizabeth Duke, governor, Federal Reserve Board, “Small Business Lending,” testimony before the House Committee on Financial Services and Committee on Small Business, February 26, 2010, p. 1. 24. National Federation of Independent Businesses, “NFIB Small Business Economic Trends,” De- cember 2010, p. 12. 25. Ben Bernanke, “Restoring the Flow of Credit to Small Business,” speaking at the Federal Reserve Meeting Series: “Addressing the Financing Needs of Small Businesses,” Washington, DC, July 12, 2010. 26. C. R. “Rusty” Cloutier, past chairman, Independent Community Bankers of America, testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 3: Financial Crisis Impacts on the Econ- omy, January 13, 2010, transcript, p. 194. 27. Federal Reserve Statistical Release, E.2 Survey of Terms of Business Lending, E.2 Chart Data: “Commercial and Industrial Loan Rates Spreads over Intended Federal Funds Rate, by Loan Size,” spread for all sizes. 28. William J. Dennis Jr., “Small Business Credit in a Deep Recession,” National Federation of Inde- pendent Businesses, February 2010, p. 18. 29. Jerry Jost, interview by FCIC, August 20, 2010. 30. Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Bank Lending Practices, April 2010. 31. Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Bank Lending Practices, July 2010. 32. Emily Maltby, “Small Biz Loan Failure Rate Hits 12%,” CNN Money, February 25, 2009; “SBA Losses Climb 154% in 2008,” Coleman Report (www.colemanpublishing.com/public/343.cfm). 33. Michael A. Neal, chairman and CEO, GE Capital, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 242. 34. GE, 2008 Annual Report, p. 38. 35. Mark S. Barber, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 263. 36. International Monetary Fund, International Financial Statistics database, World Exports. 37. International Monetary Fund, International Financial Statistics, World Tables: Exports, World Ex- ports. 38. Jane Levere, “Office Deals, 19 Months Apart, Show Market’s Move,” New York Times, August 10, 2010. 39. National Association of Realtors, Commercial Real Estate Quarterly Market Survey, December 2010, pp. 4, 5. 40. Brian Gordon, principal, Applied Analysis, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Es- tate, September 8, 2010, transcript, p. 155. 41. Anton Troianovski, “High Hopes as Builders Bet on Skyscrapers,” Wall Street Journal, September 29, 2010. 42. Ibid.; Gregory Bynum, president, Gregory D. Bynum & Associates, Inc., testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript, pp. 77–80, 77–78. 43. Federal Deposit Insurance Commission, “Failed Bank List,” January 2, 2010. 44. February Oversight Report, “Commercial Real Estate Losses and the Risk to Financial Stability,” Congressional Oversight Panel, February 10, 2010, pp. 2, 41, 45. 45. TreppWire, “CMBS Delinquency Rate Nears 9%, Up 21 BPs in August after Leveling in July, Rate Now 8.92%” Monthly Delinquency Report, September 2010, p. 1. 46. Allen Kenney, “CRE Mortgage Default Rate to Double by 2010,” REIT.com, June 18, 2009. See also “Default Rates Reach 16-Year High,” Globe St., February 24, 2010. 47. Ibid. Green Street Advisors, “Commercial Property Values Gain More Than 30% from ‘09 Lows,” December 2, 2010, pp. 3, 1. 48. “Moody’s/REAL Commercial Property Price Indices, December 2010,” Moody’s Investors Service Special Report, December 21, 2010; Moody’s Investors Service, “US Commercial Real Estate Prices Rise 1.3% in October,” December 20, 2010. 49. Congressional Oversight Panel, “Commercial Real Estate Losses,” February Oversight Report, CHRG-111shrg57320--438 Mr. Bowman," I actually would agree with everything that Chairman Bair said. Unfortunately, the OTS does not have separate regulatory responsibility or regulation writing responsibility. That goes to the Federal Reserve as HOEPA. And in terms of guidance versus regulation, regulation is the way to go in that regard. The only difficulty and the only caution I might have, taking Chairman Bair's point, one is it has to be applied across the board, both to regulated depository institutions as well as what is euphemistically referred to as the shadow banking agencies or the shadow banking industry. I think we also have to be careful in terms of, right now, we are getting lots of indications that there is a credit crunch going on in our country. Consumers, small businesses, individuals don't have the kind of access to credit that they believe they need. Some of that may be an overreaction to the response to what happened in 2003 through 2007, but the more prescriptive we become in terms of the kinds of products that are made available to consumers, I think it could have an impact upon availability of credit. Senator Levin. Subject to that risk, it is important, though, that we be clear and prescriptive? Subject to that risk that you have just outlined---- " CHRG-111hhrg54868--85 Mr. Scott," I know my time is running out. It is about to run out, too. But I did want to get to, why are so many banks closing, especially in the State of Georgia? What is there? Is there something we can point to that is going on in Georgia to explain why so many of these banks are closing? Ms. Bair. There are a lot of banks in Georgia. It was a boom area. Now, many of the boom areas are bust areas. There is residential mortgage distress and a lot of commercial real estate distress as well. In Georgia, like other parts of the country, it is broader economic problems that are feeding losses on bank balance sheets, which is driving closures as well. One of the best things you can do for the banking system, especially community banks, is to get the economy going again quickly, keep the unemployment rate down, get those retailers back in business, and get those hotels full again. Those are the kinds of things that will help banks as well. In Georgia, bank closures were a symptom of a lot of banks existing in the State, plus it was a great boom area. And as in other areas, like Florida, southern California, and Nevada, Georgia is having a severe bust now. " fcic_final_report_full--475 Indeed, the Commission’s entire investigation seemed to be directed at minimizing the role of NTMs and the role of government housing policy. In this telling, the NTMs were a “trigger” for the financial crisis, but once the collapse of the bubble had occurred the “weaknesses and vulnerabilities” of the financial system— which had been there all along—caused the crisis. These alleged deficiencies included a lack of adequate regulation of the so-called “shadow banking system” and over-the-counter derivatives, the overly generous compensation arrangements on Wall Street, and securitization (characterized as “the originate to distribute model”). Coincidentally, all these purported weaknesses and vulnerabilities then required more government regulation, although their baleful presence hadn’t been noted until the unprecedented number of subprime and Alt-A loans, created largely to comply with government housing policies, defaulted. 6. Conclusion What is surprising about the many views of the causes of the financial crisis that have been published since the Lehman bankruptcy, including the Commission’s own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble and the mortgage meltdown that followed its deflation were the precipitating causes—sometimes characterized as the “trigger”—of the financial crisis, and (ii) a seemingly studious effort to avoid examining how it came to be that mortgage underwriting standards declined to the point that the bubble contained so many NTMs that were ready to fail as soon as the bubble began to deflate. Instead of thinking through what would almost certainly happen when these assets virtually disappeared from balance sheets, many observers—including the Commission majority in their report—pivoted immediately to blame the “weaknesses and vulnerabilities” of the free market or the financial or regulatory system, without considering whether any system could have survived such a blow. One of the most striking examples of this approach was presented by Larry Summers, the head of the White House economic council and one of the President’s key advisers. In a private interview with a few of the members of the Commission (I was not informed of the interview), Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? 44 The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence 44 FCIC, Summers interview, p.77. of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises. fcic_final_report_full--43 This new system threatened the once-dominant traditional commercial banks, and they took their grievances to their regulators and to Congress, which slowly but steadily removed long-standing restrictions and helped banks break out of their tra- ditional mold and join the feverish growth. As a result, two parallel financial sys- tems of enormous scale emerged. This new competition not only benefited Wall Street but also seemed to help all Americans, lowering the  costs  of their mortgages and boosting the returns on their (k)s. Shadow banks and commer- cial banks were codependent competitors. Their new activities were very prof- itable—and, it turned out, very risky. Second, we look at the evolution of financial regulation. To the Federal Reserve and other regulators, the new dual system that granted greater license to market par- ticipants appeared to provide a safer and more dynamic alternative to the era of tradi- tional banking. More and more, regulators looked to financial institutions to police themselves—“deregulation” was the label. Former Fed chairman Alan Greenspan put it this way: “The market-stabilizing private regulatory forces should gradually dis- place many cumbersome, increasingly ineffective government structures.”  In the Fed’s view, if problems emerged in the shadow banking system, the large commercial banks—which were believed to be well-run, well-capitalized, and well-regulated de- spite the loosening of their restraints—could provide vital support. And if problems outstripped the market’s ability to right itself, the Federal Reserve would take on the responsibility to restore financial stability. It did so again and again in the decades leading up to the recent crisis. And, understandably, much of the country came to as- sume that the Fed could always and would always save the day. Third, we follow the profound changes in the mortgage industry, from the sleepy days when local lenders took full responsibility for making and servicing -year loans to a new era in which the idea was to sell the loans off as soon as possible, so that they could be packaged and sold to investors around the world. New mortgage products proliferated, and so did new borrowers. Inevitably, this became a market in which the participants—mortgage brokers, lenders, and Wall Street firms—had a greater stake in the quantity of mortgages signed up and sold than in their quality. We also trace the history of Fannie Mae and Freddie Mac, publicly traded corpora- tions established by Congress that became dominant forces in providing financing to support the mortgage market while also seeking to maximize returns for investors. Fourth, we introduce some of the most arcane subjects in our report: securitiza- tion, structured finance, and derivatives—words that entered the national vocabu- lary as the financial markets unraveled through  and . Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. This entire market de- pended on finely honed computer models—which turned out to be divorced from reality—and on ever-rising housing prices. When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed  years earlier, were the first dominoes to fall in the finan- cial sector. FOMC20080724confcall--63 61,MR. DUDLEY.," I also want to point out that for the banks that don't have enough collateral today, that doesn't mean that they don't have collateral available. It is just that the collateral hasn't been pledged at the window. So the bottom line is that we don't think that the overcollateralization requirement is very constraining--to use economics terms, the shadow price of collateral is pretty close to zero as far as we can tell. " CHRG-111shrg56415--24 Mr. Tarullo," Well, Senator, as you know, I cannot---- Senator Bunning. I am not going to get into that dispute with you. " Mr. Tarullo," OK. So let me just leave it there, though, with--I think with respect to the bank---- Senator Bunning. Ms. Bair, would you like to comment about your ability to regulate the banks with the power that you now have? Ms. Bair. There may be certain detailed areas, for instance, back-up authority, where through our good working relationships, we are able to effectively use it. Although, if we ever needed to bring an enforcement action with back-up authority, it is a fairly protracted process. Going forward as part of reform, we would like to see greater consistency in standards, particularly capital standards, between bank holding companies and banks. We think bank holding companies should be a source of strength for banks and should at least have as strong a capital level and quality of capital as the banks. There are a few areas where we would like to see some improvements, and that is not a secret. My fellow regulators know of our views on that. But, overall, I think the powers for both banks and bank holding companies have been pretty adequate, and perhaps there are areas where we could have used them better. Again, in terms of reform, looking at the disparities between the bank and the non-bank sector cannot be emphasized enough. As we try to improve the robust nature and quality of bank and bank holding company regulation, if there is still a giant shadow sector out there that is basically beyond the reach of meaningful prudential oversight, you are going to have the same problem that drove this crisis. Higher-risk activity will go into that shadow sector. Senator Bunning. That is basically what I am asking. In other words, if there is a bank either that you are in charge of or the OCC or the holding companies, and they are doing things that you know that get them in trouble, can you stop it? Ms. Bair. Yes. " fcic_final_report_full--453 The shadow banking business . The large investment banks—Bear, Lehman, Merrill, Goldman Sachs and Morgan Stanley—all encountered diffi culty in the financial crisis, and the Commission majority’s report lays much of the blame for this at the door of the Securities and Exchange Commission (SEC) for failing adequately to supervise them. It is true that the SEC’s supervisory process was weak, but many banks and S&Ls—stringently regulated under FDICIA—also failed. This casts doubt on the claim that if investment banks had been regulated like commercial banks— or had been able to offer insured deposits like commercial banks—they would not have encountered financial diffi culties. The reality is that the business model of the investment banks was quite different from banking; it was to finance a short-term trading business with short-term liabilities such as repurchase agreements (often called repos). This made them especially vulnerable in the panic that occurred in 2008, but it is not evidence that the existence of investment banks, or the quality of their regulation, was a cause of the financial crisis. Failures of risk management . Claims that there was a general failure of risk management in financial institutions or excessive leverage or risk-taking are part of what might be called a “hindsight narrative.” With hindsight, it is easy to condemn managers for failing to see the dangers of the housing bubble or the underpricing of risk that now looks so clear. However, the FCIC interviewed hundreds of financial experts, including senior offi cials of major banks, bank regulators and investors. It is not clear that any of them—including the redoubtable Warren Buffett—were suffi ciently confident about an impending crisis that they put real money behind their judgment. Human beings have a tendency to believe that things will continue to go in the direction they are going, and are good at explaining why this must be so. Blaming the crisis on the failure to foresee it is facile and of little value for policymakers, who cannot legislate prescience. The fact that virtually all participants in the financial system failed to foresee this crisis—as they failed to foresee every other crisis—does not tell us anything about why this crisis occurred or what we should do to prevent the next one. 1 See, e.g., Peter J. Wallison, “Deregulation and the Financial Crisis: Another Urban Myth,” Financial Services Outlook , American Enterprise Institute, October 2009. 447 CHRG-111shrg51395--128 PREPARED STATEMENT OF DAMON A. SILVERS Associate General Counsel, AFL-CIO March 10, 2009 Good morning, Chairman Dodd and Senator Shelby. My name is Damon Silvers, I am an Associate General Counsel of the AFL-CIO, and I am the Deputy Chair of the Congressional Oversight Panel created under the Emergency Economic Stabilization Act of 2008 to oversee the TARP. While I will describe the Congressional Oversight Panel's report on regulatory reform, my testimony reflects my views and the views of the AFL-CIO unless otherwise noted, and is not on behalf of the Panel, its staff or its chair, Elizabeth Warren. The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send their children to college. Most investors' goals are long term, and most investors rely on others to manage their money. While the boom and bust cycles of the last decade generated fees for Wall Street--in many cases astounding fees--they have turned out to have been a disaster for most investors. The 10-year nominal rate of return on the S&P 500 is now negative, and returns for most other asset classes have turned out to be more correlated with U.S. equity markets than anyone would have imagined a decade ago. While the spectacular frauds like the Madoff ponzi scheme have generated a great deal of publicity, the bigger questions are (1) how did our financial system as a whole become so weak how did our system of corporate governance, securities regulation, and disclosure-based market discipline fail to prevent trillions of dollars from being invested in value-destroying activities--ranging from subprime mortgages and credit cards, to the stocks and bonds of financial institutions, to the credit default swaps pegged to those debt instruments; and (2) what changes must be made to make our financial system a more reasonable place to invest the hard earned savings of America's working families? My testimony today will seek to answer the second question at three levels: 1 How should Congress strengthen the regulatory architecture to better protect investors; 2. How should Congress think about designing regulatory jurisdiction to better protect investors; and 3. What are some specific substantive steps Congress and the regulators should take to shore up our system of investor protections? Finally, I will briefly address how to understand the challenge of investor protection in globalized markets.Regulatory Architecture While there has been much discussion of the need for better systemic risk regulation, the Congressional Oversight Panel, in its Special Report on Regulatory Reform issued on January 29, 2009, observed that addressing issues of systemic risk cannot be a substitute for a robust, comprehensive system of routine financial regulation. \1\ There are broadly three types of routine regulation in the financial markets--(1) safety and soundness regulation for insured institutions like banks and insurance companies; (2) disclosure and fiduciary duty regulation for issuers and money managers in the public securities markets; and (3) substantive consumer protection regulation in areas like mortgages, credit cards, and insurance. These are distinct regulatory missions in significant tension with each other.--------------------------------------------------------------------------- \1\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 3 (Jan. 29, 2009), available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- Investors, people who seek to put money at risk for the prospect of gains, really are interested in transparency, enforcement of fiduciary duties, and corporate governance. This is the investor protection mission. It is often in tension with the equally legitimate regulatory mission of protecting the safety and soundness of insured financial institutions. A safety and soundness regulator is likely to be much more sympathetic to regulated entities that want to sidestep telling the investing public bad news. At the same time, investor protection is not the same thing as consumer protection--the consumer looking for home insurance or a mortgage is seeking to purchase a financial service with minimal risk, not to take a risk in the hope of a profit. Because these functions should not be combined, investor protection should be the focus of a single agency within the broader regulatory framework. That agency needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market intermediaries. Any solution to the problem of systemic risk prevention should involve the agency charged with investor protection, and not supersede it. Since the New Deal, the primary body charged with enforcing investor protections has been the Securities and Exchange Commission. Although the Commission has suffered in recent years from diminished jurisdiction and leadership failure, it remains an extraordinary government agency, whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective reregulation of the capital markets. While I have a great deal of respect for former Treasury Secretary Paulson, there is no question that his blueprint for financial regulatory reform was profoundly deregulatory in respect to the Securities and Exchange Commission. \2\ He and others, like the self-described Committee on Capital Markets Regulation led by Harvard Professor Hal Scott, sought to dismantle the Commission's culture of arms length, enforcement-oriented regulation and to replace it with something frankly more captive to the businesses it regulated. \3\ While these deregulatory approaches have fortunately yet to be enacted, they contributed to an environment that weakened the Commission politically and demoralized its staff.--------------------------------------------------------------------------- \2\ Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure, at 11-13, 106-126 (Mar. 2008), available at http://www.treas.gov/press/releases/reports/Blueprint.pdf \3\ Committee on Capital Markets Regulation, Interim Report (Nov. 30, 2006), available at http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf; Committee on Capital Markets Regulation, The Competitive Position of the U.S. Public Equity Market (Dec. 4, 2007), available at http://www.capmktsreg.org/pdfs/The_Competitive_Position_of_the_US_Public_Equity_Market.pdf--------------------------------------------------------------------------- While there has been a great deal of attention paid to the Commission's failure to spot the Madoff ponzi scheme, there has been insufficient attention to the Commission's performance in relation to the public debt markets, where the SEC regulates more than $438.3 billion in outstanding securities related to home equity loans and manufactured housing loans, among the riskiest types of mortgages. Similarly, little attention has been paid to the oversight of disclosures by the financial and homebuilding firms investing in and trading in those securities, and perhaps most importantly, the lack of action by the Commission once the financial crisis began. \4\--------------------------------------------------------------------------- \4\ Securities Industry and Financial Markets Association, Market Sector Statistics: Asset Backed Securities--Outstanding By Major Types of Credit.--------------------------------------------------------------------------- But elections have consequences, and one of those consequences should be a renewed commitment by both Congress and the new Administration to revitalizing the Commission and to rebuilding the Commission's historic investor protection oriented culture and mission. The President's budget reflects that type of approach in the funding it seeks for the Commission, and the new Chair of the Commission Mary Schapiro has appeared to be focused on just this task in her recent statements. \5\--------------------------------------------------------------------------- \5\ See, e.g., Speech by SEC Chairman: Address to Practising Law Institute's ``SEC Speaks in 2009'' Program available at http://sec.gov/news/speech/2009/spch020609mls.htm--------------------------------------------------------------------------- A key issue the Commission faces is how to strengthen its staff. Much of what needs to be done is in the hands of the Commission itself, where the Chair and the Commissioners set the tone for better or for worse. When Commissioners place procedural roadblocks in the way of enforcing the law, good people leave the Commission and weak staff are not held accountable. When the Chair sets a tone of vigorous enforcement of the laws and demands a genuine dedication to investor protection, the Commission both attracts and retains quality people. Congress should work with the Commission to determine if changes are needed to personnel rules to enable the Commission to attract and retain key personnel. The Commission should look at more intensive recruiting efforts aimed at more experienced private sector lawyers who may be looking for public service opportunities--perhaps through a special fellows program. On the other hand, Congress should work with the Commission to restrict the revolving door--ideally by adopting the rule that currently applies to senior bank examiners for senior Commission staff--no employment with any firm whose matters the staffer worked on within 12 months.Regulating the Shadow Markets and the Problem of Jurisdiction The financial crisis is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system, where the holes, the shadow markets, grew to dominate the regulated markets. If we are going to lessen future financial boom and bust cycles, Congress must give the regulators the tools and the jurisdiction to regulate the shadow markets. In our report of January 29, the Congressional Oversight Panel specifically observed that we needed to regulate financial products and institutions, in the words of President Obama, ``for what they do, not what they are.'' \6\ We further noted in that report that shadow market products and institutions are nothing more than new names and new legal structures for very old activities like insurance (read credit default swaps) and money management (read hedge funds and private equity/lbo funds). \7\--------------------------------------------------------------------------- \6\ Senator Barack Obama, Renewing the American Economy, Speech at Cooper Union in New York (Mar. 27, 2008) (transcript available at http://www.nytimes.com/2008/03/27/us/politics/27text-obama.html?pagewanted=all); Congressional Oversight Panel, Special Report on Regulatory Reform, at 29. \7\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 29.--------------------------------------------------------------------------- The Congressional Oversight Panel's report stated that shadow institutions should be regulated by the same regulators who currently have jurisdiction over their regulated counterparts. \8\ So, for example, the SEC should have jurisdiction over derivatives that are written using public debt or equity securities as their underlying asset. The Congressional Oversight Panel stated that at a minimum, hedge funds should also be regulated by the SEC in their roles as money managers by being required to register as investment advisors and being subject to clear fiduciary duties, the substantive jurisdiction of U.S. law, and periodic SEC inspections. \9\ To the extent a hedge fund or anyone else engages in writing insurance contracts or issuing credit, however, it should be regulated by the bodies charged with regulating that type of economic activity.--------------------------------------------------------------------------- \8\ Id. \9\ Id.--------------------------------------------------------------------------- Some have suggested having such shadow market financial products as derivatives and hedge funds simply regulated by a systemic regulator. This would be a terrible mistake. Shadow market products and institutions need to be brought under the same routine regulatory umbrella as other financial actors. To take a specific case, while it is a good idea to have public clearinghouses for derivatives trading, that reform by itself is insufficient without capital requirements for the issuers of derivatives and without disclosure and the application of securities law principles, generally, to derivatives based on public securities regulations. So, for example, the SEC should require the same disclosure of short positions in public equities that it requires of long positions in equities, whether those positions are created through the securities themselves or synthetically through derivatives or futures. The historic distinctions between broker-dealers and investment advisors have been eroding in the markets for years. In 2007, the Federal Appeals Court for the District of Columbia issued an opinion overturning Commission regulations seeking to better define the boundary between the two. \10\ The Commission should look at merging the regulation of the categories while ensuring that the new regulatory framework preserves clear fiduciary duties to investors. As part of a larger examination of the duties owed by both broker-dealers and investment advisors to investors, the Commission ought to examine the fairness and the efficacy of the use of arbitration as a form of dispute resolution by broker-dealers. Finally, part of what must be done in this area is to determine whether the proper regulatory approach will require Congressional action in light of the D.C. Circuit opinion.--------------------------------------------------------------------------- \10\ Fin. Planning Ass'n v. SEC, 482 F.3d 481 (D.C. Cir. 2007).--------------------------------------------------------------------------- But there is a larger point here. Financial reregulation will be utterly ineffective if it turns into a series of rifle shots at the particular mechanisms used to evade regulatory structures in earlier boom and bust cycles. What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of federal securities regulation--very broad, flexible jurisdiction that allowed the SEC to follow the activities. By this principle, the SEC should have jurisdiction over anyone over a certain size who manages public securities, and over any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC's jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC's leadership. Much regulatory thinking over the last couple of decades has been shaped by the idea that sophisticated parties should be allowed to act in financial markets without regulatory oversight. Candidly, some investors have been able to participate in a number of relatively lightly regulated markets based on this idea. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. I do not mean to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has to be a level of transparency, accountability, and mandated risk management across the financial markets. Finally, while it is not technically a shadow market, the underregulation of the credit rating agencies has turned out to have devastating consequences. The Congressional Oversight Panel called particular attention to the dysfunctional nature of the issuer pays model, and recommended a set of options for needed structural change--from the creation of PCAOB-type oversight body to the creation of a public or non-profit NRSRO. \11\--------------------------------------------------------------------------- \11\ Id. at 40-44.---------------------------------------------------------------------------Substantive Reforms Beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long term investors and to the channeling of capital to productive purposes. There is no way to look at the wreckage surrounding us today in the financial markets and not conclude we have had a regulatory regime that, intentionally or not, facilitated grotesquely short-term thinking and led to capital flowing in unheard of proportions to pointless or destructive ends. This is a large task, and I will simply point out some of the most important steps that need to be taken in three areas--governance, executive pay, and litigation. First, in the area of governance, once again the weakness of corporate boards, particularly in the financial sector, appears to be a central theme in the financial scandal. The AFL-CIO has interviewed the audit committees of a number of the major banks to better understand what happened. We found in general very weak board oversight of risk--evidenced in audit committee leadership who did not understand their companies' risk profiles, and in boards that tolerated the weakening of internal risk management. Strong boards require meaningful accountability to investors. Short-term, leveraged investors have been the most powerful voices in corporate governance in recent years, with destructive results. The AFL-CIO urges Congress to work with the SEC to ensure that there are meaningful, useable ways for long-term investors to nominate and elect psychologically independent directors to public company boards through access to the corporate proxy. I put the stress here on long-term--there must be meaningful holding time requirements for exercising this right. Recent statements by SEC Chair Mary Schapiro suggest she is focused on this area, and we urge the Congress to support her efforts. \12\--------------------------------------------------------------------------- \12\ Rachelle Younglai, SEC developing proxy access plans: sources, REUTERS, Mar. 6, 2009, at http://www.reuters.com/article/bernardMadoff/idUSTRE52609820090307--------------------------------------------------------------------------- Second, effective investor protection requires a comprehensive approach to reform in the area of executive pay. Proxy access is an important first step in this area, but we should learn from the financial crisis how destructive short-term oriented, asymmetric executive pay can be for long-term investors and for our economy. The focus of the Congressional Oversight Panel's recommendations in the area of executive pay were on ending these practices in financial institutions. \13\ Here Chairman Dodd's leadership has been very helpful in the context of the TARP.--------------------------------------------------------------------------- \13\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 37-40.--------------------------------------------------------------------------- But Congress and the Administration should pursue a comprehensive approach to executive pay reform around two concepts--equity linked pay should be held beyond retirement, and pay packages as a whole should reflect a rough equality of exposure to downside risk as to upside gain. Orienting policy in this direction requires coordination between securities regulation and tax policy. But we could begin to address what has gone wrong in executive pay incentives by (1) developing measurements for both the time horizon and the symmetry of risk and reward of pay packages that could be included in pay disclosure; (2) looking more closely at mutual fund proxy voting behavior to see if it reflects the time horizons of the funds; (3) focusing FINRA inspections of broker dealer pay policies on these two issues; and (4) providing for advisory shareholder votes on pay packages. With respect to say on pay, any procedural approaches that strengthened the hand of long term investors in the process of setting executive compensation would be beneficial. Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. \14\ These cases effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are co-conspirators in securities frauds. It appeared for a time after Enron that the courts were going to restore some sanity in this area of the law on their own, by finding a private right of action when service providers were actually not just aiders and abetters of a fraud, but actual co-conspirators. In the Stoneridge decision, with the Enron case looming over them, the Supreme Court made clear Congress would have to act. The issue here of course is not merely fairness to the investors defrauded in a particular case--it is the incentives for financial institutions to police their own conduct. We seem to have had a shortage of such incentives in recent years.--------------------------------------------------------------------------- \14\ Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994); Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008).---------------------------------------------------------------------------The International Context The Bush Administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That approach has been discredited. It needs to be replaced by a commitment on the part of the Obama Administration to building a strong global regulatory floor in coordination with the world's other major economies. This effort is vital not only for protecting U.S. investors in global markets, but for protecting our financial sector from the consequences of a global regulatory race to the bottom that will inevitably end in the kind of financially driven economic crisis that we are living through today. Congress can play a part by seeking to strengthen its relationships with its counterpart legislative bodies in the major world markets, and should look for opportunities to coordinate setting regulatory standards on a global basis. The Administration needs to make this effort a priority, and to understand that it needs to extend beyond the narrow confines of systemic risk and the banking system to issues of transparency and investor protection. However, Congress must not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to reregulate U.S. financial markets and institutions. That task is urgent and must be addressed if the U.S. is to recover from the blow this financial crisis has delivered to our private capital markets' reputation as the gold standard for transparency and accountability.Conclusion The task of protecting investors by reregulating our financial system and restoring vitality to our regulators is a large one. This testimony simply sketches the outline of an approach, and notes some key substantive steps Congress and the Administration need to take. This Committee has already taken a leadership role in a number of these areas, but there is much more to be done. Even in areas where the primary responsibility must lie with regulators, there is a much needed role for Congress to oversee, encourage, and support the efforts of the Administration. While I do not speak for the Congressional Oversight Panel, I think I am safe in saying that the Panel is honored to have been asked to assist Congress in this effort, and is prepared to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL-CIO. Thank you.SUPPLEMENT--March 10, 2009 The challenge of addressing systemic risk in the future is one, but by no means the only one, of the challenges facing Congress as Congress considers how to reregulate U.S. financial markets following the extraordinary events of the last 18 months. Systemic crises in financial markets harm working people. Damaged credit systems destroy jobs rather than create them. Pension funds with investments in panicked markets see their assets deteriorate. And the resulting instability undermines business' ability to plan and obtain financing for new investments--undermining the long term growth and competitiveness of employers and setting the stage for future job losses. The AFL-CIO has urged Congress since 2006 to act to reregulate shadow financial markets, and the AFL-CIO supports addressing systemic risk, but in a manner that does not substitute for strengthening the ongoing day to day regulatory framework, and that recognizes addressing systemic risk both requires regulatory powers and financial resources that can really only be wielded by a fully public body. The concept of systemic risk is that financial market actors can create risk not just that their institutions or portfolios will fail, but risk that the failure of their enterprises will cause a broader failure of other financial institutions, and that such a chain of broader failures can jeopardize the functioning of financial markets as a whole. The mechanisms by which this broader failure can occur involve a loss of confidence in information, or a loss of confidence in market actors ability to understand the meaning of information, which leads to the withdrawal of liquidity from markets and market institutions. Because the failure of large financial institutions can have these consequence, systemic risk management generally is seen to both be about how to determine what to do when a systemically significant institution faces failure, and about how to regulated such institutions in advance to minimize the chances of systemic crises. Historically, the United States has had three approaches to systemic risk. The first was prior to the founding of the Federal Reserve system, when there was a reluctance at the Federal level to intervene in any respect in the workings of credit markets in particular and financial markets in general. The Federal Reserve system, created after the financial collapse of 1907, ushered in an era where the Federal Government's role in addressing systemic risk largely consisted of sponsoring through the Federal Reserve system, a means of providing liquidity to member banks, and thus hopefully preventing the ultimate liquidity shortage that results from market participants losing confidence in the financial system as a whole. But then, after the Crash of 1929 and the 4 years of Depression that followed, Congress and the Roosevelt Administration adopted a regulatory regime whose purpose was in a variety of ways to substantively regulate financial markets in an ongoing way. This new approach arose out of a sense among policymakers that the systemic financial crisis associated with the Great Depression resulted from the interaction of weakly regulated banks with largely unregulated securities markets, and that exposing depositors to these risks was a systemic problem in and of itself. Such centerpieces of our regulatory landscape as the Securities and Exchange Commission's disclosure based system of securities regulation and the Federal Deposit Insurance Corporation came into being not just as systems for protecting the economic interests of depositors or investors, but as mechanisms for ensuring systemic stability by, respectively, walling off bank depositors from broader market risks, and ensuring investors in securities markets had the information necessary to make it possible for market actors to police firm risk taking and to monitor the risks embedded in particular financial products. In recent years, financial activity has moved away from regulated and transparent markets and institutions and into the so-called shadow markets. Regulatory barriers like the Glass-Steagall Act that once walled off less risky from more risky parts of the financial system have been weakened or dismantled. So we entered the recent period of extreme financial instability with an approach to systemic risk that looked a lot like that of the period following the creation of the Federal Reserve Board but prior to the New Deal era. And so we saw the policy response to the initial phases of the current financial crisis primarily take the form of increasing liquidity into credit markets through interest rate reductions and increasingly liberal provision of credit to banks and then to non-bank financial institutions. However, with the collapse of Lehman Brothers and the Federal rescues of AIG, FNMA, and the FHLMC, the federal response to the perception of systemic risk turned toward much more aggressive interventions in an effort to ensure that after the collapse of Lehman Brothers, there would be no more defaults by large financial institutions. This approach was made somewhat more explicit with the passage of the Emergency Economic Stabilization Act of 2008 and the commencement of the TARP program. The reality was though that the TARP program was the creature of certain very broad passages in the bill, which generally was written with the view that the federal government would be embarking on the purchase of troubled assets, a very different approach than the direct infusions of equity capital that began with the Capital Purchase Program in October of 2008. We can now learn some lessons from this experience for the management of systemic risk in the financial system. First, our government and other governments around the world will step in when major financial institutions face bankruptcy. We do not live in a world of free market discipline when it comes to large financial institutions, and it seems unlikely we ever will. If two administrations as different as the Bush Administration and the Obama Administration agree that the Federal Government must act when major financial institutions fail, it is hard to imagine the administration that would do differently. Since the beginning of 2008, we have used Federal dollars in various ways to rescue either the debt or the equity holders or both at the following companies--Bear Stearns, Indymac, Washington Mutual, AIG, Merrill Lynch, Fannie Mae, Freddie Mac, Citigroup, and Bank of America. But we have no clear governmental entity charged with making the decision over which company to rescue and which to let fail, no clear criteria for how to make such decisions, and no clear set of tools to use in stabilizing those that must be stabilized. Second, we appear to be hopelessly confused as to what it means to stabilize a troubled financial institution to avoid systemic harm. We have a longstanding system of protecting small depositors in FDIC insured banks, and by the way policyholders in insurance companies through the state guarantee funds. The FDIC has a process for dealing with banks that fail--a process that does not always result in 100 percent recoveries for uninsured creditors. Then we have the steps taken by the Treasury Department and the Federal Reserve since Bear Stearns collapsed. At some companies, like Fannie Mae and Freddie Mac, those steps have guaranteed all creditors, but wiped out the equity holders. At other companies, like Bear Stearns, AIG, and Wachovia, while the equity holders survive, they have been massively diluted one way or another. At others, like Citigroup and Bank of America, the equity has been only modestly diluted when looked at on an upside basis. It is hard to understand exactly what has happened with the government's interaction with Morgan Stanley and Goldman Sachs, but again there has been very little equity dilution. And then there is poor Lehman Brothers, apparently the only non-systemic financial institution, where everybody lost. In crafting a systematic approach to systemically significant institutions, we should begin with the understanding that while a given financial institution may be systemically significant, not every layer of its capital structure should be necessarily propped up with taxpayer funds. Third, much regulatory thinking over the last couple of decades has been shaped by the idea that sophisticated parties should be allowed to act in financial markets without regulatory oversight. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. This is not to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has to be a level of transparency, accountability, and mandated risk management across the financial markets. Fourth, financial markets are global now. Norwegian villages invest in U.S. mortgage backed securities. British bankruptcy laws govern the fate of U.S. clients of Lehman Brothers, an institution that appeared to be a U.S. institution. AIG, our largest insurance company, collapsed because of a London office that employed 300 of AIG's 500,000 employees. Chinese industrial workers riot when U.S. real estate prices fall. We increasingly live in a world where the least common denominator in financial regulation rules. So what lessons should we take away for how to manage systemic risk in our financial system? The Congressional Oversight Panel, in its report to Congress made the following points about addressing systemic risk: 1. There should be a body charged with monitoring sources of systemic risk in the financial system, but it could either be a new body, an existing agency, or a group of existing agencies; 2. The body charged with systemic risk managements should be fully accountable and transparent to the public in a manner that exceeds the general accountability mechanisms present in self- regulatory organizations; 3. We should not identify specific institutions in advance as too big to fail, but rather have a regulatory framework in which institutions have higher capital requirements and pay more on insurance funds on a percentage basis than smaller institutions which are less likely to be rescued as being too systemic to fail. 4. Systemic risk regulation cannot be a substitute for routine disclosure, accountability, safety and soundness, and consumer protection regulation of financial institutions and financial markets. 5. Ironically, effective protection against systemic risk requires that the shadow capital markets--institutions like hedge funds and products like credit derivatives--must not only be subject to systemic risk oriented oversight but must also be brought within a framework of routine capital market regulation by agencies like the Securities and Exchange Commisson. 6. There are some specific problems in the regulation of financial markets, such as the issue of the incentives built into executive compensation plans and the conflict of interest inherent in the credit rating agencies' business model of issuer pays, that need to be addressed to have a larger market environment where systemic risk is well managed. 7. Finally, there will not be effective reregulation of the financial markets without a global regulatory floor. I would like to explain some of these principles and at least the thinking I brought to them. First, on the issue of a systemic risk monitor, while the Panel made no recommendation, I have come to believe that the best approach is a body with its own staff and a board made up of the key regulators, perhaps chaired by the Chairman of the Board of Governors of the Federal Reserve. There are several reasons for this conclusion. First, this body must have as much access as possible to all information extant about the condition of the financial markets--including not just bank credit markets, but securities and commodities, and futures markets, and consumer credit markets. As long as we have the fragmented bank regulatory system we now have, this body would need access to information about the state of all deposit taking institutions. The reality of the interagency environment is that for information to flow freely, all the agencies involved need some level of involvement with the agency seeking the information. Connected with the information sharing issue is expertise. It is unlikely a systemic risk regulator would develop deep enough expertise on its own in all the possible relevant areas of financial activity. To be effective it would need to cooperate in the most serious way possible with all the routine regulators where the relevant expertise would be resident. Second, this coordinating body must be fully public. While many have argued the need for this body to be fully public in the hope that would make for a more effective regulatory culture, the TARP experience highlights a much more bright line problem. An effective systemic risk regulator must have the power to bail out institutions, and the experience of the last year is that liquidity provision is simply not enough in a real crisis. An organization that has the power to expend public funds to rescue private institutions must be a public organization--though it should be insulated from politics much as our other financial regulatory bodies are by independent agency structures. Here is where the question of the role of the Federal Reserve comes in. A number of commentators and Fed officials have pointed out that the Fed has to be involved in any body with rescue powers because any rescue would be mounted with the Fed's money. However, the TARP experience suggests this is a serious oversimplification. While the Fed can offer liquidity, many actual bailouts require equity infusions, which the Fed cannot currently make, nor should it be able to, as long as the Fed continues to seek to exist as a not entirely public institution. In particular, the very bank holding companies the Fed regulates are involved in the governance of the regional Federal Reserve Banks that are responsible for carrying out the regulatory mission of the Fed, and would if the current structure were untouched, be involved in deciding which member banks or bank holding companies would receive taxpayer funds in a crisis. These considerations also point out the tensions that exist between the Board of Governors of the Federal Reserve System's role as central banker, and the great importance of distance from the political process, and the necessity of political accountability and oversight once a body is charged with dispersing the public's money to private companies that are in trouble. That function must be executed publicly, and with clear oversight, or else there will be inevitable suspicions of favoritism that will be harmful to the political underpinnings of any stabilization effort. One benefit of a more collective approach to systemic risk monitoring is that the Federal Reserve Board could participate in such a body while having to do much less restructuring that would likely be problematic in terms of its monetary policy activity. On the issue of whether to identify and separately regulate systemically significant firms, another lesson of the last eighteen months is that the decision as to whether some or all of the investors and creditors of a financial firm must be rescued cannot be made in advance. In markets that are weak or panicked, a firm that was otherwise seen as not presenting a threat of systemic contagion might be seen as doing just that. Conversely, in a calm market environment, it maybe the better course of action to let a troubled firm go bankrupt even if it is fairly large. Identifying firms (ITAL)ex ante as systemically significant also makes the moral hazard problems much more intense. An area the Congressional Oversight Panel did not address explicitly is whether effective systemic risk management in a world of diversified institutions would require some type of universal systemic risk insurance program or tax. Such a program would appear to be necessary to the extent the federal government is accepting it may be in a position of rescuing financial institutions in the future. Such a program would be necessary both to cover the costs of such interventions and to balance the moral hazard issues associated with systemic risk management. However, there are practical problems defining what such a program would look like, who would be covered and how to set premiums. One approach would be to use a financial transactions tax as an approximation. The global labor movement has indicated its interest in such a tax on a global basis, in part to help fund global reregulation of financial markets. More broadly, these issues return us to the question of whether the dismantling of the approach to systemic risk embodied in the Glass-Steagall Act was a mistake. We would appear now to be in a position where we cannot wall off more risky activities from less risky liabilities like demand deposits or commercial paper that we wish to ensure. On the other hand, it seems mistaken to try and make large securities firms behave as if they were commercial banks. Those who want to maintain the current dominance of integrated bank holding companies in the securities business should have some burden of explaining how their securities businesses plan to act now that they have an implicit government guaranty. Finally, the AFL-CIO believes very strongly that the regulation of the shadow markets, and of the capital markets as a whole cannot be shoved into the category labeled ``systemic risk regulation,'' and then have that category be effectively a sort of night watchman effort. The lesson of the failure of the Federal Reserve to use its consumer protection powers to address the rampant abuses in the mortgage industry earlier in this decade is just one of several examples going to the point that without effective routine regulation of financial markets, efforts to minimize the risk of further systemic breakdowns are unlikely to succeed. We even more particularly oppose this type of formulation that then hands responsibility in the area of systemic risk regulation over to self-regulatory bodies. As Congress moves forward to address systemic risk management, one area that we believe deserves careful consideration is how much power to give to a body charged with systemic risk management to intervene in routine regulatory policies and practices. We strongly agree with Professor Coffee's testimony that a systemic risk regulator should not have the power to override investor or consumer protections. However, there are a range of options, ranging from power so broad it would amount to creating a single financial services superregulator, e.g., vesting such power in staff or a board chairman acting in an executive capacity, to arrangements requiring votes or supermajorities, to a system where the systemic risk regulator is more of scout than a real regulator, limited in its power to making recommendations to the larger regulatory community. The AFL-CIO would tend to favor a choice somewhere more in the middle of that continuum, but we think this is an area where further study might help policymakers formulate a well-founded approach. Finally, with respect to the jurisdiction and the reach of a systemic risk regulator, we believe it must not be confined to institutions per se, or products or markets, but must extend to all financial activity. In conclusion, the Congressional Oversight Panel's report lays out some basic principles that as a Panel member I hope will be of use to this Committee and to Congress in thinking through the challenges involved in rebuilding a more comprehensive approach to systemic risk. The AFL-CIO is very concerned that as Congress approaches the issue of systemic risk it does so in a way that bolsters a broader reregulation of our financial markets, and does not become an excuse for not engaging in that needed broader reregulation.AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009Bank Bailouts There has been a dramatic concentration of banking power since the Gramm-Leach-Bliley Act repealed New Deal bank regulation. More than 43 percent of U.S. bank assets are held by just four institutions: Citigroup, Bank of America, Wells Fargo and JPMorgan Chase. When these institutions are paralyzed, our whole economy suffers. When banks appear on the brink of collapse, as several have repeatedly since September, government steps in. The free market rules that workers live by do not apply to these banks. Since Congress passed financial bailout legislation in October, working people have seen our tax dollars spent in increasingly secretive ways to prop up banks that we are told are healthy, until they need an urgent bailout. In some instances, institutions that were bailed out need another lifeline soon after. The Congressional Oversight Panel, charged with overseeing the bailout, recently found that the Federal Government overpaid by $78 billion in acquiring bank stock. The AFL-CIO believes government must intervene when systemically significant financial institutions are on the brink of collapse. However, government interventions must be structured to protect the public interest, and not merely rescue executives or wealthy investors. This is an issue of both fairness and our national interest. It makes no sense for the public to borrow trillions of dollars to rescue investors who can afford the losses associated with failed banks. The most important goal of government support must be to get banks lending again by ensuring they are properly capitalized. This requires forcing banks to acknowledge their real losses. By feeding the banks public money in fits and starts, and asking little or nothing in the way of sacrifice, we are going down the path Japan took in the 1990s--a path that leads to ``zombie banks'' and long-term economic stagnation. The AFL-CIO calls on the Obama administration to get fair value for any more public money put into the banks. In the case of distressed banks, this means the government will end up with a controlling share of common stock. The government should use that stake to force a cleanup of the banks' balance sheets. The result should be banks that can either be turned over to bondholders in exchange for bondholder concessions or sold back into the public markets. We believe the debate over nationalization is delaying the inevitable bank restructuring, which is something our economy cannot afford. A government conservatorship of the banks has been endorsed by leading economists, including Nouriel Roubini, Joseph Stiglitz, and Paul Krugman. Even Alan Greenspan has stated it will probably be necessary. The consequences of crippled megabanks are extraordinarily serious. The resulting credit paralysis affects every segment of our economy and society and destroys jobs. We urge President Obama and his team to bring the same bold leadership to bear on this problem as they have to the problems of economic stimulus and the mortgage crisis.AFL-CIO Executive Council Statement--Miami, Florida--March 5, 2009Financial Regulation Deregulated financial markets have taken a terrible toll on America's working families. Whether measured in lost jobs and homes, lower earnings, eroding retirement security, or devastated communities, workers have paid the price for Wall Street's greed. But in reality, the cost of deregulation and financial alchemy are far higher. The lasting damage is in missed opportunities and investments not made in the real economy. While money poured into exotic mortgage-backed securities and hedge funds, our pressing need for investments in clean energy, infrastructure, education, and health care went unmet. So the challenge of reregulating our financial markets, like the challenge of restoring workers' rights in the workplace, is central to securing the economic future of our country and the world. In 2006, while the Bush administration was in the midst of plans for further deregulation, the AFL-CIO warned of the dangers of unregulated, leveraged finance. That call went unheeded as the financial catastrophe gathered momentum in 2007 and 2008, and now a different day is upon us. The costs of the deregulation illusion have become clear to all but a handful of unrepentant ideologues, and the public cast its votes in November for candidates who promised to end the era of rampant financial speculation and deregulation. In October, when Congress authorized the $700 billion financial bailout, it also established an Oversight Panel to both monitor the bailout and make recommendations on financial regulatory reform. The panel's report lays the foundation for what Congress and the Obama administration must do. First, we must recognize that financial regulation has three distinct purposes: (1) ensuring the safety and soundness of insured, regulated institutions; (2) promoting transparency in financial markets; and (3) guaranteeing fair dealing in financial markets, so investors and consumers are not exploited. In short, no gambling with public money, no lying and no stealing. To achieve these goals, we need regulatory agencies with focused missions. We must have a revitalized Securities and Exchange Commission (SEC), with the jurisdiction to regulate hedge funds, derivatives, private equity, and any new investment vehicles that are developed. The Commodity Futures Trading Commission should be merged with the SEC to end regulatory arbitrage in investor protection. Second, we must have an agency focused on protecting consumers of financial services, such as mortgages and credit cards. We have paid a terrible price for treating consumer protection as an afterthought in bank regulation. Third, we need to reduce regulatory arbitrage in bank regulation. At a minimum, the Office of Thrift Supervision, the regulator of choice for bankrupt subprime lenders such as Washington Mutual and IndyMac, should be consolidated with other federal bank regulators. Fourth, financial stability must be a critical goal of financial regulation. This is what is meant by creating a systemic risk regulator. Such a regulator must be a fully public agency, and it must be able to draw upon the information and expertise of the entire regulatory system. While the Federal Reserve Board of Governors must be involved in this process, it cannot undertake it on its own. We must have routine regulation of the shadow capital markets. Hedge funds, derivatives, and private equity are nothing new--they are just devices for managing money, selling insurance and securities, and engaging in the credit markets without being subject to regulation. As President Obama said during the campaign, ``We need to regulate institutions for what they do, not what they are.'' Shadow market institutions and products must be subject to transparency and capital requirements and fiduciary duties befitting what they are actually doing. Reform also is required in the incentives governing key market actors around executive pay and credit rating agencies. There must be accountability for this disaster in the form of clawbacks for pay awarded during the bubble. According to Bloomberg, the five largest investment banks handed out $145 billion in bonuses in the 5 years preceding the crash, a larger amount than the GDP of Pakistan and Egypt. Congress and the administration must make real President Obama's commitment to end short-termism and pay without regard to risk in financial institutions. The AFL-CIO recently joined with the Chamber of Commerce and the Business Roundtable in endorsing the Aspen Principles on Long-Term Value Creation that call for executives to hold stock-based pay until after retirement. Those principles must be embodied in the regulation of financial institutions. We strongly support the new SEC chair's effort to address the role played by weak boards and CEO compensation in the financial collapse. With regard to credit rating agencies, Congress must end the model where the issuer pays. Financial reregulation must be global to address the continuing fallout from deregulation. The AFL-CIO urges the Obama administration to make a strong and enforceable global regulatory floor a diplomatic priority, beginning with the G-20 meeting in April. The AFL-CIO has worked closely with the European Trade Union Congress and the International Trade Union Confederation in ensuring that workers are represented in this process. We commend President Obama for convening the President's Economic Recovery Advisory Board, chaired by former Federal Reserve Chair Paul Volcker, author of the G-30 report on global financial regulation, and we look forward to working with Chairman Volcker in this vital area. Reregulation requires statutory change, regulatory change, institutional reconstruction and diplomatic efforts. The challenge is great, but it must be addressed, even as we move forward to restore workers' rights and revive the economy more broadly. ______ CHRG-111hhrg55814--368 Mr. Trumka," Thank you, Mr. Chairman. And thank you to Ranking Member Bachus. My name is Rich Trumka, and I am the president of the AFL-CIO. The AFL-CIO is a federation of 57 unions representing 11\1/2\ million members. Our members were not invited to Wall Street's party, but we have paid for it with devastation to our pension funds, lost jobs, and public bailouts of private sector losses. Our goal is a financial system that is transparent, accountable, and stable, a system that is the servant of the real economy rather than its master. The AFL-CIO is also a coalition member of Americans for Financial Reform, and we join that coalition in complimenting the committee for its work on the Consumer Financial Protection Agency, and we endorse the testimony of AFR's witness here today; however, we are concerned with the working draft, that the committee's work thus far on the fundamental issues of regulating shadow financial markets and institutions will allow in large part the very practices that led to the financial crisis to continue. The loopholes in the derivatives bill and the failure to require any public disclosures by hedge funds and private equity funds fundamentally will leave the shadow markets in the shadows. And we urge the committee to work with the leadership to strengthen these bills before they come to the House Floor. The subject of today's hearing, of course, is systemic risk. And the AFL-CIO strongly supports the concepts in the Treasury Department White Paper, that a systemic risk regulator must have the power to set capital requirements for all systematically significant financial institutions, and be able to place a failing institution in a resolution process run by the FDIC. We are glad to see that the committee bill actually does those things. Although we have some concerns with the discussion draft that was made public earlier this week, we really haven't had a chance to go through it. And our understanding so far is that some of the intention of the committee, we may have read things at variance with that, and we think they can be worked out. But our concern is that this bill gives pretty dramatic new powers to the Federal Reserve without reforming the governance by ending the banks' involvement in selecting the boards of the regional Fed banks, where the Fed's regulatory capacity is located. The discussion draft would appear to give power to the Federal Reserve to preempt a wide range of rules regulating the capital market, power which could be used, unfortunately, to gut investor and consumer protections. If the committee wishes to give more power to the Federal Reserve, we think it should make clear that this power is only to strengthen safety and soundness regulation, and that it must simultaneously reform the Federal Reserve's governance. These powers must be given to a fully public body, and one that is able to benefit from the information and perspective of the routine regulators of the financial system. We believe a new agency with a board made up of a mixture of the heads of the routine regulators and direct presidential appointees would be the best structure. However, if the Federal Reserve were made a fully public body, it would be an acceptable alternative. Unfortunately, it is reported today that the Fed has rejected Treasury Secretary Geithner's request for a study of the Fed's governance and structure. We are also troubled by the provision in the discussion draft that would allow the Federal Government to provide taxpayer funds to failing banks and then bill other non-failing banks for the costs. We realize that it is not intended that this be a rescue, but rather a wind-down. The incentive structure created by this system seems likely to increase systemic risk, from our point of view. We believe it would be more appropriate to require financial institutions to pay into an insurance fund on an ongoing basis. Financial institutions should be subject to progressively higher fee assessments and stricter capital requirements as they get larger, and we think this would actually discourage ``too-big-to-fail.'' Finally, the discussion draft appears to envision a regulatory process that is secretive and optional. In other words, the list of systemically significant institutions is not public, and the Federal Reserve could actually choose to take no steps to strengthen the safety and soundness regulation of those systemically significant institutions. We think that in these respects, the discussion draft appears to take some of the problematic and unpopular aspects of the TARP and make them a model for permanent legislation. In closing, Mr. Chairman, I would say that instead of repeating some of the things we did in the bank bailout, Congress should be looking to create a transparent, fully public, accountable mechanism for regulating systemic risk and for acting to protect our economy in any future crises. On behalf of the AFL-CIO, I want to thank you for the opportunity to testify today. [The prepared statement of Mr. Trumka can be found on page 308 of the appendix.] " CHRG-111shrg55117--34 Mr. Bernanke," Senator, it is very hard to get credit for something that did not happen, but in September and October, I believe we faced the worst global financial crisis since the 1930s and perhaps including the 1930s. Beyond the crisis of Lehman and AIG and Merrill and Wachovia in September, in mid-October we faced a global banking crisis where not only the United States but many other industrial countries were on the verge of collapse of the banking systems. There was a loosely coordinated effort around the world involving injection of capital, provision of guarantees, purchases of distressed assets, provision of liquidity, which succeeded in stabilizing the global banking system in mid-October, which set the basis for the slow stabilization of the financial system and recovery that we have seen since then. By the way, there has been so much focus here, of course, on AIG and the interventions here, but there have been about a dozen similar interventions around the world. So we are not alone in that respect as other countries have also moved in to protect and avoid the collapse of systemically critical firms. I believe that if those actions had not been taken, if the TARP had not been available to prevent that collapse, if there had not been an aggressive international policy response, I believe we would be in a very, very deep and protracted recession which might be almost like a depression, I think much, much worse than what we are seeing now. The situation--I do not want to understate--the situation now is very poor. The unemployment rate is unacceptably high. Americans are suffering. But I do believe that we have a much better situation than we would have if we had seen a collapse of the global financial system last October. Senator Reed. Mr. Chairman, let me focus on the point that you just made about unemployment. Approximately 540,000 Americans will exhaust their unemployment benefits by the end of September; 1.5 million will run out by the end of the year. We all understand this is a central problem, maybe even a systemic risk. Would you urge us to extend unemployment benefits? " fcic_final_report_full--287 Another Fed concern was that banks and others who did have cash would hoard it. Hoarding meant foreign banks had difficulty borrowing in dollars and were there- fore under pressure to sell dollar-denominated assets such as mortgage-backed secu- rities. Those sales and fears of more sales to come weighed on the market prices of U.S. securities. In response, the Fed and other central banks around the world an- nounced (also on December ) new “currency swap lines” to help foreign banks borrow dollars. Under this mechanism, foreign central banks swapped currencies with the Federal Reserve—local currency for U.S. dollars—and lent these dollars to foreign banks. “During the crisis, the U.S. banks were very reluctant to extend liquid- ity to European banks,” Dudley said.  Central banks had used similar arrangements in the aftermath of the / attacks to bolster the global financial markets. In late , the swap lines totaled  billion. During the financial crisis seven years later, they would reach  billion. The Fed hoped the TAF and the swap lines would reduce strains in short-term money markets, easing some of the funding pressure on other struggling participants such as investment banks. Importantly, it wasn’t just the commercial banks and thrifts but the “broader financial system” that concerned the Fed, Dudley said. “His- torically, the Federal Reserve has always tended to supply liquidity to the banks with the idea that liquidity provided to the banking system can be [lent on] to solvent in- stitutions in the nonbank sector. What we saw in this crisis was that didn’t always take place to the extent that it had in the past. . . . I don’t think people going in really had a full understanding of the complexity of the shadow banking system, the role of [structured investment vehicles] and conduits, the backstops that banks were provid- ing SIV conduits either explicitly or implicitly.”  Burdened with capital losses and desperate to cover their own funding commit- ments, the banks were not stable enough to fill the void, even after the Fed lowered interest rates and began the TAF auctions. In January , the Fed cut rates again— and then again, twice within two weeks, a highly unusual move that brought the fed- eral funds rate from . to .. CHRG-111hhrg53021--95 Mr. Bachus," All right. Let me ask you something else. Back in 1998--and I will just ask this--Larry Summers testified in the Senate against the notion of regulating derivatives. Among the things he said is, ``It would cast the shadow of regulatory uncertainty over an otherwise thriving market, raising risk for the stability and competitiveness of the American derivatives trading. Even small regulatory changes could throw the whole system out of whack.'' That was after Chairman Boren proposed regulating derivatives. What has changed? Or do you have those same concerns today? " CHRG-111hhrg53021Oth--95 Mr. Bachus," All right. Let me ask you something else. Back in 1998--and I will just ask this--Larry Summers testified in the Senate against the notion of regulating derivatives. Among the things he said is, ``It would cast the shadow of regulatory uncertainty over an otherwise thriving market, raising risk for the stability and competitiveness of the American derivatives trading. Even small regulatory changes could throw the whole system out of whack.'' That was after Chairman Boren proposed regulating derivatives. What has changed? Or do you have those same concerns today? " CHRG-111shrg49488--102 Mr. Carmichael," The answer is yes, but ``multiple'' is a very small number in that our prudential regulator has the primary responsibility for on-site inspections. And I should say we are much more of a principles-based than a rules-based country, so we do not do anything like as many audits and on-site inspections as would be common under the U.S. approach. Our conduct regulator, which is the pillar that looks at mis-selling and mis-pricing of products, works on the basis of responding to complaints. So they are not out there auditing complaints as such. They will hear a complaint, and they are really looking for misconduct of a type. Then they will do an investigation. So it is very targeted. It is not a regular on-site audit of that style. So in the sense of overlap, it is really quite minimal. Senator Collins. I also recall when I was head of the Financial Department that we would have regulated entities say, well, we are going to consider becoming federally chartered unless you do X. So there is a real problem in our country with shopping for the easiest regulator and playing the States off against the Federal regulators and vice versa. And because that is an income stream to the regulator, those threats matter to State governments, particularly State governments that are strapped for funds. So I think that is an issue as well. Mr. Nason, in the United States we now recognize that a large shadow banking sector can threaten the entire financial sector, and I, for one, believe that it is not enough to monitor just the safety and soundness of traditional banks, but we need to extend safety and soundness regulation to investment banks, for example, to subsidiaries of companies like AIG. Bear Stearns, I am told, had an astonishing leverage ratio of 30:1 when it failed. Do you think that we should be extending some system of capital requirements across the financial sector? " CHRG-111shrg51395--56 Mr. Silvers," I find myself in the unusual position of having really nothing to disagree with in what I have heard so far at the table. I would say, though, that the single item that I would put to you, I would put differently than my co-panelists have done so far. I think that conceptually the thing you want to be most focused on is ensuring that we no longer have a Swiss cheese system, that we no longer have a system where you can do something like insure a bond, either in a completely regulated fashion, in which there are capital requirements and disclosure requirements and pre-clearance, or in a completely unregulated fashion through essentially a derivative and where you have none of these things; that the content of what a financial market actor does should determine the extent and type of that regulation. Closing regulatory loopholes, ending the notion that we have shadow markets, I think is the most important conceptual item for Congress to take up, because, otherwise, if it continues to be possible to essentially undertake the same types of activity with the same types of risk but to do so in an unregulated fashion, we will replay these events with a fair degree of certainty. And I believe that much of what the discussion about structure here has been is all about how we do that ending of shadow markets and regulatory gaps. I think in certain respects, some of the how is less important than actually getting it done. I would say, though, that I really strongly endorse what Mercer said about the different functions of regulation, that there is investor protection, disclosure and fiduciary duty oriented; there is consumer protection, although I think, Mercer, you had a different phrase for it, but protection around the public buying financial services which does not want to take risk; and then there is safety and soundness regulation. Those things are different, and it is dangerous to blend them. " fcic_final_report_full--9 And the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through “window dressing” of financial reports available to the investing public. The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth gov- ernment-sponsored enterprises (GSEs). For example, by the end of , Fannie’s and Freddie’s combined leverage ratio, including loans they owned and guaranteed, stood at  to . But financial firms were not alone in the borrowing spree: from  to , na- tional mortgage debt almost doubled, and the amount of mortgage debt per house- hold rose more than  from , to ,, even while wages were essentially stagnant. When the housing downturn hit, heavily indebted financial firms and families alike were walloped. The heavy debt taken on by some financial institutions was exacerbated by the risky assets they were acquiring with that debt. As the mortgage and real estate mar- kets churned out riskier and riskier loans and securities, many financial institutions loaded up on them. By the end of , Lehman had amassed  billion in com- mercial and residential real estate holdings and securities, which was almost twice what it held just two years before, and more than four times its total equity. And again, the risk wasn’t being taken on just by the big financial firms, but by families, too. Nearly one in  mortgage borrowers in  and  took out “option ARM” loans, which meant they could choose to make payments so low that their mortgage balances rose every month. Within the financial system, the dangers of this debt were magnified because transparency was not required or desired. Massive, short-term borrowing, combined with obligations unseen by others in the market, heightened the chances the system could rapidly unravel. In the early part of the th century, we erected a series of pro- tections—the Federal Reserve as a lender of last resort, federal deposit insurance, am- ple regulations—to provide a bulwark against the panics that had regularly plagued America’s banking system in the th century. Yet, over the past -plus years, we permitted the growth of a shadow banking system—opaque and laden with short- term debt—that rivaled the size of the traditional banking system. Key components of the market—for example, the multitrillion-dollar repo lending market, off-bal- ance-sheet entities, and the use of over-the-counter derivatives—were hidden from view, without the protections we had constructed to prevent financial meltdowns. We had a st-century financial system with th-century safeguards. When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans, and the risky assets all came home to roost. What resulted was panic. We had reaped what we had sown. • We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. As part of our charge, it was appropriate to review government actions taken in response to the developing crisis, not just those policies or actions that preceded it, to determine if any of those responses contributed to or exacerbated the crisis. CHRG-110hhrg38392--162 Mr. Meeks," Let me go into another area. I only have time for one question, although I have many. With what is now becoming known in issues of managed funds, hedge funds, private equity, my question is related to, for example, the collapse of the long-term capital management where there was this concern about how exposed the banking system was to LTCM. And so my question is, do you feel that currently we have adequate regulatory safeguards in place to make certain that say, for example, the collapse of a few major hedge funds won't create a systematic risk for all of the banking industry? Do we have enough in place currently? " CHRG-111hhrg53021Oth--173 Secretary Geithner," And on the firm as a whole. But, again, the capital is central to this. A core part of what brought the system to the edge of collapse was inadequate capital against a range of commitments, banks, and institutions like AIG made. " CHRG-111hhrg53021--173 Secretary Geithner," And on the firm as a whole. But, again, the capital is central to this. A core part of what brought the system to the edge of collapse was inadequate capital against a range of commitments, banks, and institutions like AIG made. " CHRG-110hhrg46593--113 Secretary Paulson," Well, okay, to answer that question, there are no banks, when the system is under pressure, unless they are ready to fail, that are going to raise their hand and say, please, I need capital; give me some capital. What happens when an economy turns down and when there is a crisis, they pull in their horns. They say, I don't need help. They don't deal with other banks. They don't lend, and the system gets ready to collapse. So the step that we took was very, very critical, and to be able to go out and go out to the healthy banks and go out before they became unhealthy and to increase confidence in the banks and of the banks so that they lend and that they do business with each other, that was absolutely what we were about. And when we came here to-- " FinancialCrisisInquiry--422 MAYO: I think we’re talking about systemically important. I think there’s four different factors we can think about as we talk about this topic. January 13, 2010 Number one would be if you’re outside the banking industry, there’s a clear lack of oversight. And so we need to get, you know, the shadow banking industry back under the umbrella of oversight. So I think we’re probably in agreement on that point. A second point would be the actual activities that are allowed to be conducted by the banks. And we may agree to disagree on that point, but I would say I was shocked and amazed because, of all the activities conducted, a lot of them are still being conducted. And the ones that aren’t being conducted, it’s just because the business isn’t there right now. When the business comes back, it will be conducted some more. And so I think that’s certainly a point for debate and discussion which activities should be allowed. I think the third point here would be there are other risk factors, so let’s not make this a one—you know, one-item issue. So I brought up management as another risk factor. And the fourth point would be size. And on the size point, I do agree with Mr. Bass here that, you know, certain firms are so large that they might be systemically important. I mean, where you draw that line is a big question, but I disagree with Jamie Dimon. There’s, in so uncertain terms, J.P. Morgan is too big to fail. $2 trillion balance sheet? They’re not failing. And I heard Mr. Blankfein, I heard Mr. Dimon present earlier. And they said—and you asked the question could you fail today. Well, they said, well, the system is a little too fragile right now, but once it’s not fragile. So let me ask you—or if you want to ask them again, under what circumstances would J.P. Morgan be at risk of failure when the system isn’t fragile? It’s not a close call in my world, and you can poll everyone else you talk to. Maybe the other people on the panel—could J.P. Morgan fail? CHRG-111hhrg53238--127 Mr. Menzies," Congressman, the $7 trillion of loss to this Nation was not the product of community banks. It was the product of mega banks and Wall Street creating shadow corporations and SIVs that stuffed toxic assets based on products that they created into those entities, and community banks are truly the victim of the product regulation that is contemplated today because of that activity. Don't take away my right to take care of a widow whom I loaned a year ago, who had 25 percent borrowed against her house, interest only for a year, at a market rate, no payments required, while she could care for her husband, who was dying, understanding that after he died she could go back and get a job and then we could amortize that loan. That is a nonconforming product in every possible manner, but it provides me with the flexibility to be creative and take care of the needs of our customers. That is essential to retain the role that community banks do for this Nation. " CHRG-111hhrg56778--5 Mr. Posey," Thank you very much, Mr. Chairman. To help protect our citizens in the future, I think we probably need to glance at least a little bit on some of our previous failures. And I understand the Office of Thrift Supervision is responsible for supervising 35 holding companies that include both thrifts and insurance operating entities. And it has come to my attention through a news clip actually, just this morning, some revelations I had not previously been aware of and we might possibly clarify in some of our testimony this morning. This was ``Dateline Washington.'' It says, ``Banks weren't the only ones giving big bonuses in the boom years before the worst financial crisis in generations. The government was also handing out millions of dollars to bank regulators rewarding `superior' work, even as an avalanche of risky mortgages helped create the meltdown. The payments detailed in the payroll data released to the Associated Press under the Freedom of Information Act are the latest evidence of the government's false sense of security during the go-go days of the financial boom. Just as the bank executives got bonuses, despite taking on dangerous amounts of risk, regulators got taxpayer funded bonuses despite missing or ignoring signs that the system was on the verge of a meltdown. ``The bonuses were part of a program, little known outside the government. Some government regulators got tens of thousands of dollars in perks, boosting their salaries by almost 25 percent. Often, though, rewards amounted to just a few hundred dollars for employees who came up with good ideas. During the 2000 306 boom, the three agencies that supervised most U.S. banks, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency, gave out at least $19 million in bonuses, records show. ``Nearly all that money was spent recognizing superior performance. The largest share, more than $8.4 million, went to financial examiners, those examiners and managers who scrutinize internal bank documents and sound first alarms. Analysts, auditors, economists, and criminal investigators also got rewards. After the meltdown, the government's internal investigators surveyed the wreckage of nearly 200 failed banks and repeatedly found that those regulators had not done enough. ```OTS did not react in a timely or forceful manner to certain repeated indications of problems,' the Treasury Department's Inspector General said of the Thrift Supervision Office following the $2.5 billion collapse of Net Bank, the first major bank failure of the economic crisis. `OCC did not issue a formal enforcement action in a timely manner and was not aggressive enough in the supervision of A&B in light of the bank's rapid growth,' the Inspector General said of the currency comptroller after the $2.1 billion failure of A&B Financial National Association. ```In retrospect, a stronger supervisory response at earlier examinations may have been prudent,' FDIC's inspector general concluded following the $1.8 billion collapse of the New Frontier Bank. `OTS examiners did not identify or sufficiently address the core weaknesses that ultimately caused a thrift to fail until it was too late,' Treasury's Inspector General said regarding IndyMac, which in 2008 became one of the largest bank failures in history. And they believed their supervision was adequate. We disagree. ```OCC's supervision of Omni National Bank was inadequate,' Treasury investigators concluded following Omni's $956 million failure. Most of the bank inspection records are not public and the government blacked-out many of the employee names before releasing the bonus data. It is impossible to determine how many auditors got bonuses, despite working on major banks that failed. Regulators say it's unfair to use those missteps seeing it's a benefit of hindsight to suggest any bonus isn't proper.'' Thank you, Mr. Chairman. I yield back. " fcic_final_report_full--7 We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the self- correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor. Yet we do not accept the view that regulators lacked the power to protect the fi- nancial system. They had ample power in many arenas and they chose not to use it. To give just three examples: the Securities and Exchange Commission could have re- quired more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles, often downgrading them just before their collapse. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will—in a political and ideological environment that constrained it—as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee. Changes in the regulatory system occurred in many instances as financial mar- kets evolved. But as the report will show, the financial industry itself played a key role in weakening regulatory constraints on institutions, markets, and products. It did not surprise the Commission that an industry of such wealth and power would exert pressure on policy makers and regulators. From  to , the financial sector expended . billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than  billion in campaign contributions. What troubled us was the extent to which the nation was deprived of the necessary strength and independence of the oversight necessary to safeguard financial stability. • We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this cri- sis. There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institu- tions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a funda- mental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activ- ities that produced hefty profits. They took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling tril- lions of dollars in mortgage-related securities, including synthetic financial products. Like Icarus, they never feared flying ever closer to the sun. CHRG-111hhrg53245--210 Mr. Perlmutter," And Garn-St. Germain and start of national banking and branch banking. We cannot ``unring'' this bell but just as a general principle, do we want a really efficient system, which is where we headed, and then it all collapsed very quickly, or do we want to put some brakes in the system that do not exist right now? Ms. Rivlin. I think we want as efficient a system as we can get consistent with reasonable stability. And I realize that is kind of gobbledygook, but it is a trade off. And if we were to go back to no-branch banking and so forth, I do not think that is either feasible or sensible. But we may have gone too far in allowing growth, and maybe not even for efficiency reasons. And so we need to re-visit this question and see where we want the trade off to be. " CHRG-111hhrg48868--656 Mr. Liddy," No, it is a debt of AIG. Mr. Miller of North Carolina. Okay. There has been a study by economists on what works and what doesn't when a nation's banking system collapses, its financial system collapses, and one of the characteristics is transparency. The second is maintaining market discipline. And that means that shareholders bear the loss, but it also means that unsecured creditors bear the loss. Anyone who is in a position to determine the ability of the corporation they are doing business with to pay their debts should bear the loss, not presumably taxpayers. Are we maintaining market discipline by continuing to give money to AIG to pay unsecured creditors, to pay the counterparties to your credit default swaps? " CHRG-111hhrg51698--55 Mr. Gooch," My point with the state of the environment about the credit clearing, so it would be the clearing house in the various futures exchanges, that these large banks and investment banks and SCMs, their capital is ultimately at risk if there is a demand on the capital of the clearing facility. I think the CME has $7 billion of clearing capital, and then after that it is the margin money that is on deposit, and then after that it is the capital of the various banks. So it is a horrible Armageddon concept, but had there been a major banking failure, which is what Secretary Paulson was concerned about, that weekend towards the end of September, a couple of weeks after Lehman had failed, that if certain investment banks had gone into bankruptcy similar to Lehman, and then there had been a domino theory through the banking system, the futures markets would have gapped wildly. The margin money on deposit would not have been sufficient to make good on all of the positions in the futures market, and then you would have been going for the very capital of the failing banks. So the clearing facility would collapse with the banking system, and you would simply end up bailing out the clearing system. " FinancialCrisisInquiry--135 Number one would be if you’re outside the banking industry, there’s a clear lack of oversight. And so we need to get, you know, the shadow banking industry back under the umbrella of oversight. So I think we’re probably in agreement on that point. A second point would be the actual activities that are allowed to be conducted by the banks. And we may agree to disagree on that point, but I would say I was shocked and amazed because, of all the activities conducted, a lot of them are still being conducted. And the ones that aren’t being conducted, it’s just because the business isn’t there right now. When the business comes back, it will be conducted some more. And so I think that’s certainly a point for debate and discussion which activities should be allowed. I think the third point here would be there are other risk factors, so let’s not make this a one—you know, one-item issue. So I brought up management as another risk factor. And the fourth point would be size. And on the size point, I do agree with Mr. Bass here that, you know, certain firms are so large that they might be systemically important. I mean, where you draw that line is a big question, but I disagree with Jamie Dimon. There’s, in so uncertain terms, J.P. Morgan is too big to fail. $2 trillion balance sheet? They’re not failing. And I heard Mr. Blankfein, I heard Mr. Dimon present earlier. And they said—and you asked the question could you fail today. Well, they said, well, the system is a little too fragile right now, but once it’s not fragile. So let me ask you—or if you want to ask them again, under what circumstances would J.P. Morgan be at risk of failure when the system isn’t fragile? It’s not a close call in my world, and you can poll everyone else you talk to. Maybe the other people on the panel—could J.P. Morgan fail? SOLOMON: No. The corollary is this. When you—when there is a government-induced oligopoly, what’s the government’s role vis-à-vis the oligopoly? And can you afford to have one member of that fail? So, no, of course, I agree with Mr. Mayo. CHRG-111hhrg49968--75 Mr. Bernanke," Well, I think there are some changes that are worth making. And I would mention specifically, I was asked a question a moment ago about AIG, for example. It was with great, great reluctance the Federal Reserve got involved in that kind of situation, there being no good alternative to avoid a collapse of a major financial firm and the consequences that would have for the financial system and for the economy. As I have said a number of times for at least a year, I think a very critical step that the Congress needs to take is to develop a resolution regime that would allow the government--not the Fed, but the government to step in when a major financial firm is near default and the financial system is in crisis. That would be parallel to what we already do now for banks through the fiduciary system. If we could have such a system in place, then the Fed would no longer be in the ``Hobson's choice'' of either standing aside and letting the system collapse or taking these actions using a 13(3) authority, which are very, very uncomfortable for us. So that would be an area where we would be happy to withdraw or pull back on our activity if the government would provide a good system for addressing that issue. " fcic_final_report_full--557 Unless otherwise specified, data come from the sources listed below. Board of Governors of the Federal Reserve System, Flow of Funds Reports: Debt, international capital flows, and the size and activity of various financial sectors Bureau of Economic Analysis: Economic output (GDP), spending, wages, and sector profit Bureau of Labor Statistics: Labor market statistics BlackBox Logic and Standard & Poor’s: Data on loans underlying CMLTI 2006-NC2 CoreLogic: Home prices Inside Mortgage Finance, 2009 Mortgage Market Statistical Annual: Data on origination of mortgages, issuance of mortgage-backed securities and values outstanding Markit Group: ABX-HE index Mortgage Bankers Association National Delinquency Survey: Mortgage delinquency and fore- closure rates 10-Ks, 10-Qs, and proxy statements filed with the Securities and Exchange Commission: Com- pany-specific information Many of the documents cited on the following pages, along with other materials, are available on www.fcic.gov. Chapter 1 1. Charles Prince, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8, 2010, transcript, p. 10. 2. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In- vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and the Financial Crisis, June 2, 2010, transcript, p. 208; Warren Buffett, interview by FCIC, May 26, 2010. 3. Lloyd Blankfein, testimony before the First Public Hearing of the FCIC, day 1, panel 1: Financial Institution Representatives, January 13, 2010, transcript, p. 36. 4. Ben S. Bernanke, closed-door session with FCIC, November 17, 2009; Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government In- tervention and the Role of Systemic Risk in the Financial Crisis, day 2, session 1: The Federal Reserve, September 2, 2010, transcript, p. 27. 5. Alan Greenspan, written testimony for the FCIC, Subprime Lending and Securitization and Gov- ernment-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010, p. 9. 553 6. Richard C. Breeden, interview by FCIC, October 14, 2010. 7. Paul A. McCulley, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 249. 8. Arnold Cattani, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Greater fcic_final_report_full--547 PDCF see Primary Dealer Credit Facility . PLS see private-label mortgage-backed securities . pooling Combining and packaging a group of loans to be held by a single entity. Primary Dealer Credit Facility Program established by the Federal Reserve in March  that al- lowed eligible companies to borrow cash overnight to finance their securities. principal Amount borrowed. private mortgage insurance Insurance on the payment of a mortgage provided by a private firm at additional cost to the borrower to protect the lender. private-label mortgage-backed securities see non-agency mortgage-backed securities. repurchase agreement (repo) A method of secured lending where the borrower sells securities to the lender as collateral and agrees to repurchase them at a higher price within a short period, often within one day. SEC see Securities and Exchange Commission . section () Section of the Federal Reserve Act under which the Federal Reserve may make se- cured loans to nondepository institutions, such as investment banks, under “unusual and exi- gent” circumstances. Securities and Exchange Commission Independent federal agency responsible for protecting in- vestors by enforcing federal securities laws, including regulating stock and security options ex- changes and other electronic securities markets, the issuance and sale of securities, broker-dealers, other securities professionals, and investment companies. securitization Process of pooling debt assets such as mortgages, car loans, and credit card debt into a separate legal entity that then issues a new financial instrument or security for sale to in- vestors. shadow banking Financial institutions and activities that in some respects parallel banking activi- ties but are subject to less regulation than commercial banks. Institutions include mutual funds, investment banks, and hedge funds. short sale The sale of a home for less than the amount owed on the mortgage. short selling To sell a borrowed security in the expectation of a decline in value. SIV see structured investment vehicle . special purpose vehicle Entity created to fulfill a narrow or temporary objective; typically holds a portfolio of assets such as mortgage-backed securities or other debt obligations; often used be- cause of regulatory and bankruptcy advantages. SPV see special purpose vehicle . structured investment vehicle Leveraged special purpose vehicle , funded through medium-term notes and asset-backed commercial paper , that invested in highly rated securities. synthetic CDO A CDO that holds credit default swaps that reference assets (rather than holding cash assets), allowing investors to make bets for or against those referenced assets. systemic risk In financial terms, that which poses a threat to the financial system. systemic risk exception Clause in the Federal Deposit Insurance Corporation Improvement Act (FDICIA) under which the FDIC may commit its funds to rescue a financial institution. TAF see Term Auction Facility . TALF see Term Asset-Backed Securities Loan Facility . TARP see Troubled Asset Relief Program . fcic_final_report_full--52 During a hearing on the rescue of Continental Illinois, Comptroller of the Cur- rency C. Todd Conover stated that federal regulators would not allow the  largest “money center banks” to fail.  This was a new regulatory principle, and within mo- ments it had a catchy name. Representative Stewart McKinney of Connecticut re- sponded, “We have a new kind of bank. It is called ‘too big to fail’—TBTF—and it is a wonderful bank.”  In , during this era of federal rescues of large commercial banks, Drexel Burnham Lambert—once the country’s fifth-largest investment bank—failed. Crip- pled by legal troubles and losses in its junk bond portfolio, the firm was forced into the largest bankruptcy in the securities industry to date when lenders shunned it in the commercial paper and repo markets. While creditors, including other investment banks, were rattled and absorbed heavy losses, the government did not step in, and Drexel’s failure did not cause a crisis. So far, it seemed that among financial firms, only commercial banks were deemed too big to fail. In , Congress tried to limit this “too big to fail” principle, passing the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb the use of taxpayer funds to rescue failing depository institutions. FDICIA mandated that federal regulators must intervene early when a bank or thrift got into trouble. In addition, if an institution did fail, the FDIC had to resolve the failed institution in a manner that produced the least cost to the FDIC’s deposit insurance fund. However, the legislation contained two important loopholes. One exempted the FDIC from the least-cost constraints if it, the Treasury, and the Federal Reserve determined that the failure of an institution posed a “systemic risk” to markets. The other loophole ad- dressed a concern raised by some Wall Street investment banks, Goldman Sachs in particular: the reluctance of commercial banks to help securities firms during previ- ous market disruptions, such as Drexel’s failure. Wall Street firms successfully lobbied for an amendment to FDICIA to authorize the Fed to act as lender of last resort to in- vestment banks by extending loans collateralized by the investment banks’ securities.  In the end, the  legislation sent financial institutions a mixed message: you are not too big to fail—until and unless you are too big to fail. So the possibility of bailouts for the biggest, most centrally placed institutions—in the commercial and shadow banking industries—remained an open question until the next crisis,  years later. fcic_final_report_full--603 Goldman Sachs. 81. Jon Liebergall and Andrew Forster, telephone conversation, July 30, 2007, transcript, pp. 402–4. 82. David Viniar, written testimony for the FCIC, Hearing on the Role of Derivatives in the Financial Crisis, day 2, session 1: American International Group, Inc. and Goldman Sachs Group, Inc., July 1, 2010, p. 2. 83. Liebergall and Forster, telephone conversation, July 30, 2007, transcript, p. 407. 84. Tom Athan, email to Andrew Forster, August 1, 2007. Chapter 13 1. Henry Paulson, quoted in Kevin Carmichael and Peter Cook, “Paulson Says Subprime Rout Doesn’t Threaten Economy,” Bloomberg , July 26, 2007. 2. Moody’s Investors Service, “Moody’s ABCP Program Index: CP Outstanding as of 06/30/2007.” 3. Moody’s Investors Service, “Moody’s Performance Overview: Rhineland Funding Capital Corpora- tion,” June 30, 2007. 4. As noted, in the United States, there was a minimal capital charge for liquidity puts equal to 10% of the base 8%, or 0.8%. Staff of Bundesanstalt fur Finanzdienstleistungsaufsicht (the Federal Financial Services Supervisory Authority, Germany’s bank regulators), interview by FCIC, September 8, 2010. See also Office of the Comptroller of the Currency, “Interagency Guidance on the Eligibility of Asset-Backed Commercial Paper Liquidity Facilities and the Resulting Risk-Based Capital Treatment,” August 4, 2005. For example, Citigroup would have held $200 million in capital against potential losses on the $25 billion in liquidity put exposure that it had accumulated on CDOs it had issued. 5. IKB, 2006/2007 Annual Report, June 28, 2007, p. 78. 6. Securities Fraud Complaint, Securities and Exchange Commission v. Goldman Sachs & Co. and Fabrice Tourre, no. 10-CV-3229 (S.D.N.Y. April 15, 2010), p. 6. 7. IKB staff, interview by FCIC, August 27, 2010; Securities and Exchange Commission (plaintiff) v. Goldman Sachs & Co. and Fabrice Tourre (defendants), Securities Fraud Complaint, 10-CV-3229, United States District Court, Southern District of New York, April 15, 2010, at 17, paragraph 58. 8. “Preliminary results for the first quarter (1 April-30 June 2007) ,” IKB press release, July 20, 2007. 9. IKB staff, interview; IKB, clarification of interview by FCIC, November 15, 2010; IKB, restated 2006/2007 Annual Report, p. 5. 10. Steven Meier, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 307. 11. Angelo Mozilo, testimony taken by the SEC in the matter of Countrywide Financial Corp., File CHRG-111hhrg53245--19 Mr. Johnson," Thank you very much, Mr. Chairman. As you said at the beginning, the question, I think, is not controversial. The issue is to remove the possibility in the future that a large financial institution can come to the Executive Branch and say, ``Either you bail us out, or there will be an enormous collapse in the financial system of this country and potentially globally.'' And I think there are two broad responses to that, two ways of addressing that problem that are on the table. The first is what I would call relatively technocratic adjustments, changing the rules around regulation or changing the rules around bankruptcy procedure. I think there are some sensible ideas there, that are relatively small ideas. I don't believe they will fundamentally solve this problem. The second approach is to reduce the size of these banks, and what we have learned, I think, over the past 9 months is a considerable amount about how small financial institutions can fail, and can fail without causing major systemic problems, both through an FDIC-type process, or through a market type process, as seen with the CIT Group. Let me emphasize or underline the difference between these two approaches, and why making them smaller is both attractive and feasible. I think that the key problem is this financial sector has become very persuasive. It has convinced itself, it has convinced its regulator, it has convinced many other people that it knows how to manage risks, that it understands what are large risks for itself. And of course this is what Mr. Greenspan now concedes was a mistake in his assessment of the situation during the boom. He thought that the large firms that had a great deal to lose if things went badly understood these risks and would control them and manage them. And they didn't. It's a massive failure of risk management and I see no indication either that the banks have improved this kind of risk management in the largest institutions, or that regulators are better able to spot this. And while I agree with the idea we should have a systemic risk spotter of some kind, analytically and politically, it seems to me we're a long way from ever achieving that. And if I may mention the lobbying of Fannie and Freddie on the one hand, and private banks on the other hand, it was just fantastic. These people are the best in the business, by all accounts, at speaking with many people, both with regard to legislation and of course detailed rules. Again, I see no reason to think that if you tweak the technocratic structures, you will remove this power and this ability that these large financial institutions have brought to bear. And it's not just in the last 5 to 10 years; it's historically in the United States and in many other countries, or perhaps most other countries the financial system has this kind of lobbying power, this kind of too-connected-to-fail issue raised by Mr. Sherman. Now I think, Mr. Chairman, if you put it in those terms and if you look hard at the technocratic adjustments, the most promising solution is to adjust the capital requirements of the firms, as Mr. Wallison said, in such as fashion as it becomes less attractive and less profitable to become a big financial firm. I also agree and would emphasize what Ms. Rivlin said, which is thinking about how to target leverage and control leverage, again through something akin to a modern version of margin requirements is very appealing in this situation. It's about size. CIT Group was $80 billion in assets. Treasury and other--looked long and hard not at that before deciding not to bail it out. I think from what we see right now, that was a smart decision. I think the market can take care of it. The line they're drawing seems to be around $100 billion in assets. Financial institutions above $500 billion in assets right now clearly benefit from some sort of implicit government guarantee, going forward. And that's a problem, that distorts incentives, exactly as many members of the committee emphasized it at the beginning. So I think stronger capital requirements. You could also do this with a larger insurance premium for bigger banks. What have they cost? What has the failure of risk management at these major banks cost the United States? Well, I would estimate that our privately held government debt will rise from around 40 percent of GDP, where it was initially to around 80 percent of GDP as the result of all the measures, direct and indirect, taken to save the financial system and to prevent this from turning into another Great Depression. That's a huge cost, and at the end of the day, you actually have more concentrated economic power, a more concentrated political access influence--call it what you want--in the financial system. So for 40 percent of GDP, we bought ourselves nothing in terms of reducing the level of system risk that we know now was very high, 2005-2007. I think it's capital requirements and you can combine that with higher insurance premium, reflecting the system costs. That's a lot of money. And include a tax on leverage. Now I want to, in my remaining 2 minutes, emphasize some issues of implementation I think are very important. The first is in terms of timing. I think the capital requirements can be phased in over time. I think the advantage of an economy that's bottoming out and starting to recover, you don't have to do this right away. The firms will likely--not for sure--will likely not engage in the same kind of restless risk-taking in the next 2 to 3 years. So there is some time to get ahead of this. But you really don't want to run through anything like the kind of boom that we have seen before. And of course this will reduce the profitability in this sector. No question about it. And the industry will point this out. They will be very cross with you, and they will tell you that this undermines productivity growth, and job creation in the United States. I see no evidence that is the case. I see no evidence that having an overleveraged financial system with excessive risk-taking does anything at all for growth in the real non-financial part of the economy. Now I would emphasize, though, two important pieces of this that we should also consider and that are more tricky. The first is foreign banks. So if we reduce the size of our banks, relative to the size of foreign banks, I think that does not create a competitive disadvantage for our industry. But it does raise the question of, ``How should you treat foreign banks operating in the United States?'' For example, Deutsche Bank, or other big European banks, banks that are very big relative to the size of those economies in Europe, let alone the size of the banks that we may end up with. Those banks, to the extent they operate in the United States, should be treated in the same way as U.S. banks. The capital requirements have to be high based on where you operate. And if you want to operate in the U.S. financial markets, that will have to be a requirement. Otherwise, you get into a situation where the next bank that comes to the Treasury and says, you know, ``It's bailout or collapse,'' will be a foreign bank, and that will be even more of a disaster than what we have faced recently. The second transactional issue, and my final point is with regards to the resolutional authority, I think Congress is rightly considering very carefully the resolutional authority requested by the Treasury, and I think that broadly speaking, that's a good idea. But I would emphasize, it is not sufficient. It's not a global resolutional authority. If a major multi-national bank comes to you with a problem and you know, you would like to say to them, ``Go through bankruptcy,'' but then when you look at the details of that, you see it will be a complete mess, because of the cross-border dimensions of that business. The same thing is true for a bailout. If you bail them out under your resolutional authority, it's also going to be a disaster unless you have a global agreement at the level of the G-20. Thank you very much, Mr. Chairman. [The prepared statement of Mr. Johnson can be found on page 49 of the appendix.] " CHRG-111hhrg52406--36 Mr. Mierzwinski," Thank you, Mr. Chairman. I am Ed Mierzwinski with the U.S. Public Interest Research Group. Along with Travis Plunkett on the next panel, of the CFA, we are submitting joint testimony, written testimony, on behalf of over a dozen community and civil rights organizations in support of the Consumer Financial Protection Agency as first proposed by Professor Warren, then introduced by Mr. Brad Miller and Mr. William Delahunt, and now part of the President's comprehensive blueprint to reform our financial system. In our written testimony, we went into great detail as to why this new agency will protect consumers from unfair credit payment and debt management products no matter what company or bank sells them and no matter what agency may serve as their primary regulator. I want to also point out that our coalition recognizes that there are a number of other problems that your committee will be addressing over the next year and that those problems, including systemic risk, including the bad incentives for executive pay, including the shadow banking system, and other issues, are all covered in our Americans for Financial Reform platform, which is available at ourfinancial security.org, and we intend to work closely with the Congress to make sure that as strong as possible recommendations are enacted. The idea of a Federal financial consumer protection agency is a critical part of the President's plan, and we urge you to recognize that it must be given authority to make the rules, to supervise compliance with the rules, and to finally to enforce those rules. In the area of enforcement of the rules, we are very appreciative that the President has proposed that not only will this agency enforce the rules but that State supervisory regulators and the State Attorney General will be able also to enforce the rules. We will reinstate Federal law as a floor, not as a ceiling, also that private rights of action will be allowed, that consumers will be able to enforce the consumer laws. The provision also provides the President's provision that arbitration, forced arbitration clauses in banking contracts, be eliminated as a way to make it easier for private enforcement of the consumer laws. We also propose, in the writing of the legislation, that you ensure that consumers be allowed to enforce the rules, not only the laws. I want to start out by saying that we have a system that is broken, and what we are trying to do is fix it. The current system does not work. It is possible to create a new system that will work. Let me look really quickly at some of the failures of the current financial system. First, the Fed had 15 years in which it did not write rules about HOEPA. Second, the OCC spent most of its time and energy preempting the States for 15 years instead of enforcing the laws. By the way, there is one law that the States still are allowed to enforce, which are fair lending laws, and before the Supreme Court now is the case where the OCC has sued New York because it tried to enforce those fair lending laws. On credit cards, we know the answer to that one. They slept while the credit card problem got worse, and Congress had to step in and solve the problem. The Fed has allowed a shadow banking system of prepaid cards outside of the current financial protection laws that target the unbanked and immigrants. The OTS allows bank payday loans to continue on prepaid cards. The Fed has refused to speed up check availability. The list goes on and on. The Fed has supported the position of payday lenders and telemarketing fraud artists by promoting and permitting remotely controlled checks to subvert consumer rights under the banking laws. These regulators do not look at consumer protection as something that they should be doing. There are basically six arguments that the other side will use against this agency. They will argue the regulators already have the power. Well, they have the power, but they do not use it, partly because of their culture, partly because of charter shopping, and partly because safety and soundness trumps consumer protection. That is why they must be separated. They will argue it will be a redundant layer of bureaucracy, that it will take away bureaucracy. We have 7 regulators enforcing 20 different laws. That is the wrong way to go. I have already discussed that we can separate consumer protection from supervision. The proposal from the President talks about a council of regulators with a prudential regulator on the board of the new agency. The President also talks about making sure that there is the sharing of information. We are looking for a new system. We are not looking to take this agency and to cut it off at the knees. We can separate the two. The agencies will argue and the banks will probably argue that small banks will be hurt. We have a detailed appendix in our testimony. Small banks are actually part of the problem. They promote payday loans. They do a lot of things that are not good. Finally, as I already discussed, the opponents of the proposal will argue that taking away Federal uniformity is somehow the wrong thing to do. We think it is the right thing to do. Thank you very much. [The joint prepared statement of Mr. Mierzwinski and Mr. Plunkett can be found on page 118 of the appendix.] " CHRG-111shrg52619--28 Mr. Polakoff," Good morning, Chairman Dodd. Thank you for inviting me to testify on behalf of OTS on ``Modernizing Bank Supervision and Regulation.'' As you know, our current system of financial supervision is a patchwork with pieces that date back to the Civil War. If we were to start from scratch, no one would advocate establishing a system like the one we have, cobbled together over the last century and a half. The complexity of our financial markets has in some cases reached mind-boggling proportions. To effectively address the risks in today's financial marketplace, we need a modern, sophisticated system of regulation and supervision that applies evenly across the financial services landscape. Our current economic crisis enforces the message that the time is right for an in-depth, careful review and meaningful, fundamental change. Any restructuring should take into account the lessons learned from this crisis. At the same time, the OTS recommendations that I am presenting here today do not represent a realignment of the current regulatory structure. Rather, they represent a fresh start using a clean slate. They represent the OTS vision for the way financial services regulation in this country should be. In short, we are proposing fundamental changes that would affect virtually all of the current financial regulators. It is important to note that these are high-level recommendations. Before adoption and implementation, many details would need to be worked out and many questions would need to be answered. The OTS proposal for modernization has two basic elements. First, a set of guiding principles, and second, recommendations for Federal bank regulation, holding company supervision, and systemic risk regulation. So what I would like to do is offer the five guiding principles. Number one, a dual banking system with Federal and State charters for banks. Number two, a dual insurance system with Federal and State charters for insurance companies. Number three, the institution's operating strategy and business model would determine its charter and identify its responsible regulatory agency. Institutions would not simply pick their regulator. Number four, organizational and ownership options would continue, including mutual ownership, public and private stock entities, and Subchapter S corporations. And number five, ensure that all entities offering financial products are subject to the consistent laws, regulations, and rigor of regulatory oversight. Regarding our recommendations on regulatory structure, the OTS strongly supports the creation of a systemic risk regulator with authority and resources to accomplish the following three functions. Number one, to examine the entire conglomerate. Number two, to provide temporary liquidity in a crisis. And number three, to process a receivership if failure is unavoidable. For Federal bank regulation, the OTS proposes two charters, one for banks predominately focused on consumer and community banking products, including lending, and the other for banks primarily focused on commercial products and services. The business models of the commercial bank and the consumer and community bank are fundamentally different enough to warrant two distinct Federal banking charters. These regulators would each be the primary Federal supervisor for State chartered banks with the relevant business models. A consumer and community bank regulator would close the gaps in regulatory oversight that led to a shadow banking system of uneven regulated mortgage companies, brokers, and consumer lenders that were significant causes of the current crisis. This regulator would also be responsible for developing and implementing all consumer protection requirements and regulations. Regarding holding companies, the functional regulator of the largest entity within a diversified financial company would be the holding company regulator. I realize I have provided a lot of information and I look forward to answering your questions, Mr. Chairman. " fcic_final_report_full--582 CDS Portfolio,” provided to the FCIC. 86. Park, interview. 87. AIG, CDS notional balances at year-end, 2000 through 2010 Q1. 88. Alan Frost, interview by FCIC, May 11, 2010. 89. AIG Financial Products Corp. Deferred Compensation Plan, March 18, 2005, p. 2. 90. Joseph Cassano, email to All Users, re: 2007 Special Compensation Plan, December 17, 2007. 91. Joseph Cassano compensation history, provided by AIG to the FCIC. 92. AIG, Form 8-K, filed May 1, 2005. 93. “Fact Sheet on AIGFP,” provided by Hank Greenberg, p. 4. 94. AIG, CDS notional balances at year-end. 95. Gene Park, email to Joseph Cassano, re: “CDO of ABS Approach Going Forward—Message to the Dealer Community,” February 28, 2006. 96. Henry M. Paulson Jr., testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 22. 97. Henry M. Paulson Jr., written testimony for the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, p. 2. 98. Goldman Sachs, 2005 and 2006 10-K (appendix 5a to Goldman’s March 8, 2010, letter to the FCIC). 99. Appendix 5c to Goldman’s March 8, 2010, letter to the FCIC. 100. Goldman’s March 8, 2010, letter to the FCIC, p. 28 (subprime securities). 101. “Protection Bought by GS,” spreadsheet provided by Goldman Sachs to the FCIC. Specifically, IKB purchased $30 million of Class A notes, $40 million of Class B notes, and $30 million of Class C notes on June 9, 2004. TCW purchased $50 million of Class A notes in January 2005, and Wachovia pur- chased $45 million of Class A notes in March 2005. See ibid., Exhibit 1. 102. FCIC staff calculations based on data provided by Goldman Sachs. 103. “Protection Bought by GS,” spreadsheet. 104. FCIC calculations based on data provided by Goldman Sachs. 105. FCIC staff analysis based on data provided by Goldman Sachs. 106. Sparks, interview. 107. Of course, in theory the net impact on the financial system is not greater, because there is a win- ner for every loser in the derivatives market. 108. Sparks, interview. 109. From Goldman Sachs data provided to the FCIC in a handout titled “Amplification” and quoted at the FCIC’s Hearing on the Role of Derivatives in the Financial Crisis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010. 110. FCIC staff analysis based on data provided by Goldman Sachs. 111. Lloyd Blankfein, chairman of the board and chief executive officer, Goldman Sachs Group, inter- view by FCIC, June 16, 2010; Sparks, interview. 112. Gary Cohn, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial Cri- sis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, transcript, p. 351. 113. Parkinson, interview. 114. Michael Greenberger, before the FCIC, Hearing on the Role of Derivatives in the Financial Cri- sis, day 1, session 1: Overview of Derivatives, June 30, 2010; oral testimony, transcript, p. 109; written tes- timony, p. 16. 115. Moody’s Investors Service, “Summary of Key Provisions for Cash CDOs as of January 2000– 2010.” 116. Gary Witt, written testimony for the FCIC, Hearing on Credibility of Credit Ratings, the Invest- ment Decisions Made Based on Those Ratings, and the Financial Crisis, day 1, session 1: The Ratings Process, June 2, 2010, pp. 12, 15. 579 117. Ibid., 12. 118. Gary Witt, testimony before the FCIC, Hearing on Credibility of Credit Ratings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis, day 1, session 1: The Ratings Process, June 2, 2010, transcript, pp. 168, 436. 119. Moody’s Investors Service, “Moody’s Approach to Rating Multisector CDOs,” September 15, 2000, p. 5. 120. Gary Witt, interview by FCIC, April 21, 2010. 121. Witt, written testimony for the FCIC, June 2, 2010, p. 17. 122. Gary Witt, follow-up interview by FCIC, May 13, 2010. 123. Witt, interview, April 21, 2010. 124. For example, Moody’s assumed that borrowers with different credit ratings would not default at the same time. The agency split the securities into three subcategories based on the average FICO score of the underlying mortgages: prime (FICO greater than 700), midprime (FICO between 700 and 625), and subprime (FICO under 625). Creating three FICO-based subcategories rather than the traditional two (prime and subprime) resulted in lower correlation assumptions, because mortgage-backed securi- ties in different subcategories were assumed to be less correlated. “Moody’s Revisits Its Assumptions Re- garding Structured Finance Default (and Asset) Correlations for CDOs,” June 27, 2005, pp. 15, 5, 7, 9, 4; Gary Witt, interview by FCIC, May 6, 2010. 125. Hedi Katz, “U.S. Subprime RMBS in CDOs,” Fitch Special Report, April 15, 2005, p. 3; Sten Bergman, “CDO Evaluator Applies Correlation and Monte Carlo Simulation to Determine Portfolio Quality,” Standard & Poor’s Global Credit Portal RatingsDirect, November 13, 2001, p. 8. 126. Ingo Fender and Janet Mitchell, “Structured Finance: Complexity, Risk and the Use of Ratings,” CHRG-111shrg55117--15 Mr. Bernanke," Well, Mr. Chairman, I think the first order of business last fall was to avert essentially the collapse of the system, and that was a very important step and we did achieve that and the system now appears to be much more stable. It is still very challenged. Banks--some banks are still short of capital. Other banks are concerned about future losses. They are concerned about the weakness in the economy and the weakness of potential borrowers. So there are legitimate concerns that banks have. That being said, the Fed and the other bank regulators have been very clear that banks should be making loans to creditworthy borrowers, that it is in their interest, the banks' interest, as well as in the interest of the economy, and we are working with banks to make sure they do that. I think that we are seeing improvement over time. We are seeing some stabilization in the terms and standards that banks are applying to borrowers. And I suspect we will see some continued improvement. But we understand that issue and we are trying as best we can to support bank lending through measures such as the TALF, which we already discussed. " CHRG-111hhrg61852--63 Mr. Koo," After the bursting of a major nationwide asset price bubble, banks are hit very badly as well, and that is what happened in Japan. That is what is happening in this country as well. Commercial real estate prices in Japan fell 87 percent from the peak. And just imagine Washington, D.C., down 87 percent. What kind of banking system do you think you would have left? That is the challenge we faced in Japan. And when all the banks have the same problem at the same time, we have to go slowly. There is no way we can go quickly, because if they tried to sell the nonperforming loans, there won't be any buyers. Asset prices would collapse even further, and that makes the situation far worse. Mrs. McCarthy of New York. The gentleman's time has expired. I remind the members that if you keep your questions shorter, you can actually get some answers. Mr. Scott from Georgia. " CHRG-111shrg56376--121 PREPARED STATEMENT OF SHEILA C. BAIR Chairman, Federal Deposit Insurance Corporation August 4, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the importance of reforming our financial regulatory system. Specifically, you have asked us to address the regulatory consolidation aspects of the Administration's proposal and whether there should be further consolidation. The proposals put forth by the Administration regarding the structure of the financial system and the supervision of financial entities provide a useful framework for discussion of areas in vital need of reform. The goal of any reforms should be to address the fundamental causes of the current crisis and to put in place a regulatory structure that guards against future crises. There have been numerous proposals over the years to consolidate the Federal banking regulators. This is understandable given the way in which the present system developed, responding to new challenges as they were encountered. While appealing in theory, these proposals have rarely gained traction because prudential supervision of FDIC insured banks has held up well in comparison to other financial sectors in the United States and against non-U.S. systems of prudential supervision. Indeed, this is evidenced by the fact that large swaths of the so-called ``shadow banking sector'' have collapsed back into the healthier insured sector, and U.S. banks--notwithstanding their current problems--entered this crisis with less leverage and stronger capital positions than their international competitors. Today, we are again faced with proposals to restructure the bank regulatory system, including the suggestion of some to eliminate separate Federal regulators for national- and State-chartered institutions. We have previously testified in support of a systemic risk council which would help assure coordination and harmonization in prudential standards among all types of financial institutions, including commercial banks, investment banks, hedge funds, finance companies, and other potentially systemic financial entities to address arbitrage among these various sectors. We also have expressed support for a new consumer agency to assure strong rules and enforcement of consumer protection across the board. However, we do not see merit or wisdom in consolidating Federal supervision of national and State banking charters into a single regulator for the simple reason that the ability to choose between Federal and State regulatory regimes played no significant role in the current crisis. One of the important causes of the current financial difficulties was the exploitation of the regulatory gaps that existed between banks and the nonbank shadow financial system, and the virtual nonexistence of regulation of over-the-counter (OTC) derivative contracts. These gaps permitted lightly regulated or, in some cases, unregulated financial firms to engage in highly risky practices and offer toxic derivatives and other products that eventually infected the financial system. In the absence of regulation, such firms were able to take on risks and become so highly levered that the slightest change in the economy's health had deleterious effects on them, the broader financial system, and the economy. Gaps existed in the regulation and supervision of commercial banks--especially in the area of consumer protection--and regulatory arbitrage occurred there as well. Despite the gaps, bank regulators maintained minimum standards for the regulation of capital and leverage that prevented many of the excesses that built-up in the shadow financial sector. Even where clear regulatory and supervisory authority to address risks in the system existed, it was not exercised in a way that led to the proper management of those risks or to provide stability for the system, a problem that would potentially be greatly enhanced by a single Federal regulator that embarked on the wrong policy course. Prudent risk management argues strongly against putting all your regulatory and supervisory eggs in one basket. Moreover, a unified supervisor would unnecessarily harm the dual banking system that has long served the financial needs of communities across the country and undercut the effectiveness of the deposit insurance system. In light of these significant failings, it is difficult to see why so much effort should be expended to create a single regulator when political capital could be better spent on more important and fundamental issues which brought about the current crisis and the economic harm it has done. In addition, a wholesale reorganization of the bank regulatory and supervisory structure would inevitably result in a serious disruption to bank supervision at a time when the industry still faces major challenges. Based on recent experience in the Federal Government with such large scale agency reorganizations, the proposed regulatory and supervisory consolidation, directly impacting the thousands of line examiners and their leadership, would involve years of career uncertainty and depressed staff morale. At a time when the supervisory staffs of all the agencies are working intensively to address challenges in the banking sector, the resulting distractions and organizational confusion that would follow from consolidating the banking agency supervision staffs would not result in long term benefits. Any benefits would likely be offset by short term risks and the serious disadvantages that a wholesale reorganization poses for the dual banking system and the deposit insurance system. My testimony will discuss the issues raised by the creation of a single regulator and supervisor and the impact on important elements of the financial system. I also will discuss the very important roles that the Financial Services Oversight Council and the Consumer Financial Protection Agency (CFPA) can play in addressing the issues that the single Federal regulator and supervisor apparently seeks to resolve, including the dangers posed by regulatory arbitrage through the closing of regulatory gaps and the application of appropriate supervisory standards to currently unregulated nonbank financial companies.Effects of the Single Regulator Model The current financial supervisory system was created in a series of ad hoc legislative responses to economic conditions over many years. It reflects traditional themes in U.S. history, including the observation in the American experience that consolidated power, financial or regulatory, has rarely resulted in greater accountability or efficiency. The prospect of a unified supervisory authority is alluring in its simplicity. However, there is no evidence that shows that this regulatory structure was better at avoiding the widespread economic damage that has occurred over the past 2 years. The financial systems of Austria, Belgium, Hungary, Iceland and the United Kingdom have all suffered in the crisis despite their single regulator approach. Moreover, it is important to point out that the single regulator system has been adopted in countries that have highly concentrated banking systems with only a handful of very large banks. In contrast, our system, with over 8,000 banks, needs a regulatory and supervisory system adapted to a country of continental dimensions with 50 separate States, with significantly different economies, and with a multiplicity of large and small banks. Foreign experience suggests that, if anything, the unified supervisory model performed worse, not better than a system of multiple regulators. It should be noted that immediately prior to this crisis, organizations representing large financial institutions were calling aggressively for a move toward the consolidated model used in the U.K. and elsewhere. \1\ Such proposals were viewed by many at the time as representing an industry effort to replicate in this country single regulator systems viewed as more accommodative to large, complex financial organizations. It would indeed be ironic if Congress now succumbed to those calls. A regulatory structure based on this approach would create serious issues for the dual banking system, the survival of community banks as a competitive force, and the strength of the deposit insurance system that has served us so well during this crisis.--------------------------------------------------------------------------- \1\ See, New York City Economic Development Corporation and McKinsey & Co., Sustaining New York's and the U.S.'s Global Financial Services Leadership, January 2007. See, also Financial Services Roundtable, Effective Regulatory Reform, Policy Statement, May 2008.---------------------------------------------------------------------------The Dual Banking System Historically, the dual banking system and the regulatory competition and diversity that it generates has been credited with spurring creativity and innovation in financial products and the organization of financial activities. State-chartered institutions tend to be community-oriented banks that are close to their communities' small businesses and customers. They provide the funding that supports economic growth and job creation, especially in rural areas. They stay close to their customers, they pay special personal attention to their needs, and they are prepared to work with them to solve unanticipated problems. These community banks also are more accountable to market discipline in that they know their institution will be closed if they become insolvent rather than being considered ``too big to fail.'' A unified supervisory approach would inevitably focus on the largest banks to the detriment of the community banking system. This could, in turn, feed further consolidation in the banking industry--a trend counter to current efforts to reduce systemic exposure to very large financial institutions and end too big too fail. Further, if the single regulator and supervisor is funded, as the national bank regulator and supervisor is now funded, through fees on the State-chartered banks it would examine, this would almost certainly result in the demise of the dual banking system. State-chartered institutions would quickly switch to national charters to escape paying examination fees at both the State and Federal levels. The undermining of the dual banking system through the creation of a single Federal regulator would mean that the concerns and challenges of community banks would inevitably be given much less attention or even ignored. Even the smallest banks would need to come to Washington to try to be heard. In sum, a unified regulatory and supervisory approach could result in the loss of many benefits of the community banking system.The Deposit Insurance System The concentration of examination authority in a single regulator would also have an adverse impact on the deposit insurance system. The FDIC's ability to directly examine the vast majority of financial institutions enables it to identify and evaluate risks that should be reflected in the deposit insurance premiums assessed on individual institutions. The loss of an ongoing significant supervisory role and the associated staff would greatly diminish the effectiveness of the FDIC's ability to perform its congressionally mandated role--reducing systemic risk through risk based deposit insurance assessments and containing the potential costs of deposit insurance by identifying, assessing and taking actions to mitigate risks to the Deposit Insurance Fund. If the FDIC were to lose its supervisory role to a unified supervisor, it would need to rely heavily on the examinations of that supervisor. In this context, the FDIC would need to expand the use of its backup authority to ensure that it is receiving information necessary to properly price deposit insurance assessments for risk. This would result in duplicate exams and increased regulatory burden for many financial institutions. The FDIC as a bank supervisor also brings the perspective of the deposit insurer to interagency discussions regarding important issues of safety and soundness. During the discussions of the Basel II Advanced Approaches, the FDIC voiced deep concern about the reductions in capital that would have resulted from its implementation. Under a system with a unified supervisor, the perspective of the deposit insurer might not have been heard. It is highly likely that the advanced approaches of Basel II would have been implemented much more quickly and with fewer safeguards, and banks would have entered the crisis with much lower levels of capital. In particular, the longstanding desire of many large institutions for the elimination of the leverage ratio would have been much more likely to have been realized in a regulatory structure in which a single regulator plays the predominant role. This is a prime example of how multiple regulators' different perspectives can result in a better outcome.Regulatory Capture The single regulator approach greatly enhances the risk of regulatory capture should this regulator become too closely tied to the goals and operations of the regulated banks. This danger becomes much more pronounced if the regulator is focused on the needs and problems of large banks--as would be highly likely if the single regulator is reliant on size-based fees for its funding. The absence of the existence of other regulators would make it much more likely that such a development would go undetected and uncorrected since there would be no standard against which the actions of the single regulator could be compared. The end result would be that the damage to the system would be all the more severe when the problems produced by regulatory capture became manifest. One of the advantages of multiple regulators is that they provide standards of performance against which the conduct of their peers can be assessed, thus preventing any single regulator from undermining supervisory standards for the entire industry.Closing the Supervisory Gaps As discussed above, the unified supervisor model does not provide a solution to the fundamental causes of the economic crisis, which included regulatory gaps between banks and nonbanks and insufficiently proactive supervision. As a result of these deficiencies, insufficient attention was paid to the adequacy of complex institutions' risk management capabilities. Too much reliance was placed on mathematical models to drive risk management decisions. Notwithstanding the lessons from Enron, off-balance-sheet vehicles were permitted beyond the reach of prudential regulation, including holding company capital requirements. The failure to ensure that financial products were appropriate and sustainable for consumers caused significant problems not only for those consumers but for the safety and soundness of financial institutions. Lax lending standards employed by lightly regulated nonbank mortgage originators initiated a downward competitive spiral which led to pervasive issuance of unsustainable mortgages. Ratings agencies freely assigned AAA credit ratings to the senior tranches of mortgage securitizations without doing fundamental analysis of underlying loan quality. Trillions of dollars in complex derivative instruments were written to hedge risks associated with mortgage backed securities and other exposures. This market was, by and large, excluded from Federal regulation by statute. To prevent further arbitrage between the bank and nonbank financial systems, the FDIC supports the creation of a Financial Services Oversight Council and the CFPA. Respectively, these agencies will address regulatory gaps in prudential supervision and consumer protection, thereby eliminating the possibility of financial service providers exploiting lax regulatory environments for their activities. The Council would oversee systemic risk issues, develop needed prudential policies and mitigate developing systemic risks. A primary responsibility of the Council should be to harmonize prudential regulatory standards for financial institutions, products and practices to assure that market participants cannot arbitrage regulatory standards in ways that pose systemic risk. The Council should evaluate differing capital standards which apply to commercial banks, investment banks, investment funds, and others to determine the extent to which differing standards circumvent regulatory efforts to contain excess leverage in the system. The Council also should undertake the harmonization of capital and margin requirements applicable to all OTC derivatives activities--and facilitate interagency efforts to encourage greater standardization and transparency of derivatives activities and the migration of these activities onto exchanges or central counterparties. The CFPA would eliminate regulatory gaps between insured depository institutions and nonbank providers of financial products and services by establishing strong, consistent consumer protection standards across the board. It also would address another gap by giving the CFPA authority to examine nonbank financial service providers that are not currently examined by the Federal banking agencies. In addition, the Administration's proposal would eliminate the potential for regulatory arbitrage that exists because of Federal preemption of certain State laws. By creating a floor for consumer protection and allowing more protective State consumer laws to apply to all providers of financial products and services operating within a State, the CFPA should significantly improve consumer protection. A distinction should be drawn between the macroprudential oversight and regulation of developing risks that may pose systemic risks to the U.S. financial system and the direct supervision of financial firms. The macroprudential oversight of systemwide risks requires the integration of insights from a number of different regulatory perspectives--banks, securities firms, holding companies, and perhaps others. Only through these differing perspectives can there be a holistic view of developing risks to our system. Prudential supervisors would regulate and supervise the institutions under their jurisdiction, and enforce consumer standards set by the CFPA and any additional systemic standards established by the Council. Entities that are already subject to a prudential supervisor, such as insured depository institutions and financial holding companies, should retain those supervisory relationships. In addition, for systemic entities not already subject to a Federal prudential supervisor, and to avoid the regulatory arbitrage that is a source of the current problem, the Council should be empowered to require that they submit to such oversight. Presumably this could take the form of a financial holding company under the Federal Reserve--without subjecting them to the activities restrictions applicable to these companies. There is not always a clear demarcation of these roles and they will need to coordinate to be effective. Industry-wide standards for safety and soundness are based on the premise that if most or all banking organizations are safe, the system is safe. However, practices that may be profitable for a few institutions may not be prudent if that same business model is adopted by a large number of institutions. From our recent experience we know that there is a big difference between one regulated bank having a high concentration of subprime loans and concentrations of subprime lending across large sections of the regulated and nonregulated financial system. Coordination of the prudential and systemic approaches will be vital to improving supervision at both the bank and systemic level. Risk management is another area where there should be two different points of view. Bank supervisors focus on whether a banking organization has a reasonable risk management plan for its organization. The systemic risk regulator would look at how risk management plans are developed across the industry. If everyone relies on similar risk mitigation strategies, then no one will be protected from the risk. In other words, if everyone rushes to the same exit at the same time, no one will get out safely. Some may believe that financial institutions are able to arbitrage between regulators by switching charters. This issue has been addressed directly by recent action by the Federal banking regulators to coordinate prudential supervision so institutions cannot evade uniform enforcement of regulatory standards. The agencies all but eliminated any possibility of this in the recent issuance of a Statement on Regulatory Conversions that will not permit charter conversions that undermine the supervisory process. The FDIC would support legislation making the terms of this agreement binding by statute. We also would support time limits on the ability to convert. The FDIC has no statutory role in the charter conversion process. However, as insurer of all depository institutions, we have a vital interest in protecting the integrity of the supervisory process and guarding against any possibility that the choice of a Federal or State charter could undermine that process.Conclusion The focus of efforts to reform the financial system should be the elimination of the regulatory gaps between banks and nonbank financial providers outside the traditional banking system, as well as between commercial banks and investment banks. Proposals to create a unified supervisor would undercut the benefits of diversity that are derived from the dual banking system and that are so important to a very large country with a very large number of banks chartered in multiple jurisdictions with varied local needs. As evidenced by the experience of other much smaller countries with much more concentrated banking systems, such a centralized, monolithic regulation and supervision system has significant disadvantages and has resulted in greater systemic risk. A single regulator is no panacea for effective supervision. Congress should create a Financial Services Oversight Council and Consumer Financial Protection Agency with authority to look broadly at our financial system and to set minimum uniform rules for the financial sector. In addition, the Administration's proposal to create a new agency to supervise federally chartered institutions will better reflect the current composition of the banking industry. Finally, but no less important, there needs to be a resolution mechanism that encourages market discipline for financial firms by imposing losses on shareholders and creditors and replacing senior management in the event of failure. I would be pleased respond to your questions. ______ CHRG-110hhrg46596--161 Mrs. Biggert," Well, you said that you are monitoring, and there are indicators that include: One, that the financial system hasn't collapsed; two, that the credit default swap spread for the 8 largest U.S. banks has declined more than 200 points; and three, that the LIBOR and OIS spreads have declined 100 basis points, but when will we hear a more concrete description just about what the institutions are doing with the funds that they are receiving? " CHRG-111hhrg53238--50 Mr. Yingling," Thank you, Mr. Chairman. ABA believes there are three areas that should be the primary focus of reform: the creation of a systemic regulator; the creation of a mechanism for resolving institutions; and filling the gaps in regulation of the shadow-banking industry. The reforms need to be grounded in a real understanding of what caused the crisis. For that reason, my written testimony discusses continuing misunderstandings of the place of traditional banking in this mess. ABA appreciates the fact that the bipartisan leadership of this committee has often commented that the crisis in large part developed outside the traditional banking industry. The Treasury's plan noted that 94 percent of high-cost mortgages were made outside traditional banking. The ABA strongly supports the creation of an agency to oversee systemic risk. The role of the systemic risk oversight regulator should be one of identifying potential systemic problems and then putting forth solutions. This process is not about regulating specific institutions, which should be left primarily to the prudential regulators. It is about looking at information on trends in the economy and different sectors within the economy. Such problematic trends from the recent past would have included the rapid appreciation of home prices, proliferation of mortgages that ignored the long-term ability to repay, excess leverage in some Wall Street firms, the rapid growth and complexity of mortgage-backed securities and how they were rated, and the rapid growth of the credit default swap market. This agency should be focused and nimble. In fact, involving it in a day-to-day regulation would be a distraction. While much of the early focus was on giving this authority directly to the Fed, now most of the focus is on creating a separate council of some type. This would make sense, but it should not be a committee. The council should have its own dedicated staff, but it should not be a large bureaucracy. The council should primarily use information gathered from institutions through their primary regulators. However, the systemic agency should have some carefully calibrated backup authority when systemic issues are not being addressed. There is currently a debate about the governance of such council. A board consisting of the primary regulators, plus Treasury, would seem logical. As to the Chair of the agency, there would seem to be three choices: Treasury; the Fed; or an independent person appointed by the President. A systemic regulator could not possibly do its job if it cannot have oversight authority over accounting rulemaking. A recent hearing before your Capital Markets Subcommittee clearly demonstrated the disastrous procyclical impact of recent accounting policies, and I appreciate the chairman's reference to that at the beginning of this hearing. Thus a new system for oversight of accounting rules needs to be created in recognition of the critical importance of accounting rules to systemic risk. H.R. 1349, introduced by Representatives Perlmutter and Lucas, would be in a position to accomplish this. ABA has strongly supported this legislation in previous testimony. As the systemic oversight agency is developed, Congress could consider making that agency the appropriate body to which the FASB reports under the approach of H.R. 1349. Let me turn to the resolution issue. We have a successful mechanism for resolving banks. Of course, there is no mechanism for resolution of systemically important nonbank firms. Our regulatory bodies should never again be in the position of making up a solution on the fly to a Bear Stearns or an AIG or not being able to resolve a Lehman Brothers. A critical issue in this regard is ``too-big-to-fail,'' and again I appreciate the chairman's reference to a separate hearing on that critical issue. Whatever is done on the resolution system will set the parameters for too-big-to-fail. We are concerned that the too-big-to-fail concept is not adequately addressed in the Administration's proposal. The goal should be to eliminate, as much as possible, moral hazard and unfairness. When an institution goes into the resolution process, its top management, board, and major stakeholders should be subject to clearly set out rules of accountability, change, and financial loss. No one should want to be considered too-big-to-fail. Finally, the ABA strongly supports maintaining the Federal thrift charter. Mr. Chairman, ABA appreciates your public statements in support of maintaining the thrift charter. There are 800-plus thrift institutions and another 125 mutual holding companies. Forcing these institutions to change their charter and business plan would be disruptive, costly, and wholly unnecessary. Thank you, Mr. Chairman. [The prepared statement of Mr. Yingling can be found on page 187 of the appendix.] " fcic_final_report_full--613 House Financial Services Committee, 111th Cong., 2nd sess., April 20, 2010, p. 1. 30. Valukas, 1:8 n. 30: Examiner’s Interview of Timothy F. Geithner, Nov. 24, 2009, p. 4. 31. Valukas, 4:1486. 32. Sirri, interview. 33. William Brodows and Til Schuermann, Federal Reserve Bank of New York, “Primary Dealer Mon- itoring: Initial Assessment of CSEs,” May 12, 2008, slides 9–10, 15–16. 34. Federal Reserve Bank of New York, “Primary Dealer Monitoring: Liquidity Stress Analysis,” June 25, 2008, p. 3. 35. Ibid., p. 5. 36. Valukas, 4:1489. 37. Ibid., 4:1496, 1497. 38. Christopher Cox, statement before the House Financial Services Committee, 111th Cong., 2nd sess., April 20, 2010, p. 5. 39. Patrick Parkinson, email to Steven Shafran, August 8, 2008. 40. Counterparty Risk Management Policy Group, “Toward Greater Financial Stability: A Private Sec- tor Perspective, The Report of the CRMPG II,” July 27, 2005. 41. Federal Reserve Bank of New York, “Statement Regarding Meeting on Credit Derivatives,” Sep- tember 15, 2005; Federal Reserve Bank of New York, “New York Fed Welcomes New Industry Commit- ments on Credit Derivatives,” March 13, 2006; Federal Reserve Bank of New York, “Third Industry Meeting Hosted by the Federal Reserve Bank of New York,” September 27, 2006. 42. See Comptroller of the Currency, “OCC’s Quarterly Report on Bank Trading and Derivatives Ac- tivities, First Quarter 2009,” Table 1; the figures in the text are reached by subtracting exchange traded fu- tures and options from total derivatives. 43. Chris Mewbourne, interview by FCIC, July 28, 2010. 44. This figure compares with a low in 2005, at the height of the mortgage boom, of $7 billion in prob- lem assets. “Problem” institutions are those with financial, operational, or managerial weaknesses that threaten their continued financial viability; they are rated either a 4 or 5 under the Uniform Financial In- stitutions Rating System. FDIC reporting for insured institutions—i.e., the regulated banking and thrift industry overall. See Quarterly Banking Profile: Fourth Quarter 2007= FDIC Quarterly 2, no. 1 (Decem- ber 31, 2007): 1, 4; Quarterly Banking Profile: First Quarter 2008 = FDIC Quarterly 2, no. 2 (March 31, 2008): 2, 4; Quarterly Banking Profile: Second Quarter 2008 = FDIC Quarterly 2, no. 3 (June 30, 2008): 1. 45. By 2009, the problem list would swell to 702 banks, with assets of $403 billion. Quarterly Banking Profile: Fourth Quarter 2009 = FDIC Quarterly 4, no. 1 (December 31, 2009): 4. 46. Quarterly Banking Profile: First Quarter 2008, p. 4. 47. Roger Cole, interview by FCIC, August 2, 2010. 48. FCIC interview with Michael Solomon and Fred Phillips-Patrick, September 20, 2010. 49. Federal Reserve Bank of New York, letter to Charles Prince, April 9, 2007. 50. Federal Reserve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Cur- rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial Services Authority, “Notes on Senior Supervisors’ Meetings with Firms,” November 19, 2007, p. 3. 51. Federal Reserve Board, “FRB New York 2009 Operations Review: Close Out Report,” p. 3. 52. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 210. 53. Steve Manzari and Dianne Dobbeck, interview by FCIC, April 26, 2010. 54. Federal Reserve Board, “Wachovia Case Study,” November 12 and 13, p. 20; 55. Angus McBryde, interview by FCIC, July 30, 2007. 56. Thompson received a severance package worth about $8.7 million in compensation and acceler- ated vesting of stock. In addition, he negotiated himself three years of office space and a personal assis- tant at Wachovia’s expense. Thompson had previously received more than $21 million in salary and stock compensation in 2007 and more than $23 million in 2006; his total compensation from 2002 through 2008 exceeded $112 million. 57. Federal Reserve Bank of Richmond, letter to Wachovia, July 22, 2008, pp. 3–5. 58. Comptroller of the Currency, letter to Wachovia, August 4, 2008, with Report of Examination; let- ter, pp. 8, 3. 59. Ibid., pp. 3–6. 60. Ibid., letter, p. 2; Report of Examination, p. 18. 61. Ibid., Report of Examination, p. 12. 62. “Home Loans Discussion,” materials prepared for WaMu Board of Directors meeting, April 18, 2006, p. 4; Senate Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: The Role of High Risk Home Loans, 111th Cong., 2nd sess., April 13, 2010, Exhibits, p. 83. 63. Senate Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: Role of the CHRG-111hhrg48875--5 Mr. Kanjorski," Good morning, Mr. Chairman. The committee will today consider the Treasury Secretary's ideas related to regulatory reform, focusing in particular on his legislative proposal vesting the Executive Branch with a new power to wind down troubled financial institutions. Specifically, this resolution authority would permit the Administration to place into receivership or conservatorship failing non-bank entities that pose systemic risk to the broader economy. During the last 7 months, the entire global economy has often stood in the balance as our government resorted to erratic 11th hour efforts to prevent a catastrophic economic collapse. Without a guidebook, policymakers could only rely on hurried, ad hoc solutions. Such options, however, are inherently flawed and regularly produce unintended consequences. As we deal with the current financial crisis, we find ourselves facing the very difficult task of fixing a leaky regulatory roof while it is raining. We therefore need to provide the Administration with a bigger hammer, a larger tarp, and the other tools needed to step in sooner when institutions are unhealthy, but not as close to death. Establishing resolution authority for all players in our financial markets has the potential to help lessen the severity of not only the present crisis, but also to prepare us for as yet unknown calamities down the road. Today's forum must also include a discussion of what to do about those entities that presently operate in the shadows of the financial system. Hedge funds, private equity pools, and other unregulated bodies have the potential to unleash devastating consequences on our broader economy. Long-term capital management and AIG financial products are two obvious examples here; and, while the extent of regulation required is debatable, we must begin this crucial examination today and we must include them in the resolution authority. We must also consider how the creation of a new Federal power to wind down troubled financial institutions will affect insurance, which is currently only regulated at the State level. Insurance is part of our financial services system, and is increasingly part of the global market, especially when it comes to products like reinsurance. Because insurance is a piece of the puzzle that we must have in order to complete the picture, I am very interested in discerning how the Treasury Secretary currently envisions the resolution authority working in this market. In sum, we now expect regulatory reform to play with at least three acts: establish a resolution authority; create a system of risk regulator; and overhaul our regulatory authority. The gravity of this situation requires that the Congress deliberate and exercise patience so that we lay a thoughtful regulatory structure that will establish the basis of a strong economy for many years to come. " CHRG-111hhrg48674--363 Mr. Perlmutter," I am putting it out there. You don't have to respond to it, but part of me longs for the good old days of smaller banks or institutions, that in the event they were to fail, it doesn't affect the system, which is what we have had here, and in too many places and in too many spots, number one. Second question, and then I will yield to the gentlewoman from Ohio. Dr. Price kept talking about private capital on the sidelines. I have heard that a lot, private capital on the sidelines. It will come rushing in when we do something. First of all, I want to compliment you; I think we staved off the collapse of a banking system, given what was going on in September. But how much private capital is there to come roaring in after the economy has dropped by 30 or 40 percent? " CHRG-111hhrg52397--233 Mr. Edmonds," Good afternoon, Chairman Kanjorski, and members of the subcommittee. I appreciate the opportunity to testify today on behalf of the International Derivatives Clearing Group. IDCG is an independently managed, majority-owned subsidiary of the NASDAQ OMX Group. IDCG is a CFDC-regulated clearinghouse, offering interest rate futures contracts, which are economically equivalent to the over-the-counter interest rate swap contracts prevalent today. The effective regulation of the over-the-counter derivatives market is essential to the recovery of our financial markets. And this is a very complicated area that is easy to get lost in. Let me summarize by emphasizing four points that go to the heart of the debate: First, central clearing dramatically reduces systemic risk. Second, if we do not make fundamental changes in the structure of these markets, we will not only tragically miss an opportunity that may never come again, but we will also run the risk of repeating the same mistakes. Half measures will not work. Specifically, access to central clearing should be open and conflict free. Third, the cost of the current system should not be understated. The cost of all counterparties posting accurate, risk-based margins pales in comparison to the costs we are incurring today for our flawed system. Finally, the benefits of central clearing, if done correctly, do open access and maximum transparency will benefit all users of these instruments and allow these financial instruments to play the role they were designed to play, the efficient management of risk, and the facilitation of market liquidity. While there is debate around the use of central counterparties, it is important to recognize not all central counterparties are the same. Ultimately, market competition will determine the commercial winners, but I encourage members of this subcommittee to stay focused on one simple point: All participants must play by exactly the same rules. This in turn increases the number of participants, which reduces systemic risk. Central clearing gathers strength from greater transparency and more competition. This is in contrast to the current bilateral world where all parties are only as strong as the weakest link in the chain. There has been much fanfare over the handling of the Lehman default. While it is true some counterparties were part of a system that provided protection, this system was far more of a club than a systemic solution. The Federal Home Loan Bank system in Jefferson County, Alabama, and the New York Giants stadium are examples of end users who suffered losses in the hundreds of millions of dollars. The current system simply failed the most critical component of user, the end user. These are real world examples of why new regulation needs to focus on all eligible market participants. This is the foundation of the all to all concept. As some have continued to confuse the true cost of clearing services, IDCG began to offer what we call ``shadow clearing.'' This is a way users can quantify the actual cost of moving existing portfolios into our central counterparty environment. We now have over $250 billion in shadow clearing. Our data has shown significant concentration risk in the interest rate swap world. In fact, two of the largest four participants were required to raise significant capital as a result of the recently completed stress test. Just last week, before this same subcommittee, Federal Housing Finance Agency Director James Lockhart acknowledged a concentration of counterparties during the past year, along with the deterioration in the quality of some institutions has resulted in Fannie Mae, Freddie Mac and the Federal Home Loan Banks consolidating their derivatives activities among fewer counterparties. We must reverse this trend or we will continue to foster the development of institutions too-large-to-fail. IDCG provides a private industry response to the current financial crisis and our mission has never been more relevant than in today's difficult economic environment. Today's financial system is not equal. The rules of engagement are not transparent, and there are significant barriers to innovation unless the work of this committee, Congress, the Administration, and all of the participants in the debate yields a system that protects all eligible market participants in a manner consistent with the largest participants, the system will fail again. Mr. Chairman, thank you for the opportunity to appear as a witness today, and I am happy to answer any questions. [The prepared statement of Mr. Edmonds can be found on page 139 of the appendix.] " fcic_final_report_full--440 A persistent debate among members of the Commission was the relative importance of a firm’s legal form and regulatory regime in the failures of large financial institu- tions. For example, Commissioners agreed that investment bank holding companies were too lightly (barely) regulated by the SEC leading up to the crisis and that the Consolidated Supervised Entities program of voluntary regulation of these firms failed. As a result, no regulator could force these firms to strengthen their capital or liquidity buffers. There was agreement among Commissioners that this was a con- tributing factor to the failure of these firms. The Commission split, however, on whether the relatively weaker regulation of investment banks was an essential cause of the crisis. Institutional structure and differential regulation of various types of financial in- stitutions were less important in causing the crisis than common factors that spanned different firm structures and regulatory regimes. Investment banks failed in the United States, and so did many commercial banks, large and small, despite a stronger regulatory and supervisory regime. Wachovia, for example, was a large insured de- pository institution supervised by the Fed, OCC, and FDIC. Yet it experienced a liq- uidity run that led to its near failure and prompted the first-ever invocation of the FDIC’s systemic risk exception. Insurance companies failed as well, notably AIG and the monoline bond insurers. Banks with different structures and operating in vastly differing regulatory regimes failed or had to be rescued in the United Kingdom, Germany, Iceland, Bel- gium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark. Some of these nations had far stricter regulatory and supervisory regimes than the United States. The bad loans in the United Kingdom, Ireland, and Spain were financed by federally-regulated lenders–not by “shadow banks.” Rather than attributing the crisis principally to differences in the stringency of regulation of these large financial institutions, it makes more sense to look for com- mon factors: • Different types of financial firms in the United States and Europe made highly concentrated, highly correlated bets on housing. • Managers of different types of financial firms in the United States and Europe poorly managed their solvency and liquidity risk. CHRG-111hhrg54867--240 Mr. Royce," I just look at the way in which--when we look at the GSEs, Fannie Mae and Freddie Mac, I just look at the way in which that bifurcation between the mission over at HUD and then OFHEO, with safety and soundness, I just look at the goals that were stressed at one end obviously in conflict with safety and soundness, and all of the overleveraging that went on and the, sort of, the mandates for the portfolio that half of it had to be subprime in the portfolio or Alt-A loans. I look at that and I see why the regulators are nervous. And that, also, is a chapter that we have experience with. But let me ask you another question, because I was going to ask if you believe the perceived government safety net under our financial system distorted market incentives and contributed to the financial collapse, especially in the housing boom and bust. Can the moral hazard from the perceived safety net itself, in other words, have something to do with the ballooning of the housing market? I am thinking of Fannie and Freddie there. That could be a contributor. " CHRG-111hhrg53238--211 Mr. Menzies," I guess your question presumes that we have some knowledge on whether this is all behind us or not; and that depends upon whether you are from Florida, California, Arizona, Nevada, Ohio, Michigan, or Atlanta, or when you are from the Eastern Shore of Maryland. You can bet I don't know the answer to that question. It also presumes that there is a need to create some regulation to deal with the problem, to deal with the collapse, if you will. And again I would repeat that it is so important to focus on what caused the problem. What caused the $7 trillion of economic loss to the American consumer? We can have all the product legislation in the world and do everything possible to protect the consumer, but the greatest damage to the consumer was the failure of a system because of concentrations and excesses across the board, of a Wall Street vehicle that gathered together substandard, subprime, weird mortgages that community banks didn't make, created a warehouse to slice and dice those entities, make huge profits selling off those items, and have very little skin in the game, very little capital at risk, and to be leveraged, leveraged in some cases, according to the Harvard Business Review this week, 70 to 1. That deserves attention. The too-big-to-fail, systemic-risk, too-big-to-manage, too-big-to-regulate issue must be dealt with. And from the perspective of the community banks, that is the crisis of the day. That is what has destroyed the free market system. " FOMC20080625meeting--296 294,MR. LOCKHART.," Thanks, Mr. Chairman. I have maybe a variation on Governor Warsh's comment of yesterday: Much has been said by many, so I will try not to take too much time here. I think Vice Chairman Geithner's admonitions are correct, and I certainly support them. I am quite supportive of extending through the year-end, and the short-term plan that the Chairman laid out seems quite sensible to me. I don't have well-informed or well-thought-out answers to the more detailed questions that were posed in advance of the meeting. I didn't devote the time to study them in any depth. So let me take refuge in some sort of high-level comments. A number of people around the table have been expressing overview types of comments. I see the touchstone of all of this to be our perceived accountability for systemic risk and financial stability. There may be, in the context of legislation, regulation, and so forth, limits to that; but I think that we are largely perceived as the most accountable party. I have to ask myself, Do we have a system today that is aligned with the reality of the financial markets? Or, put in more vernacular terms, do we have the right stuff to do what we need to do to take responsibility as best we can for financial stability? My answer to that is ""no."" I don't think we have the right stuff. I think the answer to that lies in working out the details of what the right stuff is. But the reality is that financial markets are not bank-centric any longer, with the widely discussed shadow banking system, including hedge funds, a complexity that is not going to go away; international integration that is not going to go away; very, let's just say, compelling economic and financial reasons for off-balance-sheet treatment of various kinds of things; and on and on. We could make a long list of what that reality is. To me, and I have been kind of dwelling on this for some time, that is a reality that is likely to continue. It may take a couple of steps back, but it will continue to develop along certain lines. Do we have a system that is aligned with it? The answer to that is ""no."" So if we can take care of the short-term plan and then buy the time over the next several months to hammer out what we think is the best possible thinking opposite that reality, then that is what I believe we need to be doing. So thank you, Mr. Chairman. " CHRG-110hhrg46594--422 Mr. Sachs," Congressman, we are in a downturn for sure, and it is going to be a very bad one. And even with all the emergencies, this will be the steepest recession that we have had in decades. And the fight is to keep it from turning into a depression right now. So your question is a very good one. But as I have heard all three of the CEOs testifying, what they are doing is assuming a burn rate based on sales at about 11 million units all through 2009. That is a collapse. We have gone from 17 million units down to 11 like that because this is a free fall. We have not seen this, Congressman, for decades. What they are assuming in their assumptions is not a further collapse but what is a collapse. And so I don't think that it is a wildly optimistic assumption. But the main point that I would stress is the following: We will have a deep recession, and then the question is, are we coming out of something or was this just an industry in decline? Now first, I don't believe it was an industry in decline. And I don't think the evidence suggests that it was an industry in decline. Second, I think they have a bridge to actually a whole new set of technologies and a post-SUV era. Everybody loved their SUVs, but now everyone is reconsidering. And it takes a lot of retooling and that is what is happening right now. So I think we are--in terms of make and model and technology, we are actually going somewhere. But there is a third point for Congress that I think is very important. They are going to come back to banks, not to you because we are going to have a banking system working again in this country and that is going to be very important. They do not want to come back to you for the next round. They will go back to the bond markets. They will go back to the banks. And they will have a viable business. " CHRG-111hhrg48867--190 Mr. Wallison," That is the thing that bothers me more than anything else, and worries me. And that is just from what I have experienced with watching Fannie Mae and Freddie Mac. When the government chooses a winner, when the government chooses an institution that it is going to treat specially, different from any other institution, then the market looks at that and decides, quite practically, that I will be taking less risk if I make loans to such a company. And when that happens, those companies then become much tougher competitors for everybody else in the industry. The result will be a collapse of the very competitive financial system we have today and the consolidation of that system into a few very large companies that have been chosen by the government--whether they are banks, securities firms, insurance companies, hedge funds, or anything else. " CHRG-111hhrg48867--38 Mr. Silvers," Thank you, Congressman Kanjorski. Good morning, and good morning to Ranking Member Bachus and the committee. My name is Damon Silvers. I am associate general counsel of the AFL-CIO, and I am the deputy chair of the Congressional Oversight Panel. My testimony today though is on behalf of the AFL-CIO, and though I will refer to the work of the panel on which I am honored to serve together with Congressman Hensarling, my testimony does not reflect necessarily the views of the panel, its chair, or its staff. The AFL-CIO has urged Congress since 2006 to act to reregulate shadow financial markets, and the AFL-CIO supports addressing systemic risk. The Congressional Oversight Panel made the following recommendations with respect to addressing systemic risk, recommendations which the AFL-CIO supports: First, there should be a body charged with monitoring sources of systemic risk in the financial system. The AFL-CIO believes that systemic risk regulation should be the responsibility of a coordinating body of regulators chaired by the Chairman of the Board of Governors of the Federal Reserve System. This body should have its own staff with the resources and expertise to monitor diverse sources of systemic risk in institutions, products, and markets throughout the financial system. Second, the body charged with systemic risk management should be a fully public body, accountable and transparent. The current structure of regional Federal Reserve banks, the institutions that actually do the regulation of bank holding companies, where the banks participate in the governance, is not acceptable for a systemic risk regulator. Third, we should not identify specific institutions in advance as too big to fail but, rather, have a regulatory framework in which institutions have higher capital requirements and pay more on insurance funds on a percentage basis than smaller institutions which are less likely to be rescued as being too systemically significant. Fourth, systemic risk regulation cannot be a substitute for routine disclosure, accountability, safety and soundness, and consumer protection regulation of financial institutions and financial markets. Consequently, the AFL-CIO supports a separate consumer protection agency for financial services rather than having that authority rest with bank regulators. And here we see this consumer protection function as somewhat distinct from investor protection, which the SEC should do. Fifth, effective protection against systemic risk requires that the shadow capital markets, institutions like hedge funds and private equity funds and products like credit derivatives, must not only be subject to systemic risk-oriented oversight, but must also be brought within a framework of routine capital market regulation by agencies like the SEC. We can no longer tolerate a Swiss cheese system of financial regulations. And finally, there will not be effective reregulation of the financial markets without a global regulatory floor. That ought to be a primary goal of the diplomatic arms of our government. The Congressional Oversight Panel urged that attention be paid to executive compensation in financial institutions. This is an issue of particular concern to the AFL-CIO that I want to turn to now in the remainder of my testimony in relation to systemic risk. There are two basic ways in which executive pay can be a source of systemic risk. When financial institutions' pay packages have short-term pay horizons that enable executives to cash out their incentive pay before the full consequences of their actions are known, that is a way to generate systemic risk. Secondly, there is the problem that is technically referred to as risk asymmetry. When an investor holds a stock, the investor is exposed to upside and downside risk in equal proportion. For every dollar of value lost or gained, the stock moves proportionately; but when an executive is compensated with stock options, the upside works like a stock but the downside is effectively capped. Once the stock falls well below the strike price of the option, the executive is relatively indifferent to further losses. This creates an incentive to focus on the upside and be less interested in the possibility of things going really wrong. It is a terrible way to incentivize the managers of major financial institutions, and a particularly terrible way to incentivize the manager of an institution the Federal Government might have to rescue. This is highly relevant, by the way, to the situation of sick financial institutions. When stock prices have fallen close to zero, stocks themselves behave like options from an incentive perspective. It is very dangerous to have sick financial institutions run by people who are incentivized by the stock price. You are basically inviting them to take destructive risks, from the perspective of anyone like the Federal Government, who might have to cover the downside. This problem today exists in institutions like AIG and Citigroup, not just with the CEO of the top five executives, but for hundreds of members of the senior management team. A further source of assymetric risk incentive is the combination of equity-based compensation with large severance packages. As we have learned, disastrous failure in financial institutions sometimes leads to getting fired but rarely leads to getting fired for cause. The result is the failed executive gets a large severance package. If success leads to big payouts and failure leads to big payouts but modest achievements either way do not, then there is a big incentive to shoot the moon without regard to downside risk. These sorts of pay packages in just one very large financial institution can be a source of systemic risk, but when they are the norm throughout the financial services sector, they are a systemwide source of risk, much like unregulated derivatives or asset-backed securities. Consequently, this is an issue that the regulators of systemic risk ought to have the authority to take up. I thank you for your time. [The prepared statement of Mr. Silvers can be found on page 136 of the appendix.] " fcic_final_report_full--566 Fed could have granted up to three one-year extensions of that exemption. 15. FCIC staff computations based on data from the Center for Responsive Politics. “Financial sector” here includes insurance companies, commercial banks, securities and investment firms, finance and credit companies, accountants, savings and loan institutions, credit unions, and mortgage bankers and brokers. 16. U.S. Department of the Treasury, Modernizing the Financial System (February 1991); Fed Chair- man Alan Greenspan, “H.R. 10, the Financial Services Competitiveness Act of 1997,” testimony before the House Committee on Banking and Financial Services, 105th Cong., 1st sess., May 22, 1997. 17. Katrina Brooker, “Citi’s Creator, Alone with His Regrets,” New York Times, January 2, 2010. 18. John Reed, interview by FCIC, March 24, 2010. 19. FDIC Institution Directory; SNL Financial. 20. Fed Governor Laurence H. Meyer, “The Implications of Financial Modernization Legislation for Bank Supervision,” remarks at the Symposium on Financial Modernization Legislation, sponsored by Women in Housing and Finance, Washington, D.C., December 15, 1999. 21. Ben S. Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 1: The Federal Reserve, September 2, 2010, p. 14. 22. Patricia A. McCoy et al., “Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure,” Connecticut Law Review 41 (2009): 1345–47, 1353–55. 23. Fed Chairman Alan Greenspan, “Lessons from the Global Crises,” remarks before the World Bank Group and the International Monetary Fund, Program of Seminars, Washington, DC, September 27, 1999. 24. David A. Marshall, “The Crisis of 1998 and the Role of the Central Bank,” Federal Reserve Bank of Chicago, Economic Perspectives (1Q 2001): 2. 25. Commercial and industrial loans at all commercial banks, monthly, seasonally adjusted, from the Federal Reserve Board of Governors H.8 release; FCIC staff calculation of average change in loans out- standing over any two consecutive months in 1997 and 1998. 26. Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” Jour- nal of Economic Perspectives 13 (1999): 198. 563 27. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” Report of the Pres- ident’s Working Group on Financial Markets, April 1999, p. 14. 28. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” pp. 200, 197; and CHRG-111hhrg48873--337 Mr. Bernanke," They lent $40 billion to avoid a catastrophic collapse to the system. " fcic_final_report_full--320 Douglas Roeder, the OCC’s senior deputy comptroller for Large Bank Supervision from  to , said that the regulators were hampered by inadequate informa- tion from the banks but acknowledged that regulators did not do a good job of inter- vening at key points in the run-up to the crisis. He said that regulators, market participants, and others should have balanced their concerns about safety and sound- ness with the need to let markets work, noting, “We underestimated what systemic risk would be in the marketplace.”  Regulators also blame the complexity of the supervisory system in the United States. The patchwork quilt of regulators created opportunities for banks to shop for the most lenient regulator, and the presence of more than one supervisor at an organ- ization. For example, a large firm like Citigroup could have the Fed supervising the bank holding company, the OCC supervising the national bank subsidiary, the SEC supervising the securities firm, and the OTS supervising the thrift subsidiary—creat- ing the potential for both gaps in coverage and problematic overlap. Successive Treas- ury secretaries and Congressional leaders have proposed consolidation of the supervisors to simplify this system over the years. Notably, Secretary Henry Paulson released the “Blueprint for a Modernized Financial Regulatory Structure” on March , , two weeks after the Bear rescue, in which he proposed getting rid of the thrift charter, creating a federal charter for insurance companies (now regulated only by the states), and merging the SEC and CFTC. The proposals did not move forward in .  COMMISSION CONCLUSIONS ON CHAPTER 16 The Commission concludes that the banking supervisors failed to adequately and proactively identify and police the weaknesses of the banks and thrifts or their poor corporate governance and risk management, often maintaining satisfactory ratings on institutions until just before their collapse. This failure was caused by many factors, including beliefs that regulation was unduly burdensome, that fi- nancial institutions were capable of self-regulation, and that regulators should not interfere with activities reported as profitable. Large commercial banks and thrifts, such as Wachovia and IndyMac, that had significant exposure to risky mortgage assets were subject to runs by creditors and depositors. The Federal Reserve realized far too late the systemic danger inherent in the interconnections of the unregulated over-the-counter (OTC) derivatives market and did not have the information needed to act. fcic_final_report_full--74 DOTCOM CRASH: “LAY ON MORE RISK ” The late s was a good time for investment banking. Annual public underwrit- ings and private placements of corporate securities in U.S. markets almost quadru- pled, from  billion in  to . trillion in . Annual initial public offerings of stocks (IPOs) soared from  billion in  to  billion in  as banks and securities firms sponsored IPOs for new Internet and telecommunications compa- nies—the dot-coms and telecoms.  A stock market boom ensued comparable to the great bull market of the s. The value of publicly traded stocks rose from . tril- lion in December  to . trillion in March .  The boom was particularly striking in recent dot-com and telecom issues on the NASDAQ exchange. Over this period, the NASDAQ skyrocketed from  to ,. In the spring of , the tech bubble burst. The “new economy” dot-coms and telecoms had failed to match the lofty expectations of investors, who had relied on bullish—and, as it turned out, sometimes deceptive—research reports issued by the same banks and securities firms that had underwritten the tech companies’ initial public offerings. Between March  and March , the NASDAQ fell by almost two-thirds. This slump accelerated after the terrorist attacks on September  as the nation slipped into recession. Investors were further shaken by revelations of ac- counting frauds and other scandals at prominent firms such as Enron and World- com. Some leading commercial and investment banks settled with regulators over improper practices in the allocation of IPO shares during the bubble—for spinning (doling out shares in “hot” IPOs in return for reciprocal business) and laddering (doling out shares to investors who agreed to buy more later at higher prices).  The regulators also found that public research reports prepared by investment banks’ ana- lysts were tainted by conflicts of interest. The SEC, New York’s attorney general, the National Association of Securities Dealers (now FINRA), and state regulators settled enforcement actions against  firms for  million, forbade certain practices, and instituted reforms.  The sudden collapses of Enron and WorldCom were shocking; with assets of  billion and  billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in . Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill Lynch, and other Wall Street banks paid billions of dollars—although admitted no wrongdoing—for helping Enron hide its debt until just before its collapse. Enron and its bankers had created entities to do complex transactions generating fictitious earnings, disguised debt as sales and derivative transactions, and understated the firm’s leverage. Executives at the banks had pressured their analysts to write glowing evaluations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions more than  million in settlements with the SEC; Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another . billion to investors to settle class action lawsuits.  In response, the Sarbanes- Oxley Act of  required the personal certification of financial reports by CEOs and CFOs; independent audit committees; longer jail sentences and larger fines for executives who misstate financial results; and protections for whistleblowers. Some firms that lent to companies that failed during the stock market bust were successfully hedged, having earlier purchased credit default swaps on these firms. Regulators seemed to draw comfort from the fact that major banks had succeeded in transferring losses from those relationships to investors through these and other hedging transactions. In November , Fed Chairman Greenspan said credit de- rivatives “appear to have effectively spread losses” from defaults by Enron and other large corporations. Although he conceded the market was “still too new to have been tested” thoroughly, he observed that “to date, it appears to have functioned well.”  The following year, Fed Vice Chairman Roger Ferguson noted that “the most re- markable fact regarding the banking industry during this period is its resilience and retention of fundamental strength.”  fcic_final_report_full--580 Bubble Years and Beyond (Mount Jackson, VA: Axios Press, 2008), 186. 31. UBS Global CDO Group, Presentation on Product Series (POPS), January 2007. 32. Dan Sparks, interview by FCIC, June 15, 2010. 33. Dominguez, interview. 34. The ratio of the book value of assets to equity ranged from 2.5 to 28.3 times for all SIVs; the aver- age was 13.6 times. Moody’s Investors Service, “Moody’s Special Report: Moody’s Update on Structured Investment Vehicles,” January 16, 2008, p. 13. 35. Mark Klipsch, quoted in Colleen Marie O’Connor, “Drought of CDO Collateral Tops Concerns,” Asset Securitization Report, October 18, 2004. 36. Bear Stearns Asset Management, Collateral Manager Presentation; Ralph Cioffi, interview by FCIC, October 19, 2010; Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd., finan- cial statements for the year ended December 31, 2006 (total assets were $8,573,315,025); Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund, Ltd., financial statements for the year ended December 31, 2006 (total assets were $9,403,235,402). 37. James Cayne, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1, ses- sion 2: Investment Banks and the Shadow Banking System, May 5, 2010, p. 2; Warren Spector, interview by FCIC, March 30, 2010. 38. Cioffi, interview. 39. AIMA’s Illustrative Questionnaire for Due Diligence of Bear Stearns High Grade Structured Credit Strategies Fund; Bank of America presentation to Merrill Lynch’s Board of Directors, “Bear Steams Asset Management: What Went Wrong.” 40. Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd., financial statements for the year ended December 31, 2006; Financial Statements, Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund, Ltd., financial statements for the year ended December 31, 2006; BSAM fund chart prepared by JP Morgan. 41. FCIC staff calculations using data from FCIC survey of hedge funds. The hedge funds responding to the survey had a total of $1.2 trillion in investments. 42. IMF, Global Financial Stability Report , April 2008, Table 1.2, page 23, “Typical ‘Haircut’ or Initial Margin.” 43. Alan Schwartz, interview by FCIC, April 23, 2010. 44. Cioffi, interview. 45. Ibid. 46. Ibid. 47. Bear Stearns High-Grade Structured Credit Strategies, investor presentation, stating that “the fund is subject to conflicts of interest.” Bear Stearns High-Grade Structured Credit Strategies Enhanced Lever- age Fund, L.P., Preliminary Confidential Private Placement Memorandum, August 2006. Everquest Fi- nancial Ltd., Form S-1, p. 13. 48. Bear Stearns Asset Management Collateral Manager, presentation, stating that Klio I collateral in- cludes 73% RMBS and ABS and 27% CDOs, Klio II collateral includes 74% RMBS and ABS and 26% CDOs, and Klio III collateral includes 74% RMBS and ABS and 26% CDOs; Cioffi, interview. 49. Everquest Financial Ltd., Form S-1, pp. 9, 3. 50. Bear Stearns Asset Management, Collateral Manager Presentation. 51. Cioffi and Tannin Compensation Table, produced by Paul, Weiss, Rifkind, Wharton & Garrison, LLP. 577 52. Matt Tannin, Bear Stearns, email to Bella Borg-Brenner, Stillwater Capital, March 16, 2007; Greg CHRG-111hhrg55814--195 Secretary Geithner," Again, let's just step back. Right now, the Congress of the United States has given more than four Federal agencies and a whole number of other agencies the power to do consumer protection. They just did not do it well and we're proposing to consolidate that responsibility in one place so that it can be done better. Now, outside of consumer and investor protection, what we're proposing to do is to make sure the government has the same tools to manage risk it now has in small banks and thrifts for institutions that now define our modern financial system and can bring the economy to the edge of collapse. That's a necessary function for governments to do because banks can pose enormous risk. If you don't constrain the risk-taking of banks, we'll be consigned to repeat the crisis we just went through. " CHRG-111hhrg53238--20 The Chairman," The gentleman from Texas, Mr. Green, for 2 minutes. I am sorry, the gentlewoman from California. Ms. Waters. Thank you very much, Mr. Chairman. I am pleased we have an opportunity this morning to interact with the banking industry. I am particularly pleased that many of our witnesses have indicated they support more regulation for the shadow banking industry, a collection of unregulated lenders who operate outside of State and Federal oversight due to their nonbank status. It was, yes, many of these lenders who preyed on customers with products such as no-doc loans, and helped erode the lending markets which compromised the foundation of our economy. However, I am still concerned with the consumer-related activities of regulated banks. Large banks, in particular, have substantial interactions with the public, be it as a mortgage servicer, as a place for consumers and small businesses to access necessary credit. I would agree with you that additional regulation would be unnecessary were our financial system functioning properly. However, data from the Federal Reserve on the availability of credit shows this is not the case. Likewise, neither do the calls I receive from my constituents, the ones who are facing foreclosure, yet cannot reach their servicer to modify their loan. After all that we have gone through in trying to make loan modifications available to deserving people, we still have people who cannot reach their servicers. And even when they do, the servicers are not working out credible loan modification arrangements. Clearly, the mechanisms we have to protect consumers and ensure their access to credit are inadequate. I believe that a Consumer Financial Protection Agency is vital to the proper functioning of our economy. Our current crisis began when collateralized debt obligations and mortgage-backed securities began to be packed with exotic products such as no-doc and liar loans. It was exacerbated as consumers were continually squeezed with excessive penalties and fees from bank products, reducing purchasing power and leading families everywhere to make tough decisions. A strong regulator, one which focuses solely on consumer safety and champions simpler disclosure and products would have prevented all of this. Thank you, Mr. Chairman. I yield back the balance of my time. " CHRG-111shrg51395--94 Chairman Dodd," Senator Warner. Senator Warner. Thank you, Mr. Chairman. A fascinating panel. First of all, I commend you for asking that ``What is the one take-away?'' question from each of these gentlemen. And while I think there was a consensus that we need to get rid of this shadow market, we need to make sure we get rid of this Swiss cheese approach to regulation, I think we will be challenged, taking some of these broad overviews and taking them into specific legislation. " CHRG-110hhrg46596--239 Mr. Kashkari," Yes, it was not about the public, it was just a statement that we did not allow the financial system to collapse. Ms. Brown-Waite. But, sir, the economy is collapsing. When businesses do not--cannot have access to a line of credit that they have had with the same bank for over 20 years and become--grow from a small business to a medium-sized business and employ lots of people, the economy, sir, I don't want to quote the quote that was used during one of the presidential campaigns, but it is the economy. And if the money is stagnantly being hoarded or used for these other purposes, we are going down a rat hole, sir. That is not what people who voted for it believed that they were getting. Individuals who called me encouraging me to vote originally for it, now that they know the details, are saying they were wrong. And when constituents and business people call you up and say they were wrong to try to encourage this Member of Congress to vote for it, you have to realize what the public thinks of the Treasury and of this Congress. " FOMC20080805meeting--13 11,MR. DUDLEY.," I think it is a fair point that we shouldn't assume that ""normal"" is returning to the LIBOR�OIS spreads that applied before August 2007, so we have to look at a broader set of indicators. For example, I think that it would be worthwhile looking at the spread between jumbo mortgage rates and conforming mortgage rates as evidence of the degree of the shadow price of balance sheet capacity. I think that, once financial institutions either raise sufficient capital or stop taking loan-loss provisions or writing down assets so that they have enough capacity to expand their balance sheets, we will be getting to the end of this process. Another thing I would say to add to the answer I gave earlier to President Evans is that the trajectory of housing in all of this is going to be hugely important. One thing that may signal the next phase, maybe the beginning of the end, is when people really do get a sign that the housing sector is starting to bottom, probably first in activity and then in price. Once that happens, the huge risk premium embedded in some of these mortgage-related assets will then collapse. That means that the mark-to-market losses in a lot of institutions will start to fall. So I think that is going to be a very, very important metric once housing starts to really bottom and people get some visibility about how much home prices will go down. You know, when the argument is about whether home prices are going to go down 15 percent or 20 percent, that will be a very different argument from the argument now, which is whether home prices are going to go down 15 percent or 30 percent. " CHRG-110hhrg44901--143 Mr. Bernanke," That was a very difficult episode for Japan when the bubbles in both the stock market and in property prices collapsed at the same time. I think the key lesson that we learned from that experience was that in Japan, banks had very wide holdings in land and equity and other assets whose values came down, and so the banks were in very, very bad financial condition, but they were not required to disclose or inform the public about what their actual condition was. For many, many years they kind of limped along. The same with the companies they lent to. They didn't call those loans because they knew they couldn't be paid. So it was a situation in which there was a reluctance to act and in which transparency was quite limited. I think one benefit of our current system here in the United States is that as painful as it is to see the losses that financial institutions are suffering, at least they are getting that out, they are providing that information to the public, and they have been proactive in raising capital to replace those losses. In order to avoid a prolonged stagnation, as in Japan, it is important for us to get through this period of loss and readjustment and get back to a point where the financial system can again support good, strong, stable growth for the United States. " CHRG-111hhrg48867--231 Mr. Silvers," I really appreciate that this is my friend Peter Wallison's religion, but I think that the facts are that when we had well-regulated financial markets they channelled capital to productive activity, they were a reasonable portion of our economy and they were not overleveraged and we did not suffer from financial bubbles. And that describes the period from the New Deal until roughly 1980. And then we started deregulating, and the result was financial markets that grew to unsustainable size, excessive leverage in our economy, an inability to invest capital in long-term productive purposes, an inability to solve fundamental economic problems, and escalating financial bubbles. That is the history of our country. When we had thoughtful, proportionate financial regulation, it was good for our economy. Now we are in a position, pursuant to your question, where we have global financial markets and where a global financial regulatory floor is an absolute necessity if we are going to have a stable global economy. If we choose to be the drag on that process, it is not only going to impair our ability to have a well-functioning global financial system, it will damage the United States's reputation in the world. This question is immediately before us. And I would submit to you that while systemic risk regulation is important here, underneath that are a series of substantive policy choices which will define whether or not we are serious about real reregulation of the shadow markets or not. And if we choose to be once again the defender of unregulated, irresponsible financial practices and institutions, that the world will not look kindly upon us for doing so, as they did not look kindly upon us for essentially bringing these practices to the fore in the first place. " CHRG-111hhrg54868--16 Mr. Dugan," Chairman Frank, Ranking Member Bachus, and members of the committee, I appreciate this opportunity to continue where we left off last time in discussing the Treasury Department's proposal for regulatory reform. As I testified in July, the OCC supports many elements of the proposal, including the establishment of a council of financial regulators to identify and monitor systemic risk and enhanced authority to resolve systemically significant financial firms. We also believe it would be appropriate to extend consolidated supervision to all systemically significant financial firms. The Federal Reserve already plays this role for the largest bank holding companies, but during the financial crisis, the absence of a comparable supervisor for large securities and insurance firms proved to be an enormous problem. The proposal would fill this gap by extending the Federal Reserve's holding company regulation to such firms which we believe would be appropriate. However, one aspect of the proposal goes much too far, which is to grant broad new authority to the Federal Reserve to override the primary banking supervisor on standards, examination, and enforcement applicable to the bank. Such override power would alter our present working relationship with the Federal Reserve that works very well and fundamentally undermine the authority and accountability of the banking supervisor. We also support the imposition of more stringent capital and liquidity standards on systemically significant financial firms. This would help address their heightened risk to the system and mitigate the competitive advantage they could realize from being designated as systemically significant. Similarly, the OCC supports the proposals calling for more forward-looking loan loss provisioning, which is an issue that I have spent a great deal of time on as co-Chairman of the Financial Stability Board's Working Group on Provisioning. Unfortunately, our current system unacceptably discourages banks from building reserves during good times when they can most afford it, and requires them to take larger provisions for loan losses during downturns when it weakens vulnerable banks and inhibits needed lending. And we support the proposal to effectively merge the OTS into the OCC. Finally, we support enhanced consumer financial protection standards and believe that a dedicated consumer protection agency, the CFPA, could help achieve that goal. However, we have significant concerns with the parts of the proposed CFPA that would consolidate all financial consumer protection rulewriting, examination, and enforcement in one agency, which would completely divorce these functions from safety and soundness regulation. It makes sense to consolidate all consumer protection rulewriting in a single agency with the rules applying to all financial providers of a product, both bank and nonbank, but we believe the rules must be uniform, and that banking supervisors must have meaningful input into formulating them, and unfortunately, the proposed CFPA falls short on two counts. First, the rules would not be uniform because the proposal would expressly authorize States to adopt different rules for all financial firms, including national banks, by repealing the Federal preemption that has always allowed national banks to operate under uniform Federal standards. This repeal of the uniform Federal standards option is a radical change that will make it far more difficult and costly for national banks to provide financial services to consumers in different States having different rules, and these costs will ultimately be borne by the consumer. The change will also undermine the national banking charter and the dual banking system that has served us well for nearly 150 years. Second, the rules do not afford meaningful input from banking supervisors, even on real safety and soundness issues, because in the event of any dispute, the proposed CFPA would always win. The new agency needs to have a strong mechanism for ensuring meaningful bank supervisor input into the CFPA rulemaking. Finally, the banking agencies should continue to be responsible for examination and enforcement, not the CFPA. I believe there are real benefits to an integrated approach to consumer compliance and safety and soundness exams, a process that I think has worked well over time. Moreover, moving bank examination and enforcement functions to the CFPA would only distract it from its most important and most daunting implementation challenge, which is establishing an effective enforcement regime for the shadow banking system of the tens of thousands of nonbank providers that are currently unregulated or lightly regulated, like nonbank mortgage brokers and originators. We believe the CFPA's resources should be focused on this fundamental regulatory gap rather than on already regulated depository institutions. Thank you. [The prepared statement of Comptroller Dugan can be found on page 98 of the appendix.] " fcic_final_report_full--408 The firm put more than  billion in cash on its balance sheet, with  billion in back-up bank lines of credit, if needed.  The decline in global trade also hurt the U.S. economy as well as economies across the world. As the financial crisis peaked in Europe and the United States, exports col- lapsed in nearly every major trading country.  The decline in exports shaved more than  percentage points off GDP growth in the third and fourth quarters of . Recently, exports have begun to recover, and as of the fall of  they are back near precrisis levels.  COMMERCIAL REAL ESTATE: “NOTHING ’S MOVING ” Commercial real estate—offices, stores, warehouses—also took a pounding, an indi- cator both of the sector’s reliance on the lending markets, which were impaired by the crisis, and of its role as a barometer of business activity. Companies do not need more space if they go out of business, lay off workers, or decide not to expand. Weak de- mand, in turn, lowers rents and forces landlords to give their big tenants incentives to stay put. One example: two huge real estate brokerages with headquarters in New York City received nine months’ free rent for signing leases in  and .  In fall , commercial vacancy rates were still sky-high, with  of all office space unoccupied. And the actual rate is probably much higher because layoffs create “shadow vacancies”—a couple of desks here, part of a floor there—that tenants must fill before demand picks back up. In the absence of demand, banks remain unwilling to lend to all but the safest projects involving the most creditworthy developers that have precommitted tenants. “Banks are neither financing, nor are they dumping their bad properties, creating a log jam,” one developer told a National Association of Realtors survey. “Nothing’s moving.”  In Nevada, where tourism and construction once fed the labor force, commercial property took a huge hit. Office vacancies in Las Vegas are now hovering around , compared with their low of  midway through . Vacancies in retail com- mercial space in Las Vegas top , compared with historical vacancy rates of  to . The economic downturn tugged national-brand retailers into bankruptcy, emp- tying out the anchor retail space in Nevada’s malls and shopping centers. As demand for vacant property fell, land values in and around Las Vegas plummeted.  Because lenders were still reluctant, few developers nationally could afford to build or buy, right into the fall of . Lehman’s bankruptcy meant that Monday Properties came up short in its efforts to build a  million, -story glass office tower in Ar- lington, Virginia, across the river from Washington, D.C. Potential tenants wanted to know if the developer had financing; potential lenders wanted to know if it had ten- ants. “It’s a bit of a cart-and-horse situation,” said CEO Anthony Westreich, who in October  took the big risk of starting construction on the building without signed tenants or permanent financing.  The collapse of teetering financial institutions put commercial real estate developers and commercial landlords in binds when overex- tended banks suddenly pulled out of commercial construction loans. And when banks failed and were taken over by the Federal Deposit Insurance Commission, the com- mercial landlords overnight lost major bank tenants and the long-term leases that went with them.  In California, at least  banks have failed since .  fcic_final_report_full--78 As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late s, received . million in  as CEO of Salomon Brothers.  Stanley O’Neal’s package was worth more than  million in , the last full year he was CEO of Merrill Lynch.  In , Lloyd Blankfein, CEO at Goldman Sachs, received . million;  Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about  million and  million, respectively.  That year Wall Street paid workers in New York roughly  billion in year-end bonuses alone.  Total compensation for the ma- jor U.S. banks and securities firms was estimated at  billion.  Stock options became a popular form of compensation, allowing employees to buy the company’s stock in the future at some predetermined price, and thus to reap rewards when the stock price was higher than that predetermined price. In fact, the option would have no value if the stock price was below that price. Encouraging the awarding of stock options was  legislation making compensation in excess of  million taxable to the corporation unless performance-based. Stock options had po- tentially unlimited upside, while the downside was simply to receive nothing if the stock didn’t rise to the predetermined price. The same applied to plans that tied pay to return on equity: they meant that executives could win more than they could lose. These pay structures had the unintended consequence of creating incentives to in- crease both risk and leverage, which could lead to larger jumps in a company’s stock price. As these options motivated financial firms to take more risk and use more lever- age, the evolution of the system provided the means. Shadow banking institutions faced few regulatory constraints on leverage; changes in regulations loosened the constraints on commercial banks. OTC derivatives allowing for enormous leverage proliferated. And risk management, thought to be keeping ahead of these develop- ments, would fail to rein in the increasing risks. The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Com- mission, “I think if you look at the results of what happened on Wall Street, it became, ‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are go- ing to leave my place and go someplace else.’” Managing risk “became less of an im- portant function in a broad base of companies, I would guess.”  CHRG-111hhrg53245--17 Mr. Wallison," Thank you very much, Mr. Chairman. Leaving aside Fannie Mae and Freddie Mac, which I think are a very special case, if there is such a thing as a firm that is too big to fail, it is only a large commercial bank. And we now have several of them that are enormous. When we say that a firm is too big to fail, we mean that its failure could have a major, adverse effect on the entire economy. This is not simply a mere disruption of the economy. It would have to be a systemic breakdown. We can't define that very well, but it would have to be something greater than simply the kind of disruption that would occur from the failure of a firm. In my view, only a large commercial bank can create this kind of systemic breakdown. When a large bank fails, its depositors are immediately deprived of the funds they expected to have to meet payrolls and to pay their bills. Smaller banks are depositors in the larger banks, so the failure of a large bank can send a cascade of losses through the economy. If there is such a thing as a systemic breakdown, this would be it. For the same reasons, it is difficult to see how a large non-bank financial institution, that is, a bank holding company, a securities firm, a finance company, or a hedge fund can cause systemic risk. And thus it is difficult to see why a non-bank can ever be, in terms we are talking about today, too big to fail. Non-banks do not take deposits. They borrow for the short-, medium-, and long-term, but if they fail, their creditors don't suffer any immediate cash losses that would make it difficult for them to pay their bills. No one deposits his payroll or the money he expects to use for doing business with a securities firm or a finance company. In addition, their creditors are likely to be diversified lenders, so all their eggs are not in the same basket. However, the freeze-up in lending that followed the collapse of Lehman Brothers has led some people to believe, and I think incorrectly, that Lehman caused that event. This is not accurate. They conclude that a non-bank financial firm can cause a systemic breakdown that it can thus be too big to fail. But Lehman's failure caused what is called a common shock, where a market freezes up because new information has come to light. The new information that came to light with Lehman's failure was that the government was not going to rescue every firm larger than Bear Stearns, which had been rescued 6 months before. In this new light, every market participant had to reevaluate the risks of lending to everyone else. No wonder lending ground to a halt. Common shocks don't always cause a financial crisis. This one did, because virtually all large banks were thought at that time to be weak and unstable. They held large amounts of mortgage backed securities, later called toxic assets, that were of dubious value. If the banks had not been weakened by these assets, they would have continued to lend to each other. There would not have been a freeze-up in lending and the investor panic that followed. So if we want to avoid another crisis like that, we should focus solely on ensuring that the banks--we're talking about commercial banks--are healthy. Other financial firms, no matter how large, are risk takers and should be allowed to fail. Accordingly, if we want to deal with the problem of too big to fail and systemic risk bank regulation should be significantly reformed. Capital requirements for large banks should be increased as those banks get larger, especially if their assets grow faster than asset values generally. Higher capital requirements for larger banks would cause them to reconsider whether growth for its own sense really makes sense. Bank regulators should develop metrics or indicators of risk taking that banks should be required to publish regularly. This will enhance market discipline, which is fundamentally the way we control risk taking in the financial field. Most important of all, Congress should create a systemic risk council on the foundation of the Presidents Working Group, which would include all the bank supervisors and other financial regulators. The council should have its own staff and should be charged with spotting the development of conditions in the banking industry, like the acquisition by virtually all banks of large amounts of toxic assets, that might make all major banks weak or unstable and leave them vulnerable to a common shock. If we keep our banks stable, we'll keep our financial system stable. Finally, as a member of the Financial Crisis Inquiry Commission, I urge this committee to await our report before adopting any legislation. Thank you. [The prepared statement of Mr. Wallison can be found on page 79 of the appendix.]STATEMENT OF SIMON JOHNSON, PROFESSOR, MASSACHUSETTS INSTITUTE CHRG-111hhrg53248--179 Mr. Dugan," Thank you, Mr. Kanjorski, Ranking Member Bachus, and members of the committee. I appreciate this opportunity to discuss the Administration's comprehensive proposal for reforming the regulation of financial services. The OCC supports many elements of the proposal, including the establishment of a Council of Financial Regulators to identify and monitor systemic risk. We believe that having a centralized and formalized mechanism for gathering and sharing systemically significant information and making recommendations to individual regulators makes good sense. We also support enhanced authority to resolve systemically significant financial firms. The FDIC currently has broad authority to resolve systemically significant banks in an orderly manner, but no comparable resolution authority exists for systemically significant holding companies of either banks or non-banks. The proposal would appropriately extend resolution authority like the FDIC's to such companies. We also believe it would be appropriate to designate the Federal Reserve Board as the consolidated supervisor of all systemically significant financial firms. The Board already plays this role with respect to the largest bank holding companies. In the financial crisis of the last 2 years, the absence of a comparable authority with respect to large securities and insurance firms proved to be an enormous problem. The proposal would fill this gap by extending the Federal Reserve's holding company regulation to such firms. However, one aspect of this part of the proposal goes much too far, which is to grant broad new authority to the Federal Reserve to override the banking supervisor on standards, examination, and enforcement applicable to the bank. Such override power would undermine the authority and the accountability of the banking supervisor. We also support the imposition of more stringent capital and liquidity standards on systemically significant firms. This would help address the heightened risk to the system and mitigate the competitive advantage they could realize from being designated as systemically significant. And we support the proposal to effectively merge the OTS into the OCC with a phaseout of the Federal thrift charter. However, it is critical that the resulting agency be independent from the Treasury Department and the Administration to the same extent that the OCC and the OTS are currently independent. Finally, we support enhanced consumer protection standards for financial services providers and believe that an independent agency like the proposed CFPA could achieve that goal. However, we do have significant concerns with some elements of the proposed CFPA stemming from its consolidation of all financial consumer protection, rule writing, examination, and enforcement in one agency, which would completely and inappropriately divorce all these functions from the comparable safety and soundness functions at the Federal banking agencies. I believe it makes sense to consolidate all consumer protection rule writing in a single agency with the rules applying to all financial providers of a product, both bank and non-bank, but we believe the rules must be uniform and that banking supervisors must have meaningful input into formulating these rules. Unfortunately, the proposed CFPA falls short on both counts. First, the rules would not be uniform, because the proposal would expressly authorize States to adopt different rules for all financial firms, including national banks, by repealing the Federal preemption that has always allowed national banks to operate under uniform Federal standards. This repeal of the uniform Federal standards option is a radical change that will make it far more difficult and costly for national banks to provide financial services to consumers in different States having different rules, and these costs will ultimately be borne by the consumer. The change will also undermine the national banking charter and the dual banking system that has served us very well for nearly 150 years in which national banks operate under uniform Federal Rules and States are free to experiment with different rules for the banks they charter. Second, the rules do not afford meaningful input from banking supervisors, even on real safety and soundness issues, because in the event of any disputes, the proposed CFPA would always win. That should be changed by allowing more banking supervisors on the board of the CFPA and by providing a formal mechanism for banking supervisor input into CFPA rulemaking. Finally, the CFPA should not take examination and enforcement responsibilities away from the banking agencies. The current banking regime works well, where the integration of consumer compliance and safety and soundness supervision provides real benefits for both functions. Real life examples attached to my testimony demonstrate how this works. To the extent the banking agencies have been criticized for consumer protection supervision, the fundamental problem has been with the lack of timely and strong rules, which the CFPA would address, and not the enforcement of those rules. Moreover, moving these bank supervisory functions to the CFPA would only distract it from its most important and daunting implementation challenge, establishing an effective examination and enforcement regime for the shadow banking system of the tens of thousands of non-bank providers that are currently unregulated or lightly regulated, like the non-bank mortgage brokers and originators that were at the heart of the subprime mortgage problem. CFPA's resources should be focused on this fundamental regulatory gap, rather than on already-regulated depository institutions. Thank you very much. [The prepared statement of Comptroller Dugan can be found on page 106 of the appendix.] " FinancialCrisisInquiry--122 The financial community changed dramatically in the 1980s. Incorporation and public ownership by security firms enabled them to compete with commercial banks. Innovations like junk bonds, for example, allowed securities firms to lend to non- investment-grade companies. All the firms accelerated the push into global markets, far- flung operations, mathematical modeling, proprietary dealings in debt and equity, and the growing use of leverage and derivatives to hedge risk. As the commission investigates the causes of the 2007-2009 crisis, it is important to remember that market crises occur periodically. To name a few in the last 20 years, the markets have been roiled by Asian, Russian and Mexican crises, the crash of ‘87, the collapse of long-term capital, the 2000 dot-com bubble collapse, and of course, Enron’s bankruptcy. The question before the commission is: What events or actions occurred within the capital markets or the environment which allowed this crisis to become a debacle? First, every legislative and regulatory move in the last 20 years has been towards obliterating the distinctions between providers of financial services and freeing the capital markets. The shining example, of course, is the Gramm-Leach- Bliley Act of 1999, which removed the last vestiges of Glass-Steagall. Second, financial institutions used the more lenient regulatory environment to build scale and extend scope. Citigroup, Bank of America, J.P. Morgan, and Lehman Brothers, for instance, acquired competitors and expanded their operations into new fields. Concentration created institutions too big to fail. Government regulation in terms of oversight and coherence did not keep pace with innovation, leverage and the expanded scope of the banks. Three, access to new capital permitted the banks and security firms to shift the nature of their business away from agency transactions and towards more proprietary trading that took positions in marketable and less liquid securities and assets such as commercial real estate. Combined with greater leverage, earnings volatility increased. CHRG-111shrg54675--12 Mr. Johnson," Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, my name is Art, and I am the Chairman and CEO of United Bank of Michigan, and I am the Chairman-Elect of the American Bankers Association. I am pleased to share the banking industry's perspective on banking and the economy in rural America. Community banks continue to be one of the most important resources supporting the economic health of rural communities. Not surprisingly, the banks that serve our Nation's small towns also tend to be small community banks. Less well known is that over 3,500 banks--41 percent of the banking industry--have fewer than 30 employees. These banks understand fully the needs of their customers and their community. This is not the first recession faced by banks. Most banks have been in their communities for decades and intend to be there for many decades to come. My bank was chartered in 1903. We have survived the Great Depression and many other ups and downs for over a century. And we are not alone. Over 2,500 banks--nearly one-third of the industry--have been in been in business for more than a century. These numbers tell a dramatic story about the staying power of community banks and their commitment to their communities. We cannot be successful unless we develop and maintain long-term relationships and treat our customers fairly. In spite of the downturn, community banks in rural communities expanded lending by 7 percent since the recession began. Loans made by banks that focus on farmers and ranchers also increased by 9 percent. Considerable challenges remain, of course. In my home State of Michigan, for example, we are facing our eighth consecutive year of job losses. Other rural areas with manufacturing employment bases are also suffering similar problems. In this environment, businesses are reevaluating their credit needs and, as a result, loan demand is declining. Banks, too, are being prudent in underwriting, and our regulators demand it. Accordingly, it is unlikely that loan volumes will increase this year. With the recession, credit quality has suffered and losses have increased. Fortunately, community banks entered this recession with strong capital levels. However, it is very difficult to raise new capital today. Without access to capital, maintaining the flow of credit in rural communities will be increasingly difficult. We believe the Government can take action to help viable community banks weather the current downturn. The success of local economies depends on the success of these banks. Comparatively small steps now can make a huge difference to these banks, their customers, and their communities--keeping capital and resources focused where they are needed most. Importantly, the amount of capital required to provide an additional cushion for all community banks--which had nothing to do with the current crisis--is tiny compared to the $182 billion provided to AIG. In fact, the additional capital needed is less than $3 billion for all smaller banks to be well capitalized, even under a baseline stress test. Simply put, capital availability means credit availability. In addition to providing avenues for new capital for community banks, we believe there are three key policy issues that deserve congressional action: one, creating a systemic regulator; two, providing a strong mechanism for resolving troubled systemically important firms; and, three, filling gaps in the regulation of the shadow banking industry. The critical issue in this regard is ``too-big-to-fail.'' This concept has profound moral hazard implications and competitive effects that need to be addressed. In an ideal world, no institution would be ``too-big-to-fail,'' and that is ABA's goal. While recent events have shown how difficult that is to accomplish, whatever is done on the systemic regulator and on a resolution system should narrow dramatically the range of circumstances that might be expected to prompt Government action. These actions would address the causes of the financial crisis and constitute major reform. We believe there is a broad consensus in addressing these issues. I would be happy to answer any questions that you may have. " CHRG-111hhrg48867--80 Mr. Silvers," Congressman, I think there are three ways of answering your question. First, if we are going to be serious about watching systemic risk across the financial system, in a realm where people innovate--and the people who do most of the innovating in this area are lawyers--then you really do have to have a pretty sort of comprehensive writ of authority to look where you need to look. GE Capital is clearly an institution capable of generating systemic risk, although GE is a manufacturing enterprise. Secondly, though this is not sufficient, I think much of the problem here in terms of shadow markets comes from not giving routine regulators the ability to follow the action, and I think that it will be very difficult for some of the reasons you were alluding to, to capture the full range of market activity if the day-to-day regulators don't have the kind of broad jurisdiction that they enjoyed in the post-New Deal era and that was taken away gradually over the last 20 years or so. But there is a trick here, and I am not sure what the answer to it is, but I think the committee ought to be well aware of it. It is one thing to give oversight and surveillance power; it is another thing to give the systemic risk regulator the ability to override judgments of day-to-day regulators, and particularly this is true in relation to investor and consumer protection. There is a natural and unavoidable tension between anyone charged with essentially the safety and soundness of financial institutions and agencies charged with transparency and investor protection and consumer protection. That tension has always been there. If you give a systemic risk regulator the authority to hide things, there is a real danger they will use it, and that will actually not--that will actually not protect us against systemic risk but, rather, do the opposite. " CHRG-111shrg56376--8 Mr. Dugan," Thank you very much, Mr. Chairman. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate this opportunity to discuss the Administration's proposal for regulatory reform. The OCC supports many elements of the proposal, including the establishment of a council of financial regulators to identify and monitor systemic risk and enhanced authority to resolve systemically significant financial firms. We also believe it would be appropriate to establish a consolidated supervisor of all systemically significant financial firms. The Federal Reserve already plays this role for the largest bank holding companies, but during the financial crisis, the absence of a comparable supervisor for large securities and insurance firms proved to be an enormous problem. The proposal would fill this gap by extending the Federal Reserve's holding company regulation to such firms, which we believe would be appropriate. However, one aspect of the proposal goes much too far, which is to grant broad new authority to the Federal Reserve to override the primary banking supervisor on standards, examination, and enforcement applicable to the bank. Such override power would fundamentally undermine the authority and accountability of the banking supervisor. We also support the proposal to effectively merge the OTS into the OCC with a phase-out of the Federal Thrift Charter. My written testimony responds in detail to the Chairman's questions about options for additional banking agency consolidation by: first, establishing either the Federal Reserve or the FDIC as the single Federal agency responsible for regulating State-chartered banks; second, establishing a single prudential supervisor to supervise all national and State banks; and, third, transferring all holding company regulation from the Federal Reserve to the prudential supervisor. While there are significant potential benefits to be gained from all three proposals, there are also potential costs, especially with removing the Federal Reserve altogether from the holding company regulation of systemically important companies. Finally, we support enhanced consumer financial protection standards and believe that a dedicated consumer protection agency could help to achieve that goal. However, we have significant concerns with the parts of the proposed CFPA that would consolidate all financial consumer protection rulewriting, examination, and enforcement in a single agency which would completely divorce these functions from safety and soundness regulation. It makes sense to consolidate all consumer protection rulewriting in a single agency with the rules applying to all financial providers of a product, both bank and nonbank. But we believe the rules must be uniform and that banking supervisors must have meaningful input into formulating them. Unfortunately, the proposed CFPA falls short on both counts. First, the rules would not be uniform because the proposal would expressly authorize States to adopt different rules for all financial firms, including national banks, by repealing the Federal preemption that has always allowed national banks to operate under uniform Federal standards. This repeal of a uniform Federal standards option is a radical change that will make it far more difficult and costly for national banks to provide financial services to consumers in different States having different rules, and these costs will ultimately be borne by the consumer. The change will also undermine the national banking charter and the dual banking system that have served us well for nearly 150 years. Second, the rules do not afford meaningful input from banking supervisors, even on real safety and soundness issues, because in the event of any disputes, the proposed CFPA would always win. The new agency needs to have a strong mechanism for ensuring meaningful bank supervisor input into CFPA rulemaking. Finally, the CFPA should not take examination and enforcement responsibilities away from the banking agencies. The current bank supervisory process works well where the integration of consumer compliance and safety and soundness supervision provides real benefits for both functions. Moreover, moving bank examination and enforcement functions to the CFPA would only distract it from its most important and daunting implementation challenge--that is, establishing an effective enforcement regime for the shadow banking system of the literally tens of thousands of nonbank providers that are currently unregulated or lightly regulated, like mortgage brokers and originators. The CFPA's resources should be focused on this fundamental regulatory gap rather than on already regulated depository institutions. Thank you very much. " CHRG-110hhrg46596--195 Mr. Kashkari," Congressman, I think that all of those considerations are important. I think some of them can be competing. And it can be difficult to prioritize, especially in a time of financial crisis. As an example, we absolutely want to protect the taxpayer, but we first and foremost want to prevent the financial system from collapsing. That was our highest priority. Once we were able to do that, we want to do that in a manner that provides as much protection to the taxpayer as possible. Also keep in mind what would happen to the taxpayers if the financial system had been allowed to collapse. So these are very complex and important considerations, and I will just tell you our highest priority was to get out there and move aggressively to stabilize the financial system. " CHRG-111hhrg51591--95 Mr. Webel," Well, I mean, the point is that--I mean, the question of competitiveness at an international level is frequently brought up when you talk about too-big-to-fail. The Citibanks, the Bank of Americas, are competing on a global level with Deutsche Bank, with Royal Bank of Scotland, with--in a globalized financial system. And this gains the country an immense amount. But if you approach too-big-to-fail and say, we are just not going to let things get too big, you know, one way to do that, one way to say is, okay, you have a systematically significant institution. We are going to put additional capital controls on it. We are going to put additional regulations on it to make sure that it is not as likely to fail. Another option would be to just say, we are just not going to let things get that big. One of the counter examples that people frequently point to is this lack of competitiveness, that you are not--you know, other countries are doing this. They are letting their institutions do this. Our balance of trade will suffer. And that is true. I would just point out that there are a lot of places in policy where the government basically says, okay, we could let the market go this way and it might make more profit. But for a social reason, we are not going to let it go that way. You know, you could mine in Yellowstone National Park, but as a society, we say we are not going to do that. If you look at the cost of the crisis that we are in, one might conclude that it would be worth it to say, okay, if other people, like Iceland, want to let their banks get to be 40 times the size of their GDP or whatever it was, and then collapse when their banks collapse, they can go that route. We are going to say no. We are going to accept the fact that we are going to be uncompetitive in this particular area. But at least when the crisis hits, we are not going to suffer like they do. " fcic_final_report_full--10 As our report shows, key policy makers—the Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New York—who were best posi- tioned to watch over our markets were ill prepared for the events of  and . Other agencies were also behind the curve. They were hampered because they did not have a clear grasp of the financial system they were charged with overseeing, par- ticularly as it had evolved in the years leading up to the crisis. This was in no small measure due to the lack of transparency in key markets. They thought risk had been diversified when, in fact, it had been concentrated. Time and again, from the spring of  on, policy makers and regulators were caught off guard as the contagion spread, responding on an ad hoc basis with specific programs to put fingers in the dike. There was no comprehensive and strategic plan for containment, because they lacked a full understanding of the risks and interconnections in the financial mar- kets. Some regulators have conceded this error. We had allowed the system to race ahead of our ability to protect it. While there was some awareness of, or at least a debate about, the housing bubble, the record reflects that senior public officials did not recognize that a bursting of the bubble could threaten the entire financial system. Throughout the summer of , both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paul- son offered public assurances that the turmoil in the subprime mortgage markets would be contained. When Bear Stearns’s hedge funds, which were heavily invested in mortgage-related securities, imploded in June , the Federal Reserve discussed the implications of the collapse. Despite the fact that so many other funds were ex- posed to the same risks as those hedge funds, the Bear Stearns funds were thought to be “relatively unique.” Days before the collapse of Bear Stearns in March , SEC Chairman Christopher Cox expressed “comfort about the capital cushions” at the big investment banks. It was not until August , just weeks before the government takeover of Fannie Mae and Freddie Mac, that the Treasury Department understood the full measure of the dire financial conditions of those two institutions. And just a month before Lehman’s collapse, the Federal Reserve Bank of New York was still seeking information on the exposures created by Lehman’s more than , deriv- atives contracts. In addition, the government’s inconsistent handling of major financial institutions during the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae and Freddie Mac into conservatorship, followed by its decision not to save Lehman Brothers and then to save AIG—increased uncertainty and panic in the market. In making these observations, we deeply respect and appreciate the efforts made by Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly presi- dent of the Federal Reserve Bank of New York and now treasury secretary, and so many others who labored to stabilize our financial system and our economy in the most chaotic and challenging of circumstances. • We conclude there was a systemic breakdown in accountability and ethics. The integrity of our financial markets and the public’s trust in those markets are essential to the economic well-being of our nation. The soundness and the sustained prosper- ity of the financial system and our economy rely on the notions of fair dealing, re- sponsibility, and transparency. In our economy, we expect businesses and individuals to pursue profits, at the same time that they produce products and services of quality and conduct themselves well. FinancialCrisisReport--230 Hindsight establishes that the CAMELS ratings assigned to Washington Mutual Bank were inflated. Whether the ratings inflation was attributable to the OTS culture of deference to management, examiners who were too intimidated to downgrade the agency’s largest institution, an overly narrow regulatory focus that was blinded by WaMu’s short term profits and ignored systemic risk, or an absence of forward-looking risk analysis, the WaMu collapse suggests that the CAMELS rating system did not work as it should. (e) Fee Issues During the investigation, when asked why OTS senior officials were not tougher on Washington Mutual Bank, several persons brought up the issue of fees – that WaMu supplied $30 million or nearly 15% of the fees per year that paid for OTS’ operating expenses. WaMu’s former Chief Risk Officer James Vanasek offered this speculation: “I think you have to look at the fact that Washington Mutual made up a substantial portion of the assets of the OTS and one wonders if the continuation of the agency would have existed had Washington Mutual failed.” 876 The issue was also raised by Treasury IG Thorson who warned that OTS should have been “very clear from top to bottom” that WaMu’s payment of $30 million in fees per year to OTS was “not a factor. It just [was] not.” 877 The OCC and OTS are the only federal banking regulators reliant on fees paid by their regulated entities to fund their operations. At OTS, Washington Mutual was far larger than any other thrift overseen by the agency and was a far larger and more important contributor to the agency’s budget. It is possible that the agency’s oversight was tempered by recognition of the thrift’s unique importance to the agency’s finances and a concern that tough regulation might cause WaMu to convert its charter and switch to a different regulator. Its dependence on WaMu fees may have given OTS the incentive to avoid subjecting WaMu to regulatory enforcement actions and ultimately compromised its judgments. Conclusion. WaMu is the largest bank failure in the history of the United States. When OTS seized it, WaMu had $307 billion in assets. By comparison, the next largest U.S. bank failure was Continental Illinois, which had $40 billion in assets when it collapsed in 1984. OTS’ failure to act allowed Washington Mutual to engage in unsafe and unsound practices that cost borrowers their homes, led to a loss of confidence in the bank, and sent hundreds of billions of dollars of toxic mortgages into the financial system with its resulting impact on financial markets at large. Even more sobering is the fact that WaMu’s failure was large enough that, if the bank had not been purchased by JPMorgan Chase, it could have exhausted the entire Deposit Insurance Fund which then contained about $45 billion. Exhausting the Deposit Insurance Fund 876 April 13, 2010 Subcommittee Hearing at 40 (Testimony of James Vanasek). 877 See April 16, 2010 Subcommittee Hearing at 25. could have triggered additional panic and loss of confidence in the U.S. banking system and financial markets. (2) Other Regulatory Failures CHRG-111shrg52619--207 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JOSEPH A. SMITH, JR.Q.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chairman Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. First of all, CSBS agrees completely with Chairman Bair. In fact, in a letter to the Government Accountability Office (GAO) in December 2008, CSBS Executive Vice President John Ryan wrote, ``While there are clearly gaps in our regulatory system and the system is undeniably complex, CSBS has observed that the greater failing of the system has been one of insufficient political and regulatory will, primarily at the federal level.'' Perhaps the resilience of our financial system during previous crises gave policymakers and regulators a false sense of security and a greater willingness to defer to powerful interests in the financial industry who assured them that all was well. From the state perspective, it is clear that the nation's largest and most influential financial institutions have themselves been major contributors to our regulatory system's failure to prevent the current economic collapse. All too often, it appeared as though legislation and regulation facilitated the business models and viability of our largest institutions, instead of promoting the strength of consumers or encouraging a diverse financial industry. CSBS believes consolidating supervisory authority will only exacerbate this problem. Regulatory capture by a variety of interests would become more likely with a consolidated supervisory structure. The states attempted to check the unhealthy evolution of the mortgage market and it was the states and the FDIC that were a check on the flawed assumptions of the Basel II capital accord. These checks should be enhanced by regulatory restructuring, not eliminated. To best ensure that regulators exercise their authorities ``effectively and aggressively,'' I encourage Congress to preserve and enhance the system of checks and balances amongst regulators and to forge a new era of cooperative federalism. It serves the best interest of our economy, our financial services industry, and our consumers that the states continue to have a role in financial regulation. States provide an important system of checks and balances to financial oversight, are able to identify emerging trends and practices before our federal counterparts, and have often exhibited a willingness to act on these trends when our federal colleagues did not. Therefore, CSBS urges Congress to implement a recommendation made by the Congressional Oversight Panel in their ``Special Report on Regulatory Reform'' to eliminate federal preemption of the application of state consumer protection laws. To preserve a responsive system, states must be able to continue to produce innovative solutions and regulations to provide consumer protection. Further, the federal government would best serve our economy and our consumers by advancing a new era of cooperative federalism. The SAFE Act enacted by Congress requiring licensure and registration of mortgage loan originators through NMLS provides a mode for achieving systemic goals of high regulatory standards and a nationwide regulatory roadmap and network, while preserving state authority for innovation and enforcement. The SAFE Act sets expectations for greater state-to-state and state-to-federal regulatory coordination. Congress should complete this process by enacting a federal predatory lending standard as outlined in H.R. 1728, the Mortgage Reform and Anti-Predatory Lending Act. However, a static legislative solution would not keep pace of market innovation. Therefore, any federal standard must be a floor for all lenders that does not stifle a state's authority to protect its citizens through state legislation that builds upon the federal standard. States should also be allowed to enforce-in cooperation with federal regulators-both state and federal predatory lending laws for institutions that act within their state. Finally, rule writing authority by the federal banking agencies should be coordinated through the FFIEC. Better state/federal coordination and effective lending standards is needed if we are to establish rules that are appropriately written and applied to financial services providers. While the biggest institutions are federally chartered, the vast majority of institutions are state chartered and regulated. Also, the states have a breadth of experience in regulating the entire financial services industry, not just banks. Unlike our federal counterparts, my state supervisory colleagues and I oversee all financial service providers, including banks, thrifts, credit unions, mortgage banks, and mortgage brokers.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. Our legislative and regulatory efforts must be counter-cyclical. A successful financial system is one that survives market booms and busts without collapsing. The key to ensuring our system can survive these normal market cycles is to maintain and strengthen the diversity of our industry and our system of supervision. Diversity provides strength, stability, and necessary checks-and-balances to regulatory power. Consolidation of the industry or financial supervision could ultimately product a financial system of only mega-banks, or the behemoth institutions that are now being propped up and sustained by taxpayer bailouts. An industry of only these types of institutions would not be resilient. Therefore, Congress must ensure this consolidation does not take place by strengthening our current system and preventing supervisory consolidation.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking? While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk? Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.3. To begin, the seeming correlation between federal supervision and success now appears to be unwarranted and should be better understood. The failures we have seen are divided between institutions that are suffering because of an extreme business cycle, and others that had more fundamental flaws that precipitated the downturn. In a healthy and functional economy, financial oversight must allow for some failures. In a competitive marketplace, some institutions will cease to be feasible. Our supervisory structure must be able to resolve failures. Ultimately, more damage is done to the financial system if toxic institutions are allowed to remain in business, instead of allowed to fail. Propping up these institutions can create lax discipline and risky practices as management relies upon the government to support them if their business models become untenable. ------ CHRG-111hhrg53234--158 Mr. Berner," Thank you, Mr. Chairman, Ranking Member Paul, and other members of the committee. Thanks for inviting me to this hearing to address this important question, the role of the Federal Reserve in systemic risk regulation. I think the broader question here is how should we address the significant weaknesses in our financial system and our financial regulatory structure that the current financial crisis has exposed? Among market participants, and I talk to many of them, I think there are two policy changes that are needed that are well recognized: first, strengthen our regulatory infrastructure; and second, adopt appropriate regulation oversight to mitigate systemwide risks across financial market instruments, markets, and institutions. In addition, I believe that macroeconomic policy should lean against asset and credit booms, which create financial instability. In my view, the Federal Reserve is best equipped to take the lead on systemic risk regulation and oversight. Like others, I think this function is an essential and natural extension of the Fed's traditional monetary policy role and of its responsibilities as lender of last resort. Three factors support that claim: First, the Fed is the ultimate guardian of our financial markets, and so it should be the agency that ensures the safety and soundness of the most important financial institutions operating in those markets. Second, the process of intermediation through traditional lenders in the capital markets has become increasingly complex. Supervision of the institutions involved will enhance the Fed's ability to make the right monetary policy decisions. And, finally, the Fed's expertise in financial markets and institutions makes it the natural choice for this role. The Fed's leadership in the Supervisory Capital Assessment Program demonstrated that expertise. In short, good monetary policy and financial stability, in my view, are complementary. Asset booms and busts destabilized the economy and financial system at great cost. A financial stability mandate for the Fed requires that focus on asset and credit booms as well as systemic regulation and oversight. And the policy tools required for each overlap substantially. That may explain why the other countries that separate such responsibilities from the traditional role of the central bank have fared no better than we did in this crisis. The U.K. is a good example. While the Bank of England and the Financial Services Authority clearly have collaborated in the recent crisis, their separation of powers did not help manage the current crisis more successfully than U.S. regulators. However, naming the Fed to this role won't solve all of our problems that I just enumerated. To see why, in the rest of my time, I outline some related remedies. I will conclude by answering the four questions you posed. In my view, our regulatory system has three major shortcomings: First, we supervise institutions rather than financial activities, which allows some firms to take on risky activities with inadequate oversight. A focus on systemic risk is one remedy for that problem. Designating the Fed to take the lead will limit risky activities and important market information slipping through the cracks, and it will promote supervisory accountability. Second, our regulatory safety net is excessively prone to moral hazard, encouraging inappropriate risk-taking. Concentration, as you have all alluded to in this hearing, in our financial services industry has created institutions that are too big to fail. Remedies needed should include: more extensive oversight and supervision of large, complex financial institutions; an explicit regulatory charge on such institutions to help us offset the moral hazard created by an implicit guarantee; and a strong resolution framework that is understood by all before crisis hits. An ad hoc approach creates uncertainty and reduces the credibility of policy. The third problem is procyclicality. Our regulatory infrastructure encourages excessive leverage, which magnifies financial market volatility. Three remedies needed here are: First, we need a stronger system of capital regulation that should improve financial stability and help monetary policy lean against the wind of asset booms. We must resolve the tension between accountants who want to limit reserves and regulators who want to build them--in favor of the regulators. Second, securities must be more transparent and homogeneous and less reliant on credit ratings. And third, to reduce settlement and payment system risk, we need greater use of central counterparties for over-the-counter derivatives. I want to conclude by answering your four questions. Are there conflicts with the Fed's traditional role here? Yes, there can be. In a crisis, decisions about particular firms likely would involve the Fed in inherently political considerations and the use of taxpayer funds that could compromise its independence. We should insulate the Fed's independence with two firewalls. First, the resolution of troubled financial institutions should fall to the FDIC; and, second, and globally, we must change institutions now too big to fail into being too strong to fail. Remedies will include many of the options I just discussed. Both firewalls should strengthen the Fed's role as lender of last resort by reducing moral hazard, especially by reducing the chance that we will keep nonviable institutions alive, a concern you have expressed. What are the policy pros and cons here? In my view, the pros outweigh the cons. Interconnectedness means that supervision must look horizontally across instruments, markets, institutions, and regions rather than in vertical silos. In my view, the Fed has the most expertise and reach to provide that. The Fed is also best positioned to prescribe and enforce remedies to procyclicality and to build financial shock absorbers. Now, I hasten to state the obvious: The Fed is imperfect. As the guardian of our financial system, the Fed in the past has come up short in a number of ways. I would only say that while we consider making the Fed the lead systemic regulator, the Fed and we must examine how it can improve its functioning to take on these new duties. What about the arguments against? Well, ensuring financial stability may be too big a job for just one regulator. Even if the Fed takes the lead, coordination with other regulators will be essential for success. Coordination with regulators and central banks abroad may be even more critical than being in sync with regulators at home. Our markets and institutions are global, but our regulation is largely local. So I like the President's recommendations for the Financial Services Oversight Council and international cooperation and coordination especially. Last, what about reassigning some Federal responsibilities to other agencies? Regulators should do what they do best. And, for example, as others have said, consumer protection and promotion of financial literacy could go to another agency, but I think that the Fed may still play a useful role in supporting these areas. Mr. Chairman, let me add that these views are mine and not necessarily those of my employer, Morgan Stanley, or its staff. I want to thank you for your attention. I am happy to answer any questions. [The prepared statement of Dr. Berner can be found on page 46 of the appendix.] " FinancialCrisisInquiry--604 CLOUTIER: Thank you very much. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Rusty Cloutier, and I am pleased to testify today on the current state of the financial crisis and in particular the effect it has had on the small- business lending community. I am president and chief executive officer of MidSouth Bank, a $980 million community bank headquartered in Lafayette, Louisiana, with locations throughout south Louisiana and southeast Texas. I am also the author of the book “Big Bad Banks,” which details how a few megabanks and powerful individuals fueled the current financial and economic crisis. I’m proud to testify today on behalf of the Independent Community Bankers of America and its 5,000 community bank members nationwide. Mr. Chairman, it is difficult to talk about the effects of the financial crisis without speaking to the root cause. Too-big-to-fail institutions and the systemic risks that they pose were the heart of our financial and economic meltdown. Equally responsible were those institutions making up the unregulated shadow banking industry operating just not outside of legal parameters, of the regulatory framework, which made most of the subprime exotic loans and brought the housing markets to its knees. For far too long, these institutions have enjoyed privileges of favorable government treatment, easier access to cheaper funding sources, lower or no compliance cost, and little if any oversight. A little more than a few years ago, a key element of the financial system nearly collapsed due to the failure of these institutions to manage their highly risky activities. January 13, 2010 These reckless and irresponsible actions by a handful of managers with too much power nearly destroyed our equity, real estate, consumer loan and global financial markets and cost the American people some $12 trillion in net worth. This crisis also has pushed our nation to the brink of insolvency by forcing the federal government to intervene with trillions in capital and loans and commitments to large, complex financial institutions whose balance sheets were overlevereged, lacked adequate liquidity to offset the risks that they had recklessly taken. We’re at the point where some of the world markets are even questioning if the United States dollar should be retained as the world’s reserve currency. All of this was driven by the ill-conceived logic that some institutions should be allowed to exist even if they were too big to manage, too big to regulate, too big to fail, and above the law of the United States of America. By contrast, community banks like mine, highly regulated, stuck to their knitting and had no role in the economic crisis. Even though community banks did not cause the economic crisis, we have been affected by it through a shrinking of our asset base, heavier FDIC assessments, and suffocating examination environments. The work of this commission is important if Congress is already actively advancing dramatic financial sector reforms. The ICBA wants Congress to pass meaningful financial reforms to rein in the financial behemoths and the shadow financial industry to ensure that this crisis like this never happen again to the American people. We need a financial reform that will restore reasonable balance between Wall Street and Main Street. So where are we today? While the financial meltdown and deep global recession may be over, economic growth remains too weak to quickly reverse the massive job losses and asset price damage that is resulting. After more than a year and a half of economic decline, the United States economy grew by a modest 2.2 percent in the third quarter January 13, 2010 of 2009, unemployment is still at a 26-year high and new hiring remains elusive at this modest growth level. The long, deep recession has dramatically increased the lending risk for all banks, as individuals’ and business credit risk have increased with the declining balance sheets and reduced sales in most cases. Today bank regulators are far more sensitive to lending risk and force banks to be much more conservative in underwriting on all types of loans. While this is to be expected after a deep recession, the regulatory pendulum has swung too far in the direction of overkill and choking off credit at the community bank level. Indeed, the mixed signals that appear to be coming out of Washington have dampened the lending environment in many communities. On one hand, the administration and lawmakers are saying lend, lend, lend, and on the other, that message seems to be lost on the examiners, particularly in the parts of the nation most severely affected by the recession. Bankers continue to comment that they are being treated like they have portfolio full of subprime mortgages and even though they had no subprime on their books. Under the climate community bankers may avoid making good loans for the fear of an examination criticism, write-down and resulting loss of income and capital. Community banks are willing to lend. That’s how banks generate a return and survive. However, quality loan demand is down. It is a fact that demand for credit overall is down as business suffered lower sales, reducing their inventory, cut capital spending, shed workers and cut debt. In a recent National Federation of Independent Business survey, respondents identified weak sales as the biggest problem they face, with only 5 percent of the respondents saying that access to credit is a hurdle. I can tell you from my own bank’s experience customers are scared about the economic climate and are not borrowing. They are basically panicked. Credit is available, but businesses are not demanding it. The good news is that my bank did make $233 million in new loans this past year. MidSouth is extremely well capitalized and would do even more if quality loans were available. January 13, 2010 For example, my bank’s lines of credit usage is down to the lowest utilization in 25 years. I am pressing my loan officers daily to find more loans, but demand is not there. All community banks want to lend. Less lending hurts profits and income. For the first time in my 44 years in banking I have witnessed a decline in assets in my banks due to lower loan demand. In total, my loans were down from $600 million to $585 million this past year. Most businesses I work with are using cash flow only and are not interested in taking on new debt. The key reason they cite for not seeking credit is their uncertainty of the economic climate and the cost of doing business going forward. Until their confidence in the economic outlook improves, businesses will be unlikely to borrow from any bank. The financial meltdown should be a lesson learned in supporting diversity in the banking and in community banks. Community banks represent the other side of the financial story in credit markets. Community banks serve a vital role in small-business lending and local community activity not supported by Wall Street, who has only an international view. For their size, community banks are enormous small-business lenders. Community banks represent only about 12 percent of all bank assets, they currently make up 31 percent of the dollar amount of all small business loans less than a million dollars. Notably, more than half of all small business loans under $100,000 are made by community banks. In contrast, banks with more than $100 billion in assets, the nation’s largest financial firms, make only 22 percent of small business loans. Community banks in general rely more on local deposits to fund local lending. So they don’t rely on the Wall Street capital markets for funding. In fact, small banks of $1 billion in asset size or less were the only segment to show any increase in net loans and leases year over year in the latest third quarter 2009 quarterly FDIC data. However, small business loan demand is down in general, because businesses and individuals are deleveraging and reducing their reliance on debt after the current meltdown. The FDIC quarterly banking profile for the third quarter of 2009 showed a January 13, 2010 record $210 billion quarterly decline in outstanding loan balances. Net loans and leases declined across all asset size groups on—in a quarterly basis in the third quarter of 2009. Despite a quarterly decline of net loans and leases, at 2.6 percent annual, community banks with less than a billion dollars in assets were the only group to show a year over year increase in net loans and leases of 0.5 percent. While modest, these gains were the best in the financial sector. Our nation’s biggest banks, who were here earlier today, cut back on lending the most. The institutions with more than $100 billion in assets showed a quarterly decline of 10.9 percent annual rate and a 10.5 percent decrease, year over year. Banks $10 billion to $100 billion asset banks, had net loans and leases decline at an astounding 17.8 percent annual rate over the previous quarter. In conclusion, highly regulated community bank sector did not trigger the financial crisis. We must end too big to fail, reduce systemic risk and focus regulation on the unregulated financial entities that caused this economic meltdown on Wall Street. The best financial reform will protect small business from being crushed by the devastating effects of one giant financial institution stumbling. A diverse, competitive financial system will best serve the needs of small business in America. Thank you, and I’m prepared to answer any questions. CHRG-110hhrg46593--176 Secretary Paulson," Okay. I will answer it briefly and then go to Ben. The purpose of the TARP program is, as I said, fundamentally about preserving our system here, keeping it from collapsing and then helping it recover. Now, once you have the government intervene, that is by definition going against many of principles that we believed in for a long time in terms of markets. We are doing this to preserve our markets. So we have--there are two programs we have outlined to date. One program, if there is a failing institution, and the failure would be big enough to be systemic, we need to come into that. With regard to the healthy bank program, my concern was the exact opposite of yours, just to be candid. My concern was, I thought, if we were looking back in history, the biggest concern I might have would be government intervenes and puts money into institutions that weren't viable and weren't going to be competitive long term. Now, we at Treasury-- " CHRG-111hhrg51698--126 Mr. Kissell," Thank you, Mr. Chairman. Thank you, panel. I am going to approach this a little bit differently than Mr. Damgard and Mr. Gooch. Mr. Gooch, you said you had thought the system functioned very well, and maybe I am interpreting it wrong, but it seemed to me it functioned well because there was no major train wreck like we saw in the financial end; the banks weren't collapsing and so forth. But from the perspective of the individuals, the families in my district and across this nation, there were millions of train wrecks. I am interested in your idea that the system functioned well when the speculation that took place caused so much hardship for our families, and created such an economic crisis of energy and food and other hardships on our families. So how could the system maybe be tweaked so that it continues to function well in some regards, but it offers protections to our families where those small train wrecks are taking place? " CHRG-111hhrg63105--104 Mr. Chilton," Certainly Congress told us to put the limits in. We had the authority actually before this, but we didn't have support to do this. So we were instructed in the Dodd-Frank bill to put limits in. And the original purpose in the Commodity Exchange Act doesn't say that you have to jump some hurdle that proves beyond a shadow of a doubt in a court of law that speculators moved gas prices ten percent. The law says that we are to prevent and deter fraud, abuse, and manipulation; and so that is sort of the guiding onus that I look at, sir. " CHRG-110hhrg44901--72 Mr. Bernanke," Well, as we look back on it, we see that there were just some serious failures in the management of risks. There were many firms that had exposure to the housing market in a variety of ways across the firm, including holding mortgages and other ways. And they didn't fully appreciate that in the contingency that the housing boom would turn around, that house prices would begin to drop; they didn't fully appreciate their exposure to that situation. The regulators bear some responsibility on that. It is our job to make sure that they measure and manage their risks appropriately. We have been working on that for a number of years related to bank supervision initiatives like the Basel Initiative, for example, and so on. But it is clear that we need to redouble our efforts to make sure that the risk management is sound, that the underwriting is sound, and that we don't get ourselves into this kind of situation again. Ms. Pryce. Well, you mentioned Basel. Are there further risks ahead to our system and therefore the overall economy that might arise, and the new capital adequacy standards in Basel? You know, if we are trying to have this happen simultaneously, could that create new risk to the system? Effects of a crisis in any overseas market, could that affect our system in a negative way? Further decline in the dollar. There is a list of many things that could potentially happen. One of the things I would like your comment on is the commercial real estate market. You know, many banks astutely avoided the subprime lending, and they instead expanded their commercial real estate lending. So everywhere we turn we see increased vacancy signs and downward pressure on rents. And do we expect another wave of pressure from that market? And are we planning ahead as a country to address these things as opposed to, you know, being reactionary as it seems that we have had to be of late? " fcic_final_report_full--173 As one recent study argues, many economists were “agnostics” on housing, un- willing to risk their reputations or spook markets by alleging a bubble without find- ing support in economic theory.  Fed Vice Chairman Donald Kohn was one. “Identification [of a bubble] is a tricky proposition because not all the fundamental factors driving asset prices are directly observable,” Kohn said in a  speech, cit- ing research by the European Central Bank. “For this reason, any judgment by a cen- tral bank that stocks or homes are overpriced is inherently highly uncertain.”  But not all economists hesitated to sound a louder alarm. “The situation is begin- ning to look like a credit-induced boom in housing that could very well result in a systemic bust if credit conditions or economic conditions should deteriorate,” Federal Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March  report. “During the past five years, the average U.S. home has risen in value by , while homes in the fastest-growing markets have approximately doubled in value.” While this increase might have been explained by strong market fundamen- tals, “the dramatic broadening of the housing boom in  strongly suggests the in- fluence of systemic factors, including the low cost and wide availability of mortgage credit.”  A couple of months later, Fed economists in an internal memo acknowledged the possibility that housing prices were overvalued, but downplayed the potential im- pacts of a downturn. Even in the face of a large price decline, they argued, defaults would not be widespread, given the large equity that many borrowers still had in their homes. Structural changes in the mortgage market made a crisis less likely, and the financial system seemed well capitalized. “Even historically large declines in house prices would be small relative to the recent decline in household wealth owing to the stock market,” the economists concluded. “From a wealth-effects perspective, this seems unlikely to create substantial macroeconomic problems.”  CHRG-110hhrg46593--29 Secretary Paulson," Yes, Congressman Bachus, I think we are on the right track. Remember, this is early days. In terms of the capital, it has just gone out, and a lot of it still hasn't gone out to the banks. The way I look at where we are today is, I think we have turned the corner in terms of stabilizing the system, preventing a collapse. I think there is a lot of work that still needs to be done in terms of recovery of the financial system, getting it working again, getting credit flowing again. I think this is going to be key to getting the economy going. And it is going to take a lot of work and time. I agree with what the chairman said about bank lending. And I just want to say, one, to get to your point on foreclosure prevention, I understand the chairman's point. And he expects and wants to see something in the TARP, specifically in the TARP to deal with that. We are continuing to work on that. I did want to say, though, that because I was so aware of what the American people expected and what Congress expected and because I cared so much about this, that I believe that the actions we took outside of the TARP with regard to the GSEs and the national standard they set has the potential to touch more and do more than we might have achieved if we had used all $700 billion to buy illiquid assets. So we are working. I understand the point. I know what you would like to see us do, but I just wanted to make that point there. " CHRG-111hhrg48867--202 Mr. Bartlett," Congressman, I suppose I understand why the discussion keeps, sort of, trending over towards identifying specific firms, but let me try to offer some clarity. That is not the goal. It is a set of practices and activities across the markets, it is the system that we should focus on. There is no--at least we don't have a proposal to identify, ``systemically significant firms.'' That should not be done. It should not be size-mattered. It should be related to whether their system or the practices create systemic risk. Now, let me give you a real-life example of one that we just went through. Hundreds of thousands of mortgage brokers, not big companies but hundreds of thousands, had a practice of selling mortgage products not related to whether they were good mortgages or not, without the ability to repay. Thousands of lenders--42 percent were regulated banks; 58 percent were unregulated by anyone--had a practice of originating those loans, even though they were systemically a major risk, as it turned out, and then selling them to mortgage-backed securities on Wall Street, who then put them into pools, who then had them insured, that were regulated by 50 State insurance commissioners. So the system itself was the systemic failure. It wasn't any one of those firms. And so the goal here, I think, is to create a regulatory system that can identify those patterns or practices that then can result in a systemic collapse before it happens. " fcic_final_report_full--398 Over the next several months Bank of America worked with its regulators to iden- tify the assets that would be included in the asset pool. Then, on May , Bank of America asked to exit the ring fence deal, explaining that the company had deter- mined that losses would not exceed the  billion that Bank of America was required to cover in its first-loss position. Although the company was eventually allowed to ter- minate the deal, it was compelled to compensate the government for the benefits it had received from the market’s perception that the government would insure its as- sets. On September , Bank of America agreed to pay a  million termination fee:  million to Treasury,  million to the Fed, and  million to the FDIC. COMMISSION CONCLUSIONS ON CHAPTER 20 The Commission concludes that, as massive losses spread throughout the finan- cial system in the fall of , many institutions failed, or would have failed but for government bailouts. As panic gripped the market, credit markets seized up, trading ground to a halt, and the stock market plunged. Lack of transparency contributed greatly to the crisis: the exposures of financial institutions to risky mortgage assets and other potential losses were unknown to market participants, and indeed many firms did not know their own exposures. The scale and nature of the over-the-counter (OTC) derivatives market cre- ated significant systemic risk throughout the financial system and helped fuel the panic in the fall of : millions of contracts in this opaque and deregulated market created interconnections among a vast web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults. Enormous positions concentrated in the hands of systemically significant institutions that were major OTC derivatives dealers added to uncertainty in the market. The “bank runs” on these institutions in- cluded runs on their derivatives operations through novations, collateral de- mands, and refusals to act as counterparties. A series of actions, inactions, and misjudgments left the country with stark and painful alternatives—either risk the total collapse of our financial system or spend trillions of taxpayer dollars to stabilize the system and prevent catastrophic damage to the economy. In the process, the government rescued a number of fi- nancial institutions deemed “too big to fail”—so large and interconnected with other financial institutions or so important in one or more financial markets that their failure would have caused losses and failures to spread to other institutions. The government also provided substantial financial assistance to nonfinancial corporations. As a result of the rescues and consolidation of financial institutions through failures and mergers during the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few very large, systemically signifi- cant institutions. This concentration places greater responsibility on regulators for effective oversight of these institutions. CHRG-110hhrg46596--197 Mr. Kashkari," Congressman, there is no question that clarity and certainty are very important for developing market confidence. We have had to move and be nimble and react to changes on the ground. I say since the beginning of the credit crisis, the one constant has been its unpredictability. And it has only intensified and deepened more rapidly than we had expected, even in the few weeks that we were working with the Congress on this legislation. So I think we have a choice of being on our back foot and seeing what happens, potentially risking a financial collapse, or being on our front foot and being aggressive to try to stabilize the system, prevent a collapse, and then let the system heal. But I agree with you that more clarity will help with confidence, and will help the system to heal faster. And we think we have the right strategy. " FinancialCrisisReport--224 In addition to a policy of deference to management, weak standards, and demoralized examiners, OTS employed an overly narrow regulatory focus that allowed WaMu’s short term profits to excuse its risky practices and that ignored systemic risk. For a time, its short term profits masked the problems at Washington Mutual, and regulators allowed practices which they knew to be risky and problematic to continue. Because it mishandled its responsibilities, OTS gave the illusion to investors, economists, policy makers, and others that the bank was sound, when in reality, it was just the opposite. Unfortunately, the truth of the matter was not revealed until it was too late, and the bank collapsed. Using Short Term Profits to Excuse Risk. OTS justified not taking enforcement action against WaMu in part by pointing to Washington Mutual’s profits and low loss rates during the height of the mortgage boom, claiming they made it difficult to require the bank to reduce the risks threatening its safety and soundness. In 2005, when faced with underwriting problems at WaMu, the OTS Examiner-in-Charge put it this way: “It has been hard for us to justify doing much more than constantly nagging (okay, ‘chastising’) through ROE [Reports of Examination] and meetings, since they [WaMu] have not been really adversely impacted in terms of losses. It has been getting better and has not recently been bad enough to warrant any ratings downgrade.” 854 The OTS Handbook was explicit, however, in stating that profits should not be used to overlook or excuse high risk activities: 853 10/7/2008 emails from OTS examiner Thomas Constantine to OTS Examiner-in-Charge Benjamin Franklin, “West Region Update,” Franklin_Benjamin-00034415_002, Hearing Exhibit 4/16-14. 854 9/15/2005 email from Examiner-in-Charge Lawrence Carter to Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. “If an association has high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced insignificant losses in the near term.” 855 fcic_final_report_full--72 But leverage works both ways, and in just one month after Russia’s partial default, the fund lost more than  billion—or more than  of its nearly  billion in capi- tal. Its debt was about  billion. The firm faced insolvency.  If it were only a matter of less than  billion, LTCM’s failure might have been manageable. But the firm had further leveraged itself by entering into derivatives contracts with more than  trillion in notional amount—mostly interest rate and equity derivatives.  With very little capital in reserve, it threatened to default on its obligations to its derivatives counterparties—including many of the largest commer- cial and investment banks. Because LTCM had negotiated its derivatives transactions in the opaque over-the-counter market, the markets did not know the size of its posi- tions or the fact that it had posted very little collateral against those positions. As the Fed noted then, if all the fund’s counterparties had tried to liquidate their positions simultaneously, asset prices across the market might have plummeted, which would have created “exaggerated” losses. This was a classic setup for a run: losses were likely, but nobody knew who would get burned. The Fed worried that with financial mar- kets already fragile, these losses would spill over to investors with no relationship to LTCM, and credit and derivatives markets might “cease to function for a period of one or more days and maybe longer.”  To avert such a disaster, the Fed called an emergency meeting of major banks and securities firms with large exposures to LTCM.  On September , after considerable urging,  institutions agreed to organize a consortium to inject . billion into LTCM in return for  of its stock.  The firms contributed between  million and  million each, although Bear Stearns declined to participate.  An orderly liquidation of LTCM’s securities and derivatives followed. William McDonough, then president of the New York Fed, insisted “no Federal Reserve official pressured anyone, and no promises were made.”  The rescue in- volved no government funds. Nevertheless, the Fed’s orchestration raised a question: how far would it go to forestall what it saw as a systemic crisis? The Fed’s aggressive response had precedents in the previous two decades. In , the Fed had supported the commercial paper market; in , dealers in silver futures; in , the repo market; in , the stock market after the Dow Jones In- dustrial Average fell by  percent in three days. All provided a template for future interventions. Each time, the Fed cut short-term interest rates and encouraged finan- cial firms in the parallel banking and traditional banking sectors to help ailing mar- kets. And sometimes it organized a consortium of financial institutions to rescue firms.  During the same period, federal regulators also rescued several large banks that they viewed as “too big to fail” and protected creditors of those banks, including uninsured depositors. Their rationale was that major banks were crucial to the finan- cial markets and the economy, and regulators could not allow the collapse of one large bank to trigger a panic among uninsured depositors that might lead to more bank failures. CHRG-111shrg57923--30 Mr. Liechty," Well, I think that for the large--when people approach the financial markets, they typically approach from the statistical perspective. Even though it is a whole bunch of individual agents interacting with each other, it is too complicated typically to really model effectively. There are some folks at Los Alamos and there is a really big simulation study over in Tokyo. I know there are IBMs involved with where they are trying to do Asian-based modeling. But typically, you have to sit back and look at aggregate summaries and model it from that perspective. Now, we have a lot of information that is already about the financial markets that is widely disseminated and we would be talking about adding additional information on top of that. I think where you start to begin to have problems or people begin to influence is if you have people all doing the same type of behaviors, so lots of people are making mortgage-backed securities and securitizing them and selling them off to pension fund, and there are lots of similar behaviors happening and then a shock comes through and everybody has to respond in a similar fashion. Then, in some sense, the model collapses down to a much simpler system because everyone is forced into a corner in the way they are going to have to behave. For the most part, I think giving more information and trying to model it is not going to have an impact, because I don't know that anybody is going to really have the ability to nudge the system one way or another. But what you hope you will find is when the system gets to a point where there, in essence, are bubbles that could be collapsing and what might trigger those bubbles, how you respond to that is going to be very carefully thought about, and is going to have to be very carefully thought about by the systemic regulator and the other regulators when they have that information. Do they want to talk to banks quietly? Do they want to make a public announcement? These are things that you are going to have to think very carefully about, and I am not prepared to lay the guidelines out right now. Senator Corker. So you are not really thinking about creating a world full of elevator music or anything. We would still have some degree of chaos in the marketplace. " fcic_final_report_full--604 No. LA-03370-A, November 9, 2007, pp. 150, 36–37. 12. Angelo Mozilo, email to Lyle Gramley, member of Board of Countrywide Financial Corporation (cc Michael Perry, chief executive officer, IndyMac Bank), August 1, 2007. 13. Eric Sieracki, quoted in Mark DeCambre, “Countrywide Defends Liquidity,” TheStreet.com , Au- gust 2, 2007. 14. “Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial Corporation,” August 6, 2007, pp. 1, 2, 1. 15. Fed Chairman Ben Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010. 16. Federal Reserve Staff, memo to Board of Governors of the Federal Reserve System, “Background on Countrywide Financial Corporation,” August 14, 2007, pp. 1–2. 17. Ibid., pp. 12–13. 18. Countrywide Financial Corporation, Form 8-K, Exhibit 99.1, filed August 6, 2007. See also “Min- utes of a Special Telephonic Meeting of the Boards of Directors of Countrywide Financial Corporation and Countrywide Bank, FSB,” August 15, 2007. 19. Angelo Mozilo, interview by FCIC, September 24, 2010. 20. Kenneth Bruce, “Liquidity Is the Achilles Heel,” Merrill Lynch Analyst Report, August 15, 2007, p. 4; Kenneth Bruce, “Attractive Upside, but Not without Risk,” Merrill Lynch Analyst Report, August 13, 2007, p. 4. 21. Mozilo, interview; the article, by E. Scott Reckard and Annette Haddad, was titled “Credit Crunch Imperils Lender: Worries Grow about Countrywide’s Ability to Borrow—and Even a Possible Bank- ruptcy.” 22. Angelo Mozilo, quoted in “One on One with Angelo Mozilo, Chairman and CEO of Countrywide Financial,” Nightly Business Report, PBS, August 23, 2007, transcript; and in “CEO Exclusive: Country- wide CEO, Pt. 1,” The Call, CNBC, interview by Maria Bartiromo, August 23, 2007, transcript, p. 1. 23. Sebastian Boyd, “BNP Paribas Freezes Funds as Loan Losses Roil Markets,” Bloomberg, August 9, 2007. 24. “BNP Paribas Investment Partners Temporally [ sic ] Suspends the Calculation of the Net Asset Value of the following funds: Parvest Dynamic ABS, BNP Paribas ABS EURIBOR and BNP Paribas ABS EONIA,” BNP Paribas press release, August 9, 2007. 25. Paul A. McCulley, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, pp. 237, 309. 26. Daniel M. Covitz, Nellie Liang, and Gustavo A. Suarez, “The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market,” August 24, 2009, p. 39. 27. Ibid., figure 1, panel B, p. 33. 28. “The Federal Reserve Is Providing Liquidity to Facilitate the Orderly Functioning of Financial Markets,” Federal Reserve Board press release, August 10, 2007. 29. Federal Reserve Board, press release, August 17, 2007. 30. Henry Tabe, Moody’s Investors Service, “SIVs: An Oasis of Calm in the Sub-prime Maelstrom: Structured Investment Vehicles,” International Structured Finance: Special Report, July 20, 2007, p. 1. 31. Ibid. 32. Henry Tabe, interview by FCIC, October 4, 2010. 33. Moody’s Investors Service, “From Illiquidity to Liquidity: The Path Toward Credit Market Nor- malization,” Moody’s International Policy Perspectives, September 5, 2007, p. 1. 34. Tabe, interview. 35. Moody’s Investors Service, “Moody’s Update on Structured Investment Vehicles,” Moody’s Special Report, January 16, 2008, p. 12. 36. Information provided to the FCIC by Deloitte LLP’s counsel, August 2, 2010. 37. Moody’s Rating Action, “Sigma Finance,” September 30, 2008; Henry Tabe, The Unravelling of Structured Investment Vehicles: How Liquidity Leaked through SIVs: Lessons in Risk Management and Reg- ulatory Oversight ([Chatham, Kent]: Thoth Capital, 2010), p. 60. 38. The SEC indicated it is aware of at least 44 money market funds that were supported by affiliates because of SIV investments. See Securities and Exchange Commission, “Money Fund Reform” (Proposed rule), June 20, 2009, p. 14 n. 38. 601 39. Christopher Condon and Rachel Layne, “GE Bond Fund Investors Cash Out After Losses from CHRG-111shrg53822--66 Mr. Baily," The Volcker Commission used this with SIFIs, or ``systemically important financial institutions,'' maybe that is a better word than ``too big too fail,'' but, anyway, certainly institutions in which there is a danger that the whole system will come down. How do you define that? I do not know the answer to that. I think it has to be done through guidelines provided by Congress with some discretion for the regulators. In terms of AIG going down and Lehman going down, I disagree with Peter fundamentally. I think we had to do what was done with AIG to prevent further repercussions. I do think that the failure of Lehman was a mistake, and I think most people looking back would agree that it would not have taken that much to prevent the disorderly collapse of Lehman, which had substantial impacts in London and other parts of the world. So I do think we do need to make sure not that shareholders benefits--because shareholders go down, as they should, but that some of the fallout from those institutions is prevented. You mentioned that we have sort of created these monsters now by putting together some of the banks. I think the Treasury and the Federal Reserve were acting quickly to try to deal with a very difficult crisis. I think with the benefit of hindsight, maybe it would not have been such a great idea to make Bank of America take over Merrill, or whatever. I think some of those mistakes--or some of those decisions that were made rather quickly were not always--may not have been the best ones. But in point of fact, we are now stuck with those institutions. They are SIFIs, and they have to be regulated with additional capital requirements and some of the additional requirements so that they do not pose systemic dangers. Senator Warner. We are down to 7 minutes, and we have got to get over to the capital, so, Professor, briefly. " CHRG-110hhrg46595--447 Mr. Sachs," I think this is relevant also for this restructuring issue. We can't send a signal that we are just dripping an IV line into a moribund patient. That will not work. The idea of doing this for 3 weeks is a zero in my mind. It doesn't make any sense. Six months only works, by the way, if it is done in a very positive way with President-Elect Obama saying, we are going to make this work for the longer term; we are going to be in there. And--sorry, if I might, Congressman, just to emphasize--we don't need Chapter 11 to do a balance sheet restructuring. We can do it in the shadow of this and preserve value. " CHRG-111shrg55278--117 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SHEILA C. BAIRQ.1. Many proposals call for a risk regulator that is separate from the normal safety and soundness regulator of banks and other firms. The idea is that the risk regulator will set rules that the other regulators will enforce. That sounds a lot like the current system we have today, where different regulators read and enforce the same rules different ways. Under such a risk regulator, how would you make sure the rules were being enforced the same across the board?A.1. The significant size and growth of unsupervised financial activities outside the traditional banking system--in what is termed the shadow financial system--has made it all the more difficult for regulators or market participants to understand the real dynamics of either bank credit markets or public capital markets. The existence of one regulatory framework for insured institutions and a much less effective regulatory scheme for nonbank entities created the conditions for arbitrage that permitted the development of risky and harmful products and services outside regulated entities. We have proposed a Systemic Risk Council composed of the principal prudential regulators for banking, financial markets, consumer protection, and Treasury to look broadly across all of the financial sectors to adopt a ``macroprudential'' approach to regulation. The point of looking more broadly at the financial system is that reasonable business decisions by individual financial firms may, in aggregate, pose a systemic risk. This failure of composition problem cannot be solved by simply making each financial instrument or practice safe. Rules and restrictions promulgated by the proposed Systemic Risk Council would be uniform with respect to institutions, products, practices, services, and markets that create potential systemic risks. Again, a distinction should be drawn between the direct supervision of systemically significant financial firms and the macroprudential oversight and regulation of developing risks that may pose systemic risks to the U.S. financial system. The former appropriately calls for the identification of a prudential supervisor for any potential systemically significant holding companies or similar conglomerates. Entities that are already subject to a prudential supervisor, such as insured depository institutions and financial holding companies, should retain those supervisory relationships. In addition, for systemic entities not already subject to a Federal prudential supervisor, this Council should be empowered to require that they submit to such oversight, presumably as a financial holding company under the Federal Reserve--without subjecting them to the activities restrictions applicable to these companies. We need to combine the current microprudential approach with a macroprudential approach through the Council. The current system focuses only on individual financial instruments or practices. Each agency is responsible for enforcing these regulations only for their institutions. In addition, there are separate regulatory schemes used by the SEC and the CFTC as well as the State level regulation of insurance companies. The macroprudential oversight of systemwide risks requires the integration of insights from a number of different regulatory perspectives--banks, securities firms, holding companies, and perhaps others. Thus, the FDIC supports the creation of a Council to oversee systemic risk issues, develop needed prudential policies, and mitigate developing systemic risks.Q.2. Before we can regulate systemic risk, we have to know what it is. But no one seems to have a definition. How do you define systemic risk?A.2. We would anticipate that the Systemic Risk Council, in conjunction with the Federal Reserve would develop definitions for systemic risk. Also, mergers, failures, and changing business models could change what firms would be considered systemically important from year-to-year.Q.3. Assuming a regulator could spot systemic risk, what exactly is the regulator supposed to do about it? What powers would they need to have?A.3. The failure of some large banks and nonbanks revealed that the U.S. banking agencies should have been more aggressive in their efforts to mitigate excessive risk concentrations in banks and their affiliates, and that the agencies' powers to oversee systemically important nonbanks require strengthening. As discussed in my testimony, the FDIC endorses the creation of a Council to oversee systemic risk issues, develop needed prudential policies, and mitigate developing systemic risks. For example, the Council could ensure capital standards are strong and consistent across significant classes of financial services firms including nonbanks and GSEs. Prior to the current crisis, systemic risk was not routinely part of the ongoing supervisory process. The FDIC believes that the creation of a Council would provide a continuous mechanism for measuring and reacting to systemic risk across the financial system. The powers of such a Council would ultimately have to be developed through a dialogue between the banking agencies and Congress, and empower the Council to ensure appropriate oversight of unsupervised nonbanks that present systemic risk. Such nonbanks should be required to submit to such oversight, presumably as a financial holding company under the Federal Reserve.Q.4. How do you propose we identify firms that pose systemic risks?A.4. The proposed Systemic Risk Council could establish what practices, instruments, or characteristics (concentrations of risk or size) that might be considered risky, but should not identify any set of firms as systemic. We have concerns about formally designating certain institutions as a special class. We recognize that there may be very large interconnected financial entities that are not yet subject to Federal consolidated supervision, although most of them are already subject to such supervision as a result of converting to banks or financial holding companies in response to the crisis. Any recognition of an institution as systemically important, however, risks invoking the moral hazard that accompanies institutions that are considered too-big-to-fail. That is one reason why, most importantly, a robust resolution mechanism, in addition to enhanced supervision, is important for very large financial organizations.Q.5. Any risk regulator would have access to valuable information about the business of many firms. There would be a lot of people who would pay good money to get that information. How do we protect that information from being used improperly, such as theft or an employee leaving the regulator and using his knowledge to make money?A.5. The FDIC, as deposit insurer and supervisor of over 5,000 banks, prides itself on maintaining confidentiality with our stakeholders. We have a corporate culture that demands strict confidentiality with regard to bank and personal information. Our staff is trained extensively on the use, protection, and disclosure of nonpublic information as well as expectations for the ethical conduct. Disclosure of nonpublic information is not tolerated and any potential gaps are dealt with swiftly and disclosed to affected parties. The FDIC's Office of Inspector General has a robust process for dealing with improper disclosures of information both during and postemployment with FDIC. These ethical principles are supported by criminal statutes which provide that Federal officers and employees are prohibited from the disclosure of confidential information generally (18 U.S.C. 1905) and from the disclosure of information from a bank examination report (18 U.S.C. 1906). All former Federal officers and employees are subject to the postemployment restrictions (18 U.S.C. 207), which prohibit former Government officers and employees from knowingly making a communication or appearance on behalf of any other person, with the intent to influence, before any officer or employee of any Federal agency or court in connection with a particular matter in which the employee personally and substantially participated, which involved a specific party at the time of the participation and representation, and in which the U.S. is a party or has a direct and substantial interest. In addition, an officer or employee of the FDIC who serves as a senior examiner of an insured depository institution for at least 2 months during the last 12 months of that individual's employment with the FDIC may not, within 1 year after the termination date of his or her employment with the FDIC, knowingly accept compensation as an employee, officer, director, or consultant from the insured depository institution; or any company (including a bank holding company or savings and loan holding company) that controls such institution (12 U.S.C. 1820(k). ------ CHRG-111hhrg53021Oth--107 Secretary Geithner," It is absolutely recognized, and it is a significant issue of concern. But, what is causing those pressures on both borrowers and banks is the fact that large parts of the financial system in this country just took on too much risk during the boom. And the costs of that--it is fundamentally unfair, but that is what happens in financial crises--fall not just on those who took too much risk, but they fall on a bunch of businesses and banks across the country which were very responsible and prudent. And that is why these things can be so damaging. And that is why it is very important that we do everything we can to put a better foundation for recovery in demand and growth, and try to make sure that the financial system has capital where it is necessary, and that these markets for credit start to get moving again. And that is the basic philosophy that has underpinned everything we have done. You are also right that there is a risk in financial crises that people overcorrect; that, after a period of taking on too much risk, that they take too little. People that got way overextended pull back too much. And that can cause, also, a lot of collateral damage. And, again, that is the basic rationale in a financial crisis for trying to make sure you do as much as you can to provide enough support for the economy to get back on track. But, I am very much aware of the concerns you expressed. I believe that the principal bank supervisors are, too. They are carefully managing those risks. And you are also right that any time you think about reform to legislation in the financial area, that is going to come with a period of uncertainty. We need to minimize that uncertainty. And, that is one reason why we want to bring clarity, relatively quickly, to the rules of the game that govern our financial system, going forward. If we were to wait years to do this, the markets would be left with a greater period of uncertainty, and that might deter more lending and risk taking. " CHRG-111hhrg53021--107 Secretary Geithner," It is absolutely recognized, and it is a significant issue of concern. But, what is causing those pressures on both borrowers and banks is the fact that large parts of the financial system in this country just took on too much risk during the boom. And the costs of that--it is fundamentally unfair, but that is what happens in financial crises--fall not just on those who took too much risk, but they fall on a bunch of businesses and banks across the country which were very responsible and prudent. And that is why these things can be so damaging. And that is why it is very important that we do everything we can to put a better foundation for recovery in demand and growth, and try to make sure that the financial system has capital where it is necessary, and that these markets for credit start to get moving again. And that is the basic philosophy that has underpinned everything we have done. You are also right that there is a risk in financial crises that people overcorrect; that, after a period of taking on too much risk, that they take too little. People that got way overextended pull back too much. And that can cause, also, a lot of collateral damage. And, again, that is the basic rationale in a financial crisis for trying to make sure you do as much as you can to provide enough support for the economy to get back on track. But, I am very much aware of the concerns you expressed. I believe that the principal bank supervisors are, too. They are carefully managing those risks. And you are also right that any time you think about reform to legislation in the financial area, that is going to come with a period of uncertainty. We need to minimize that uncertainty. And, that is one reason why we want to bring clarity, relatively quickly, to the rules of the game that govern our financial system, going forward. If we were to wait years to do this, the markets would be left with a greater period of uncertainty, and that might deter more lending and risk taking. " fcic_final_report_full--310 The Fed’s internal report on the stress tests criticized Merrill’s “significant amount of illiquid fixed income assets” and noted that “Merrill’s liquidity pool is low, a fact [the company] does not acknowledge.” As for Lehman Brothers, the Fed concluded that “Lehman’s weak liquidity position is driven by its relatively large exposure to overnight [commercial paper], combined with significant overnight secured [repo] funding of less liquid assets.”  These “less liquid assets” included mortgage-related securities—now devalued. Meanwhile, Lehman ran stress tests of its own and passed with billions in “excess cash.”  Although the SEC and the Fed worked together on the liquidity stress tests, with equal access to the data, each agency has said that for months during the crisis, the other did not share its analyses and conclusions. For example, following Lehman’s failure in September, the Fed told the bankruptcy examiner that the SEC had de- clined to share two horizontal (cross-firm) reviews of the banks’ liquidity positions and exposures to commercial real estate. The SEC’s response was that the documents were in “draft” form and had not been reviewed or finalized. Adding to the tension, the Fed’s on-site personnel believed that the SEC on-site personnel did not have the background or expertise to adequately evaluate the data.  This lack of communica- tion was remedied only by a formal memorandum of understanding (MOU) to gov- ern information sharing. According to former SEC Chairman Christopher Cox, “One reason the MOU was needed was that the Fed was reluctant to share supervi- sory information with the SEC, out of concern that the investment banks would not be forthcoming with information if they thought they would be referred to the SEC for enforcement.”  The MOU was not executed until July , more than three months after the collapse of Bear Stearns. DERIVATIVES: “EARLY STAGES OF ASSESSING THE POTENTIAL SYSTEMIC RISK ” The Fed’s Parkinson advised colleagues in an internal August  email that the sys- temic risks of the repo and derivatives markets demanded attention: “We have given considerable thought to what might be done to avoid a fire sale of tri-party repo col- lateral. (That said, the options under existing authority are not very attractive—lots of risk to Fed/taxpayer, lots of moral hazard.) We still are at the early stages of assess- ing the potential systemic risk from close-out of OTC derivatives transactions by an investment bank’s counterparties and identifying potential mitigants.”  The repo market was huge, but as discussed in earlier chapters, it was dwarfed by CHRG-111shrg56376--14 Mr. Bowman," Good morning, Chairman Dodd, Ranking Member Shelby, and other Members of the Committee. Thank you for the opportunity to testify on the Administration's proposal for financial regulatory reform. It is my pleasure to address this Committee for the first time in my role as Acting Director of the Office of Thrift Supervision. I will begin my testimony by outlining the core principles I believe are essential to accomplishing true and lasting reform. Then I will address specific questions you asked regarding the Administration's proposal. Let me start with the four principles. One, ensure that changes to the financial regulatory system address real problems. We all agree that the system has real problems and needs real reform. What we must determine, as we consider each proposed change, is whether the proposal would fix what is broken. In the rush to address what went wrong, let us not try to fix nonexisting problems or try to fix real problems with flawed solutions. Two, ensure uniform regulation. One of the biggest lessons learned from the current economic crisis is that all entities offering financial products to consumers must be subject to the same rules. Underregulated entities competing in the financial marketplace have a corrosive, damaging impact on the entire system. Also, complex derivative products such as credit default swaps should be regulated. Three, ensure that systemically important firms are effectively supervised and, if necessary, wound down in an orderly manner. No provider of financial products should be too big to fail, achieving through size and complexity an implicit Federal Government guarantee to prevent its collapse. The U.S. economy operates on the principle of healthy competition. Enterprises that are strong, industrious, well managed, and efficient succeed and prosper. Those that fall short of the mark struggle or fail, and other stronger enterprises take their places. Enterprises that become too big to fail subvert the system. When the Government is forced to prop up failing systemically important computers, it is, in essence, supporting poor performance and creating a moral hazard. Let me be clear. I am not advocating a cap on size, just effective, robust authority for properly regulating and resolving the largest and most complex financial institutions. Number four, ensure that consumers are protected. A single agency should have the regulation of financial products as its central mission. That agency should establish the rules and standards for all consumer financial products, regardless of the issuer of those products, rather than having multiple agencies with fragmented authority and a lack of singular accountability. Regarding feedbacks on the questions the Committee asked, the OTS does not support the Administration's proposal to eliminate the Office of the Comptroller of the Currency and the Office of Thrift Supervision, transferring the employees of each into a national bank supervisory agency or for the elimination of the Federal Thrift Charter. Failures by insured depository institutions have been no more severe among thrifts than among institutions supervised by other Federal banking regulators. If you look at the numbers of failed institutions, most have been State-chartered banks whose primary Federal regulator is not the OTS. If you look at the size of failed institutions, you see that the Federal Government prevented the failures of the largest banks that collapsed by authorizing open bank assistance. These too-big-to-fail institutions are not and were not regulated by the OTS. The argument about bank shopping for the most lenient regulator is also without merit. Most financial institutions and more assets have converted away from OTS supervision in the last 10 years than have converted to OTS supervision. In the same way the thrift charter is not part of the problem, we do not see any reason to cause major disruptions with the hundreds of legitimate, well-run financial businesses that are operating successfully with the thrift charter and making credit available to American consumers. My written testimony contains detailed information you requested about the proposed elimination of the exceptions in the Bank Holding Company Act for thrifts and certain special-purpose banks and about the Federal Reserve System's prudential supervision of holding companies. Thank you again, Mr. Chairman, and I would be happy to answer any questions. " fcic_final_report_full--594 Crisis, day 1, session 3: Risk Taking and Leverage, February 26, 2010, p. 16. 42. OCC, “Subprime CDO Valuation and Oversight Review—Conclusion Memorandum,” memoran- dum from Michael Sullivan, RAD, and Ron Frake, NBE, to John Lyons, Examiner-in-Charge, Citibank, NA, January 17, 2008, p. 6; Paul, Weiss, Citigroup’s counsel, letter to FCIC, June 23, 2010, “Responses of Nestor Dominguez.” 43. Richard Bookstaber, interview by FCIC, May 11, 2010. 44. “RMBS and Citi-RMBS as a Percentage of Citi-CDO Portfolio Notionals,” produced by Citi for the FCIC. 45. Federal Reserve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Cur- rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial Services Authority, “Notes on Senior Supervisors’ Meetings with Firms,” November 19, 2007, p. 3. 46. FCIC staff estimates, based on analysis of Moody’s CDO EMS database. 47. Paul, Weiss, Citigroup’s counsel, letter to FCIC, March 1, 2010, in re the FCIC’s second supple- mental request, “Response to Interrogatory no. 7”; Paul, Weiss, letter to FCIC, March 31, 2010, updated response to interrogatory no. 7, p. 5. 48. Nestor Dominguez, interview by FCIC, March 2, 2010; Paul, Weiss, letter of March 31, 2010, pp. 3–6. 49. Board Analyst Profile for Citigroup Inc., April 16, 2007. 50. SEC staff (Sam Forstein, Tim McGarey, Mary Ann Gadziala, Kim Mavis, Bob Sollazo, Suzanne McGovern, and Chris Easter), interview by FCIC, February 9, 2010. 51. Comptroller of the Currency, memorandum, Examination of Citigroup Risk Management (CRM), January 13, 2005, p. 3. 52. Ronald Frake, Comptroller of the Currency, letter to Geoffrey Coley, Citibank, N.A., December 22, 2005. 53. Federal Reserve, “New York Operations Review, May 17–25, 2005,” p. 4. 54. Federal Reserve Bank of New York Bank Supervision Group, “Operations Review Report,” De- cember 2009. 55. Federal Reserve Bank of New York, “Summary of Supervisory Activity and Findings, Citigroup Inc., January 1, 2005–December 31, 2005,” April 10, 2006; Federal Reserve Bank of New York, “Summary of Supervisory Activity and Findings,” Citigroup Inc., January 1, 2004–December 31, 2004,” April 5, 2005. 56. Citigroup Inc., Form 8-K, April 3, 2006, Exhibit 99.1. 57. Federal Reserve Board, memo to Governor Susan Bies, February 17, 2006. 58. The board reversed a 15% reduction that had been implemented when the issues began and then added a 5% raise. Citigroup, 2006 Proxy Statement, p. 37. 59. Comptroller of the Currency, letter to Citigroup CEO Vikram Pandit (Supervisory Letter 2008- 05), February 14, 2008; quotation, p. 2. 60. Federal Reserve Bank of New York, letter to Vikram Pandit and the Board of the Directors of Citi- group, April 15, 2008, pp. 6–7. 61. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 128. 62. Gene Park, interview by FCIC, May 18, 2010. 63. Andrew Forster, email to Gary Gorton, Alan Frost, et al., July 21, 2005. 64. Park, interview. 65. Gorton, interview. 66. Park, interview. 67. Gene Park, email to Joseph Cassano, February 28, 2006. 68. Park, interview. 591 69. Data supplied by AIG. The CDO—RFC CDO III Ltd.—was 93% subprime and 7% RMBS Home Equity, according to the AIG credit committee. A review by FCIC staff showed that the remaining 7% designated as RMBS Home Equity included subprime collateral. 70. AIG, “Residential Mortgage Presentation (Financial Figures are as of June 30, 2007),” August 9, 2007, p. 28. 71. Park, interview. 72. Joseph Cassano, interview by FCIC, June 25, 2010. 73. Park, interview. 74. Dow Kim, interview by FCIC, September 9, 2010. 75. Stanley O’Neal, interview by FCIC, September 16, 2010. 76. Kim, interview. 77. FCIC staff estimates based on analysis of Moody’s CDO EMS database. 78. Complaint, Coöperatieve Centrale Raiffeisen=Boerenleenbank v. Merrill Lynch, No. 601832/09 (N.Y.S. June 12, 2009), paragraph 147. 79. Kim, interview. 80. FCIC analysis based on Moody’s CDO EMS database. 81. Presentation to Merrill Lynch and Co. Board of Directors, “Leveraged Finance and fcic_final_report_full--307 On May , the Fed broadened the kinds of collateral allowed in the TSLF to in- clude other triple-A-rated asset-backed securities, such as auto and credit card loans. In June, the Fed’s Dudley urged in an internal email that both programs be extended at least through the end of the year. “PDCF remains critical to the stability of some of the [investment banks],” he wrote. “Amounts don’t matter here, it is the fact that the PDCF underpins the tri-party repo system.”  On July , the Fed extended both pro- grams through January , . JP MORGAN: “REFUSING TO UNWIND . . . WOULD BE UNFORGIVABLE ” The repo run on Bear also alerted the two repo clearing banks—JP Morgan, the main clearing bank for Lehman and Merrill Lynch, as it had been for Bear Stearns, and BNY Mellon, the main clearing bank for Goldman Sachs and Morgan Stanley—to the risks they were taking. Before Bear’s collapse, the market had not really understood the colossal expo- sures that the tri-party repo market created for these clearing banks. As explained earlier, the “unwind/rewind” mechanism could leave JP Morgan and BNY Mellon with an enormous “intraday” exposure—an interim exposure, but no less real for its brevity. In an interview with the FCIC, Dimon said that he had not become fully aware of the risks stemming from his bank’s tri-party repo clearing business until the Bear crisis in .  A clearing bank had two concerns: First, if repo lenders aban- doned an investment bank, it could be pressured into taking over the role of the lenders. Second, and worse—if the investment bank defaulted, it could be stuck with unwanted securities. “If they defaulted intraday, we own the securities and we have to liquidate them. That’s a huge risk to us,” Dimon explained.  To address those risks in , for the first time both JP Morgan and BNY Mellon started to demand that intraday loans to tri-party repo borrowers—mostly the large investment banks—be overcollateralized. The Fed increasingly focused on the systemic risk posed by the two repo clearing banks. In the chain-reaction scenario that it envisioned, if either JP Morgan or BNY Mellon chose not to unwind its trades one morning, the money funds and other repo lenders could be stuck with billions of dollars in repo collateral. Those lenders would then be in the difficult position of having to sell off large amounts of collateral in or- der to meet their own cash needs, an action that in turn might lead to widespread fire sales of repo collateral and runs by lenders.  The PDCF provided overnight funding, in case money market funds and other repo lenders refused to lend as they had in the case of Bear Stearns, but it did not pro- tect against clearing banks’ refusing exposure to an investment bank during the day. On July , Fed officials circulated a plan, ultimately never implemented, that ad- dressed the possibility that one of the two clearing banks would become unwilling or unable to unwind its trades.  The plan would allow the Fed to provide troubled in- vestment banks, such as Lehman Brothers, with  billion in tri-party repo financ- ing during the day—essentially covering for JP Morgan or BNY Mellon if the two clearing banks would not or could not provide that level of financing.  Fed officials made a case for the proposal in an internal memo: “Should a dealer lose the confi- dence of its investors or clearing bank, their efforts to pull away from providing credit could be disastrous for the firm and also cast widespread doubt about the in- strument as a nearly risk free, liquid overnight investment.”  fcic_final_report_full--151 CDOs, and leverage, Cioffi’s funds earned healthy returns for a time: the High-Grade fund had returns of  in ,  in , and  in  after fees.  Cioffi and Tannin made millions before the hedge funds collapsed in . Cioffi was rewarded with total compensation worth more than  million from  to . In , the year the two hedge funds filed for bankruptcy, Cioffi made more than . mil- lion in total compensation. Matt Tannin, his lead manager, was awarded compensa- tion of more than . million from  to .  Both managers invested some of their own money in the funds, and used this as a selling point when pitching the funds to others.  But when house prices fell and investors started to question the value of mort- gage-backed securities in , the same short-term leverage that had inflated Cioffi’s returns would amplify losses and quickly put his two hedge funds out of business. CITIGROUP ’S LIQUIDITY PUTS: “A POTENTIAL CONFLICT OF INTEREST ” By the middle of the decade, Citigroup was a market leader in selling CDOs, often using its depositor-based commercial bank to provide liquidity support. For much of this period, the company was in various types of trouble with its regulators, and then-CEO Charles Prince told the FCIC that dealing with those troubles took up more than half his time.  After paying the  million fine related to subprime mort- gage lending, Citigroup again got into trouble, charged with helping Enron—before that company filed for bankruptcy in —use structured finance transactions to manipulate its financial statements. In July , Citigroup agreed to pay the SEC  million to settle these allegations and also agreed, under formal enforcement actions by the Federal Reserve and Office of the Comptroller of the Currency, to overhaul its risk management practices.  By March , the Fed had seen enough: it banned Citigroup from making any more major acquisitions until it improved its governance and legal compliance. Ac- cording to Prince, he had already decided to turn “the company’s focus from an ac- quisition-driven strategy to more of a balanced strategy involving organic growth.”  Robert Rubin, a former treasury secretary and former Goldman Sachs co-CEO who was at that time chairman of the Executive Committee of Citigroup’s board of direc- tors, recommended that Citigroup increase its risk taking—assuming, he told the FCIC, that the firm managed those risks properly.  Citigroup’s investment bank subsidiary was a natural area for growth after the Fed and then Congress had done away with restrictions on activities that could be pur- sued by investment banks affiliated with commercial banks. One opportunity among many was the CDO business, which was just then taking off amid the booming mort- gage market. In , Citi’s CDO desk was a tiny unit in the company’s investment banking arm, “eight guys and a Bloomberg” terminal, in the words of Nestor Dominguez, then co-head of the desk.  Nevertheless, this tiny operation under the command of CHRG-110hhrg46596--110 Mr. Kashkari," That is a great question. I am glad you asked it. This is an economic stabilization plan to prevent a financial system collapse, to stabilize the financial system. It is not an economic growth plan, an economic stimulus plan. Those are very different. And our energy is focused on making sure the financial system is stable so that credit can flow. The economy has real challenges, as you indicated. And that is not going to be addressed. Even if we execute the TARP perfectly, that is different than stabilizing the financial system. " FinancialCrisisInquiry--760 VICE CHAIRMAN THOMAS: Mr. Chairman, I’ll take a—a minute, and then ask the question in terms of the distribution of the commercial loans vis-à-vis subprime and the rest. We had big banks in. Is there a greater strain on community banks in terms of the commercial loans versus the subprime being consolidated, and taken to a higher level? And that I think is something that should cause a lot of concern. Because if you get a collapse at that level, and we haven’t seen the response to recover or protect at that level, you’re going to have a far more fundamental erosion of locales than you would based upon what happened in the subprime. CHRG-111shrg50564--47 Mr. Volcker," Well, I think that is true, but there is plenty of room for innovation outside of the basic banking system, and that is a distinction we make. All kinds of sophisticated capital market techniques, a derivative explosion which may have gone too far, but the whole idea of securitization could be developed outside the banking system. To the extent it is inside the banking system, we say, well, the bank should hold onto what they securitize. That is a traditional function. But outside, they can engage in all kinds of trading and---- Senator Warner. But wouldn't you say some of these outside functions now need to have some kind of regulatory---- " fcic_final_report_full--364 COMMISSION CONCLUSIONS ON CHAPTER 19 The Commission concludes AIG failed and was rescued by the government prima- rily because its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a pro- found failure in corporate governance, particularly its risk management practices. AIG’s failure was possible because of the sweeping deregulation of over-the- counter (OTC) derivatives, including credit default swaps, which effectively elim- inated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG’s failure. The OTC derivatives market’s lack of transparency and of effective price discovery exacer- bated the collateral disputes of AIG and Goldman Sachs and similar disputes be- tween other derivatives counterparties. AIG engaged in regulatory arbitrage by setting up a major business in this unregulated product, locating much of the business in London, and selecting a weak federal regulator, the Office of Thrift Supervision (OTS). The OTS failed to effectively exercise its authority over AIG and its affiliates: it lacked the capability to supervise an institution of the size and complexity of AIG, did not recognize the risks inherent in AIG’s sales of credit default swaps, and did not understand its responsibility to oversee the entire company, including AIG Financial Products. Furthermore, because of the deregulation of OTC derivatives, state insurance supervisors were barred from regulating AIG’s sale of credit de- fault swaps even though they were similar in effect to insurance contracts. If they had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves, would not have been able to enter into con- tracts requiring the posting of collateral, and would not have been able to provide default protection to speculators; thus AIG would have been prevented from act- ing in such a risky manner. AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on credit default swaps and other activities such as securities lending that its po- tential failure created systemic risk. The government concluded AIG was too big to fail and committed more than  billion to its rescue. Without the bailout, AIG’s default and collapse could have brought down its counterparties, causing cascading losses and collapses throughout the financial system. CHRG-111hhrg53245--179 Mr. Johnson," I am not a big council fan myself and not really endorsing that, but I think it has to rest with whomever has the authority to do the bailouts. Who makes the bailout versus collapse decision? It is Treasury under our system. I think it remains Treasury because they write the checks. " CHRG-111shrg55278--112 PREPARED STATEMENT OF ALICE M. RIVLIN Senior Fellow, Economic Studies, Brookings Institution July 23, 2009 Mr. Chairman and Members of the Committee, I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system. It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic well-being and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and overborrowing, excessive risk taking, and outsized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world's economic well-being.Approaches To Reducing Systemic Risk The crisis was a financial ``perfect storm'' with multiple causes. Different explanations of why the system failed--each with some validity--point to at least three different approaches to reducing systemic risk in the future.The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.The system crashed because large interconnected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms--or even break them up--and to expedited resolution authority for large financial firms (including nonbanks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier 1 Financial Institutions. I believe it would be a mistake to identify specific institutions as too-big-to-fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.The Case for a Macro System Stabilizer One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, antiregulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. Perverse Incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer--the Fed should have played this role and failed to do so--and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were resecuritized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain 5 percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea. The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans--long thought to be a benign way to spread the risk of individual loans--became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created. Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV's) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company. The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem. The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and ``identify emerging risks.'' It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed's efforts to monitor the State of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk--and more information on which to base judgments would enhance its effectiveness as a central bank. Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the overleveraged superstructure of complex derivatives erected on the shaky foundation of America's housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster. One approach to controlling serious asset-price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high--as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level. The Fed already has the power to set margin requirements--the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future. During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed's Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble. The 1930s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market's upward momentum--a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy's still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system. In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve--as Macro System Stabilizer--could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes. With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up. With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low. One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high. Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.Systemically Important Institutions The Obama administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier 1 Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go. It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the Federal Government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late. Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks. Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ``too-big-to-fail'' and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures. Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the U.K.'s FSA, but structured to be more effective than the FSA proved in the current crisis. In the U.S. one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies. I don't pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier 1 Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy. Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben Bernanke--who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort--including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed's control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown--and the Fed has been more transparent about its objectives. Although respect for the Fed's monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives. If the Fed were to take on the role of consolidated prudential regulator of Tier 1 Financial Holding Companies, it would need strong, committed leadership with regulatory skills--lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan, or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed's budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed's effectiveness and credibility in containing inflation. In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system--again in coordination with the Council. I would not create a special regulator for Tier 1 Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank. Thank you, Mr. Chairman and Members of the Committee. ______ CHRG-111shrg52619--206 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JOSEPH A. SMITH, JR.Q.1. Consumer Protection Regulation--Some have advocated that consumer protection and prudential supervision should be divorced, and that a separate consumer protection regulation regime should be created. They state that one source of the financial crisis emanated from the lack of consumer protection in the underwriting of loans in the originate-to-distribute space. What are the merits of maintaining it in the same agency? Alternatively, what is the best argument each of you can make for a new consumer protection agency?A.1. CSBS believes safety and soundness and consumer protection should be maintained for the benefit of the system. While CSBS recognizes there is a tension between consumer protection and safety and soundness supervision, we believe these two forms of supervision strengthen the other. Consumer protection is integral to the safety and soundness of consumer protections. The health of a financial institution ultimately is connected to the health of its customers. If consumers lack confidence in their institution or are unable to maintain their economic responsibilities, the institution will undoubtedly suffer. Similarly, safety and soundness of our institutions is vital to consumer protection. Consumers are protected if the institutions upon which they rely are operated in a safe and sound manner. Consumer complaints have often spurred investigations or even enforcement actions against institutions or financial service providers operating in an unsafe and unsound manner. States have observed that federal regulators, without the checks and balances of more locally responsive state regulators or state law enforcement, do not always give fair weight to consumer issues or lack the local perspective to understand consumer issues fully. CSBS considers this a weakness of the current system that would be exacerbated by creating a consumer protection agency. Further, federal preemption of state law and state law enforcement by the OCC and the OTS has resulted in less responsive consumer protections and institutions that are much less responsive to the needs of consumers in our states. CSBS is currently reviewing and developing robust policy positions upon the administration's proposed financial regulatory reform plan. Our initial thoughts, however, are pleased the administration has recognized the vital role states play in preserving consumer protection. We agree that federal standards should be applicable to all financial entities, and must be a floor, allowing state authorities to impose more stringent statutes or regulations if necessary to protect the citizens of our states. CSBS is also pleased the administration's plan would allow for state authorities to enforce all applicable law--state and federal--on those financial entities operating within our state, regardless of charter type.Q.2. Regulatory Gaps or Omissions--During a recent hearing, the Committee has heard about massive regulatory gaps in the system. These gaps allowed unscrupulous actors like AIG to exploit the lack of regulatory oversight. Some of the counterparties that AIG did business with were institutions under your supervision. Why didn't your risk management oversight of the AIG counterparties trigger further regulatory scrutiny? Was there a flawed assumption that AIG was adequately regulated, and therefore no further scrutiny was necessary? Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC? If the credit default swap contracts at the heart of this problem had been traded on an exchange or cleared through a clearinghouse, with requirement for collateral and margin payments, what additional information would have been available? How would you have used it?A.2. CSBS believes this is a question best answered by the Federal Reserve and the OCC. However, we believe this provides an example of why consolidated supervision would greatly weaken our system of financial oversight. Institutions have become so complex in size and scope, that no single regulator is capable of supervising their activities. It would be imprudent to lessen the number of supervisors. Instead, Congress should devise a system which draws upon the strength, expertise, and knowledge of all financial regulators.Q.3. Liquidity Management--A problem confronting many financial institutions currently experiencing distress is the need to roll-over short-term sources of funding. Essentially these banks are facing a shortage of liquidity. I believe this difficulty is inherent in any system that funds long-term assets, such as mortgages, with short-term funds. Basically the harm from a decline in liquidity is amplified by a bank's level of ``maturity-mismatch.'' I would like to ask each of the witnesses, should regulators try to minimize the level of a bank's maturity-mismatch? And if so, what tools would a bank regulator use to do so?A.3. While banks tend to have an inherent maturity-mismatch, greater access to diversified funding has mitigated this risk. Beyond traditional retail deposits, banks can access brokered deposits, public entity deposits, and secured borrowings from the FHLB. Since a bank essentially bids or negotiates for these funds, they can structure the term of the funding to meet their asset and liability management objectives. In the current environment, the FDIC's strict interpretation of the brokered deposit rule has unnecessarily led banks to face a liquidity challenge. Under the FDIC's rules, when a bank falls below ``well capitalized'' they must apply for a waiver from the FDIC to continue to accept brokered deposits. The FDIC has been overly conservative in granting these waivers or allowing institutions to reduce their dependency on brokered deposits over time, denying an institution access to this market. Our December 2008 letter to the FDIC on this topic is attached.Q.4. Regulatory Conflict of Interest--Federal Reserve Banks which conduct bank supervision are run by bank presidents that are chosen in part by bankers that they regulate. Mr. Tarullo, do you see the potential for any conflicts of interest in the structural characteristics of the Fed's bank supervisory authorities? Mr. Dugan and Mr. Polakoff does the fact that your agencies' funding stream is affected by how many institutions you are able to keep under your charters affect your ability to conduct supervision?A.4. I believe these questions are best answered by the Federal Reserve, the OCC, and the OTS.Q.5. Too-Big-To-Fail--Chairman Bair stated in her written testimony that ``the most important challenge is to find ways to impose greater market discipline on systemically important institutions. The solution must involve, first and foremost, a legal mechanism for the orderly resolution of those institutions similar to that which exists for FDIC-insured banks. In short we need to end too big to fail.'' I would agree that we need to address the too-big-to-fail issue, both for banks and other financial institutions. Could each of you tell us whether putting a new resolution regime in place would address this issue? How would we be able to convince the market that these systemically important institutions would not be protected by taxpayer resources as they had been in the past?A.5. CSBS strongly agrees with Chairman Bair that we must end ``too big to fail.'' Our current crisis has shown that our regulatory structure was incapable of effectively managing and regulating the nation's largest institutions and their affiliates. Further, CSBS believes a regulatory system should have adequate safeguards that allow financial institution failures to occur while limiting taxpayers' exposure to financial risk. The federal government, perhaps through the FDIC, must have regulatory tools in place to manage the orderly failure of the largest financial institutions regardless of their size and complexity. The FDIC's testimony effectively outlines the checks and balances provided by a regulator with resolution authority and capability. Part of this process must be to prevent institutions from becoming ``too big to fail'' in the first place. Some methods to limit the size of institutions would be to charge institutions additional assessments based on size and complexity, which would be, in practice, a ``too big to fail'' premium. In a February 2009 article published in Financial Times, Nassim Nicholas Taleb, author of The Black Swan, discusses a few options we should avoid. Basically, Taleb argues we should no longer provide incentives without disincentives. The nation's largest institutions were incentivized to take risks and engage in complex financial transactions. But once the economy collapsed, these institutions were not held accountable for their failure. Instead, the U.S. taxpayers have further rewarded these institutions by propping them up and preventing their failure. Accountability must become a fundamental part of the American financial system, regardless of an institution's size.Q.6. Pro-Cyclicality--I have some concerns about the pro-cyclical nature of our present system of accounting and bank capital regulation. Some commentators have endorsed a concept requiring banks to hold more capital when good conditions prevail, and then allow banks to temporarily hold less capital in order not to restrict access to credit during a downturn. Advocates of this system believe that counter-cyclical policies could reduce imbalances within financial markets and smooth the credit cycle itself. What do you see as the costs and benefits of adopting a more counter-cyclical system of regulation? Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.6. Our legislative and regulatory efforts should be counter-cyclical. In order to have an effective counter-cyclical regulatory regime, we must have the will and political support to demand higher capital standards and reduce risk-taking when the economy is strong and companies are reporting record profits. We must also address accounting rules and their impact on the depository institutions, recognizing that we need these firms to originate and hold longer-term, illiquid assets. We must also permit and encourage these institutions to build reserves for losses over time. Similarly, the FDIC must be given the mandate to build upon their reserves over time and not be subject to a cap. This will allow the FDIC to reduce deposit insurance premiums in times of economic stress. A successful financial system is one that survives market booms and busts without collapsing. The key to ensuring our system can survive these normal market cycles is to maintain and strengthen the diversity of our industry and our system of supervision. Diversity provides strength, stability, and necessary checks-and-balances to regulatory power. Consolidation of the industry or financial supervision could ultimately produce a financial system of only mega-banks, or the behemoth institutions that are now being propped up and sustained by taxpayer bailouts. An industry of only these types of institutions would not be resilient. Therefore, Congress must ensure this consolidation does not take place by strengthening our current system and preventing supervisory consolidation.Q.7. G20 Summit and International Coordination--Many foreign officials and analysts have said that they believe the upcoming G20 summit will endorse a set of principles agreed to by both the Financial Stability Forum and the Basel Committee, in addition to other government entities. There have also been calls from some countries to heavily re-regulate the financial sector, pool national sovereignty in key economic areas, and create powerful supranational regulatory institutions. (Examples are national bank resolution regimes, bank capital levels, and deposit insurance.) Your agencies are active participants in these international efforts. What do you anticipate will be the result of the G20 summit? Do you see any examples or areas where supranational regulation of financial services would be effective? How far do you see your agencies pushing for or against such supranational initiatives?A.7. This question is obviously targeted to the federal financial agencies. However, while our supervisory structure will continue to evolve, CSBS does not believe international influences or the global marketplace should solely determine the design of regulatory initiatives in the United States. CSBS believes it is because of our unique dual banking system, not in spite of it, that the United States boasts some of the most successful institutions in the world. U.S. banks are required to hold high capital standards compared to their international counterparts. U.S. banks maintain the highest tier 1 leverage capital ratios but still generate the highest average return on equity. The capital levels of U.S. institutions have resulted in high safety and soundness standards. In turn, these standards have attracted capital investments worldwide because investors are confident in the strength of the U.S. system. Viability of the global marketplace and the international competitiveness of our financial institutions are important goals. However, our first priority as regulators must be the competitiveness between and among domestic banks operating within the United States. It is vital that regulatory restructuring does not adversely affect the financial system in the U.S. by putting banks at a competitive disadvantage with larger, more complex institutions. The diversity of financial institutions in the U.S. banking system has greatly contributed to our economic success. CSBS believes our supervisory structure should continue to evolve as necessary and prudent to accommodate our institutions that operate globally as well as domestically. ------ fcic_final_report_full--406 The introduction in October  of the Commercial Paper Funding Facility, un- der which the Federal Reserve loaned money to nonfinancial entities, enabled the commercial paper market to resume functioning at more normal rates and terms. But even with the central bank’s help, nearly  of banks tightened credit standards and lending in the fourth quarter of .  And small businesses particularly felt the squeeze. Because they employ nearly  of the country’s private-sector workforce, “loans to small businesses are especially vital to our economy,” Federal Reserve Board Governor Elizabeth Duke told Congress early in .  Unlike the larger firms, which had come to rely on capital markets for borrowing, these companies had gen- erally obtained their credit from traditional banks, other financial institutions, nonfi- nancial companies, or personal borrowing by owners. The financial crisis disrupted all these sources, making credit more scarce and more expensive. In a survey of small businesses by the National Federation of Independent Business in ,  of respondents called credit “harder to get.” That figure compares with  in  and a previous peak, at around , during the credit crunch of .  Fed Chairman Ben Bernanke said in a July  speech that getting a small busi- ness loan was still “very difficult.” He also noted that banks’ loans to small businesses had dropped from more than  billion in the second quarter of  to less than  billion in the first quarter of .  Another factor—hesitancy to take on more debt in an anemic economy—is cer- tainly behind some of the statistics tracking lending to small businesses. Speaking on behalf of the Independent Community Bankers of America, C. R. Cloutier, president and CEO of Midsouth Bank in Lafayette, Louisiana, told the FCIC, “Community banks are willing to lend. That’s how banks generate a return and survive. However, quality loan demand is down. . . . I can tell you from my own bank’s experience, cus- tomers are scared about the economic climate and are not borrowing. . . . Credit is available, but businesses are not demanding it.”  Still, creditworthy borrowers seeking loans face tighter credit from banks than they did before the crisis, surveys and anecdotal evidence suggest. Historically, banks charged a  percentage point premium over their funding costs on business loans, but that premium had hit  points by year-end  and had continued to rise in , raising the costs of borrowing.  Small businesses’ access to credit also declined when the housing market col- lapsed. During the boom, many business owners had tapped the rising equity in their homes, taking out low-interest home equity loans. Seventeen percent of small em- ployers with a mortgage refinanced it specifically to capitalize their businesses.  As housing prices declined, their ability to use this option was reduced or blocked alto- gether by the lenders. Jerry Jost told the FCIC he borrowed against his home to help his daughter start a bridal dress business in Bakersfield several years ago. When the economy collapsed, Jost lost his once-profitable construction business, and his daughter’s business languished. The Jost family has exhausted its life savings while struggling to find steady work and reliable incomes.  fcic_final_report_full--601 Investigations, Exhibit 91. 17. Fabrice Tourre, email to Marine Serres, January 23, 2007, Senate Permanent Subcommittee on Investigations, Exhibit 62. 18. Lloyd Blankfein, email to Tom Montag, February 11, 2007, Senate Permanent Subcommittee on Investigations, Exhibit 130. 19. FCIC calculations using data from “2004–2007 GS Synthetic CDOs,” produced by Goldman Sachs. 20. Gretchen Morgenson and Louise Story, “Banks Bundled Bad Debt, Bet Against It and Won,” New York Times , December 24, 2009. 21. Lloyd Blankfein, testimony before the FCIC, First Public Hearing of the FCIC, first day, panel 1: Financial Institution Representatives, January 13, 2010, transcript, pp. 26–27. 22. “Goldman Sachs Clarifies Various Media Reports of Aspect of FCIC Hearing,” Goldman Sachs press release, January 14, 2010. 23. Gary Cohn, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial Crisis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, transcript, p. 267. 24. Michael Swenson, opening statement, Hearing on Wall Street and the Financial Crisis: The Role of Investment Banks, Senate Permanent Subcommittee on Investigations, pp. 2–3. 25. Complaint, Basis Yield Alpha Fund v. Goldman Sachs Group, Inc., et al. (S.D.N.Y. June 9, 2010), p. 29. 26. Blankfein, testimony before the FCIC, January 13, 2010, transcript, p. 140. 27. Craig Broderick, written testimony for the FCIC, Hearing on the Role of Derivatives in the Finan- cial Crisis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, p. 1. 28. Craig Broderick, email to Alan Rapfogel and others, May 11, 2007, Senate Permanent Subcommit- tee on Investigations, Exhibit 84. 29. High Grade Risk Analysis, April 27, 2007, p. 4; High Grade—Enhanced Leverage Q&/A, June 13, 2007, stating “the percentage of underlying collateral in our investment grade structures collateralized by “sub-prime” mortgages is approximately 60. On the March 12, 2007, investor call, Matthew Tannin told investors that “most of the CDOs that we purchased are backed in some form by subprime” (Conference Call transcript, pp. 21–22). 30. Email from matt.tannin@gmail.com to matt.tannin@gmail.com, November 23, 2006. 31. Matthew Tannin, Bear Stearns, email to Chavanne Klaus, MEAG New York, March 7, 2007. 32. BSAM Conference Call, April 25, 2007, transcript, p. 5. 33. Matt Tannin, Bear Stearns, email to Klaus Chavanne, MEAG New York, March 7, 2007; Matthew Tannin, email to Steven Van Solkema, March 30, 2007; Complaint, SEC v. Cioffi, No. 08 Civ. 2457 (E.D.N.Y. June 19, 2008), p. 32. 34. Jim Crystal, Bear Stearns, email to Ralph Cioffi (and others), March 22, 2007; Ralph Cioffi, Bear Stearns, email to Ken Mak, Bear Stearns, March 23, 2007. 35. Warren Spector, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, ses- sion 1: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, pp. 83–84. 36. Information provided to FCIC by legal counsel to Bank of America, September 28, 2010. 37. Ibid. 38. Alan Schwartz, interview by FCIC, April 23, 2010. Notably, as one of only two tri-party repo clear- ing banks, JP Morgan had more information about BSAM’s lending obligations than did most other mar- ket participants or regulators. As discussed in greater detail later in this chapter, this superior market knowledge later put JP Morgan in a position to step in and purchase Bear Stearns virtually overnight. 39. Email from Goldman to Bear, April 2, 2007. 40. Steven Van Solkema, Bear Stearns, internal email, Summary of CDO Analysis Using Credit Model, April 19, 2007. 41. Matt Tannin, Bear Stearns, email from Gmail account to Ralph Cioffi, Bear Stearns, at his Hotmail account, April 22, 2007. 42. BSAM Conference Call, April 25, 2007, transcript. 43. Iris Semic, email to Matthew Tannin et al., May 1, 2007. 44. Robert Ervin, email to Ralph Cioffi et al., May 1, 2007; email from Goldman (ficc-ops-cdopricing) to rervin@bear.com, May 1, 2007. 45. BSAM Pricing Committee minutes, June 5, 2007; Robert Ervin, email to Greg Quental et al., May 10, 2007, showing that losses for the High Grade fund would be 7.02% if BSAM used the prices Lehman’s repo desk was using, rather than 11.45%—the loss without Lehman’s marks. 46. Email from “BSAM Hedge Fund Product Management (Generic),” May 16, 2007, produced by CHRG-110hhrg44900--20 Mr. Bernanke," Thank you. Chairman Frank, Ranking Member Bachus, and other members of the committee, I am pleased to be here today to discuss financial regulation and financial stability. The financial turmoil that began last summer has impeded the ability of the financial system to perform its normal functions and has adversely affected the broader economy. This experience indicates a clear need for careful attention to financial regulation and financial stability by the Congress and other policymakers. Regulatory authorities have been actively considering the implications of the turmoil for regulatory policy and for private sector practices. In March, the President's Working Group on Financial Markets issued a report and recommendations for addressing the weaknesses revealed by recent events. At the international level, the Financial Stability Forum has also issued a report and recommendations. Between them, the two reports focused on a number of specific problem areas, including mortgage lending practices and their oversight, risk measurement and management at large financial institutions, the performance of credit rating agencies, accounting and evaluation issues, and issues relating to the clearing and settlement of financial transactions. Many of the recommendations of these reports were directed at regulators in the private sector and are already being implemented. These reports complement the Blueprint for regulatory reform issued by the Treasury in March, which focused on broader questions of regulatory architecture. Work is also ongoing to strengthen the framework for prudential oversight of financial institutions. Notably, recent events have led the Basel Committee on Banking Supervision to consider higher capital charges for such items as certain complex structured credit products, assets and banks trading books, and liquidity guarantees provided to off-balance sheet vehicles. New guidelines for banks liquidity management are also being issued. Regarding implementation, the recent reports have stressed the need for supervisors to insist on strong risk measurement and risk management practices that allow managers to assess the risk that they face on a firm-wide basis. In the remainder of my remarks, I will comment briefly on three issues. The supervisory oversight of primary dealers, including the major investment banks, the need to strengthen the financial infrastructure, and the possible need for new tools for facilitating the orderly liquidation of a systemically important securities firm. Since the near collapse of the Bear Stearns companies in March, the Federal Reserve has been working closely with the Securities and Exchange Commission, which is the functional supervisor of each of the primary dealers and the consolidated supervisor of the four large investment banks, to help ensure that those firms have the financial strength needed to withstand conditions of extreme market stress. To formalize our effective working relationship, the SEC and the Federal Reserve this week agreed to a memorandum of understanding. Cooperation between the Fed and SEC is taking place within the existing statutory framework, with the objective of addressing the near-term situation. In the longer term, however, legislation may be needed to provide a more robust framework for prudential supervision of investment banks and other securities dealers. In particular, under current arrangements, the SEC's oversight of the holding companies of the major investment banks is based on a voluntary agreement between the SEC and those firms. Strong holding company oversight is essential, and thus in my view the Congress should consider requiring consolidated supervision of those firms and providing the regulator the authority to set standards for capital liquidity holdings and risk management. At the same time, reforms in the oversight of these firms must recognize the distinctive features of investment banking and take care neither to unduly inhibit innovation, nor to induce a migration of risk-taking activities to less-regulated or offshore institutions. The potential vulnerability of the financial system to the collapse of Bear Stearns was exacerbated by weaknesses in the infrastructure of financial markets, notably in the markets for over-the-counter derivatives and in short-term funding markets. The Federal Reserve together with other regulators in the private sector is engaged in a broad effort to strengthen the financial infrastructure. For example, since September 2005, the Federal Reserve Bank of New York has been leading a major joint initiative by both the public and private sectors to improve arrangements for clearing and settling credit default swaps and other OTC derivatives. The Federal Reserve and other authorities are also focusing on enhancing the resilience of the markets for triparty repurchase agreements, in which the primary dealers and other large banks and broker-dealers obtain very large amounts of secured financing from money funds and other short-term risk-averse investors. In these efforts we aim not only to make the financial system better able to withstand future shocks, but also to mitigate moral hazard and the problem of too big to fail by reducing the range of circumstances in which systemic stability concerns might prompt a government intervention. More generally, the stability of the broader financial system requires key payment and settlement systems to operate smoothly under stress and to effectively manage counterparty risk. Currently the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor as well as on moral suasion to help ensure that the various payment and settlement systems have the necessary procedures and controls in place to manage the risks that they face. By contrast, many major central banks around the world have an explicit statutory basis for their oversight of payment and settlement systems. Because robust payment and settlement systems are vital for financial stability, the Congress should consider granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems. The financial turmoil is ongoing and our efforts today are concentrated on helping the financial system to return to more normal functioning. It is not too soon, however, to think about steps that might be taken to reduce the incidence and severity of future financial crises. In particular, in light of the Bear Stearns episode, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities. The details of any such tools and the associated decision-making process require more study. One possible model is the process currently in place under the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, for dealing with insolvent commercial banks. The fiducial procedures give the FDIC the authority to act as a receiver for an insolvent bank and to set up a bridge bank to facilitate an orderly liquidation of that firm. The fiducial law also requires that failing banks be resolved in a way that imposes the least cost to the government, except when the authorities through a well-defined procedure determine that following the least cost route would entail significant systemic risk. To be sure, securities firms differ significantly from commercial banks in their financing, business models, and in other ways, so the fiducial rules are not directly applicable to these firms. Although designing a resolution regime appropriate for securities firms would be a complex undertaking, I believe it would be worth the effort. In particular, by setting a high bar for such actions, the adverse effects on market discipline could be minimized. Thank you. I would be pleased to take your questions. [The prepared statement of Chairman Bernanke can be found on page 61 of the appendix.] " CHRG-110hhrg46596--309 Mr. Kashkari," Congressman, let me start by saying we didn't want to own 80 percent of AIG. We didn't want to intervene in AIG. AIG was on the verge of collapse, which jeopardized the financial system as a whole. So we had to take this action. " CHRG-111shrg52619--187 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM SHEILA C. BAIRQ.1.a. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. Chair Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue?A.1.a. It is unclear whether a change in the U.S. regulatory structure would have made a difference in mitigating the outcomes of this crisis. Countries that rely on a single financial regulatory body are experiencing the same financial stress the U.S. is facing now. Therefore, it is not certain that a single powerful federal regulator would have acted aggressively to restrain risk taking during the years leading up to the crisis. For this reason, the reform of the regulatory structure also should include the creation of a systemic risk council (SRC) to address issues that pose risks to the broader financial system. The SRC would be responsible for identifying institutions, practices, and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring that the key supervisors with responsibility for direct supervision apply those standards. The macro-prudential oversight of system-wide risks requires the integration of insights from a number of different regulatory perspectives--banks, securities firms, holding companies, and perhaps others. Only through these differing perspectives can there be a holistic view of developing risks to our system. In the long run it is important to develop a ``fail-safe'' system where the failure of any one large institution will not cause the financial system to break down-that is, a system where firms are not systemically large and are not too-big-to fail. In order to move in this direction, we need to create incentives that limit the size and complexity of institutions whose failure would otherwise pose a systemic risk. Finally, a key element to address systemic risk is the establishment of a legal mechanism for quick and orderly resolution of these institutions similar to what we use for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely or to insure all liabilities, but to permit a timely and orderly resolution and the absorption of assets by the private sector as quickly as possible. Done correctly, the effect of the resolution authority will be to increase market discipline and protect taxpayers.Q.1.b. Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1.b. History shows that banking supervisors are reluctant to impose wholesale restrictions on bank behavior when banks are making substantial profits. Regulatory reactions to safety and soundness risks are often delayed until actual bank losses emerge from the practices at issue. While financial theory suggests that above average profits are a signal that banks have been taking above average risk, bankers often argue otherwise and regulators are all too often reluctant to prohibit profitable activities, especially if the activities are widespread in the banking system and do not have a history of generating losses. Supervision and regulation must become more proactive and supervisors must develop the capacity to intervene before significant losses are realized. In order to encourage proactive supervision, Congress could require semi-annual hearings in which the various regulatory agencies are required to: (1) report on the condition of their supervised institutions; (2) comment on the sustainability of the most profitable business lines of their regulated entities; (3) outline emerging issues that may engender safety and soundness concerns within the next three years; (4) discuss specific weaknesses or gaps in regulatory authorities that are a source of regulatory concern and, when appropriate, propose legislation to attenuate safety and soundness issues. This requirement for semi-annual testimony on the state of regulated financial institutions is similar in concept to the Humphrey-Hawkins testimony requirement on Federal Reserve Board monetary policy.Q.2.a. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms?A.2.a. During good times and bad, regulators must strike a balance between encouraging prudent innovation and strong bank supervision. Without stifling innovation, we need to ensure that banks engage in new activities in a safe-and-sound manner and originate responsible loans using prudent underwriting standards and loan terms that borrowers can reasonably understand and have the capacity to repay. Going forward, the regulatory agencies should be more aggressive in good economic times to contain risk at institutions with high levels of credit concentrations, particularly in novel or untested loan products. Increased examination oversight of institutions exhibiting higher-risk characteristics is needed in an expanding economy, and regulators should have the staff expertise and resources to vigilantly conduct their work.Q.2.b. Is this an issue that can be addressed through regulatory restructure efforts?A.2.b. Reforming the existing regulatory structure will not directly solve the supervision of risk concentration issues going forward, but may play a role in focusing supervisory attention on areas of emerging risk. For example, a more focused regulatory approach that integrates the supervision of traditional banking operations with capital markets business lines supervised by a nonbanking regulatory agency will help to address risk across the entire banking company.Q.3.a. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3.a. Since 2007, the failure of community banking institutions was caused in large part by deterioration in the real estate market which led to credit losses and a rapid decline in capital positions. The causes of such failures are consistent with our receivership experience in past crises, and some level of failures is not totally unexpected with the downturn in the economic cycle. We believe the regulatory environment in the U.S. and the implementation of federal financial stability programs has actually prevented more failures from occurring and will assist weakened banks in ultimately recovering from current conditions. Nevertheless, the bank regulatory agencies should have been more aggressive earlier in this decade in dealing with institutions with outsized real estate loan concentrations and exposures to certain financial products. For the larger institutions that failed, unprecedented changes in market liquidity had a significant negative effect on their ability to fund day-to-day operations as the securitization and inter-bank lending markets froze. The rapidity of these liquidity related failures was without precedent and will require a more robust regulatory focus on large bank liquidity going forward.Q.3.b. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.3.b. Although hedge funds are not regulated by the FDIC, they can comprise large asset pools, are in many cases highly leveraged, and are not subject to registration or reporting requirements. The opacity of these entities can fuel market concern and uncertainty about their activities. In times of stress these entities are subject to heightened redemption requests, requiring them to sell assets into distressed markets and compounding downward pressure on asset values.Q.3.c. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.3.c. As stated above, the bank regulatory agencies should have been more aggressive earlier in this decade in dealing with institutions with outsized real estate loan concentrations and exposures to certain financial products. Although the federal banking agencies identified concentrations of risk and a relaxation of underwriting standards through the supervisory process, we could have been more aggressive in our regulatory response to limiting banks' risk exposures.Q.4.a. From your perspective, how dangerous is the ``too big to fail'' doctrine and how might it be addressed? Is it correct that deposit limits have been in place to avoid monopolies and limit risk concentration for banks?A.4.a. While there is no formal ``too big to fail'' (TBTF) doctrine, some financial institutions have proven to be too large to be resolved within our traditional resolution framework. Many argued that creating very large financial institutions that could take advantage of modem risk management techniques and product and geographic diversification would generate high enough returns to assure the solvency of the firm, even in the face of large losses. The events of the past year have convincingly proven that this assumption was incorrect and is why the FDIC has recommended the establishment of resolution authority to handle the failure of large financial firms. There are three key elements to addressing the problem of systemic risk and too big to fail. First, financial firms that pose systemic risks should be subject to regulatory and economic incentives that require these institutions to hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system. In addition, restrictions on leverage and the imposition of risk-based assessments on institutions and their activities would act as disincentives to the types of growth and complexity that raise systemic concerns. The second important element in addressing too big to fail is an enhanced structure for the supervision of systemically important institutions. This structure should include both the direct supervision of systemically significant financial firms and the oversight of developing risks that may pose risks to the overall U.S. financial system. Centralizing the responsibility for supervising these institutions in a single systemic risk regulator would bring clarity and accountability to the efforts needed to identify and mitigate the buildup of risk at individual institutions. In addition, a systemic risk council could be created to address issues that pose risks to the broader financial system by identifying cross-cutting practices, and products that create potential systemic risks. The third element to address systemic risk is the establishment of a legal mechanism for quick and orderly resolution of these institutions similar to what we use for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely or to insure all liabilities, but to permit a timely and orderly resolution and the absorption of assets by the private sector as quickly as possible. Done correctly, the effect of the resolution authority will be to increase market discipline and protect taxpayers. With regard to statutory limits on deposits, there is a 10 percent nationwide cap on domestic deposits imposed in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. While this regulatory limitation has been somewhat effective in preventing concentration in the U.S. system, the Riegle-Neal constraints have some significant limitations. First, these limits only apply to interstate bank mergers. Also, deposits in savings and loan institutions generally are not counted against legal limits. In addition, the law restricts only domestic deposit concentration and is silent on asset concentration, risk concentration or product concentration. The four largest banking organizations have slightly less than 35 percent of the domestic deposit market, but have over 45 percent of total industry assets. As we have seen, even with these deposit limits, banking organizations have become so large and interconnected that the failure of even one can threaten the financial system.Q.4.b. Might it be the case that for financial institutions that fund themselves less by deposits and more by capital markets activities that they should be subject to concentration limits in certain activities? Would this potentially address the problem of too big to fail?A.4.b. A key element in addressing TBTF would be legislative and regulatory initiatives that are designed to force firms to internalize the costs of government safety-net benefits and other potential costs to society. Firms should face additional capital charges based on both size and complexity, higher deposit insurance related premiums or systemic risk surcharges, and be subject to tighter Prompt Corrective Action (PCA) limits under U.S. laws. In addition, we need to end investors' perception that TBTF continues to exist. This can only be accomplished by convincing the institutions (their management, their shareholders, and their creditors) that they are at risk of loss should the institution become insolvent. Although limiting concentrations of risky activities might lower the risk of insolvency, it would not change the presumption that a government bailout would be forthcoming to protect creditors from losses in a bankruptcy proceeding. An urgent priority in addressing the TBTF problem is the establishment of a special resolution regime for nonbank financial institutions and for financial and bank holding companies--with powers similar to those given to the FDIC for resolving insured depository institutions. The FDIC's authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets as market conditions allow offers a good model for such a regime. A temporary bridge bank allows the government time to prevent a disorderly collapse by preserving systemically critical functions. It also enables losses to be imposed on market players who should appropriately bear the risk.Q.5. It appears that there were major problems with these risk management systems, as I heard in GAO testimony at my subcommittee hearing on March 18, 2009, so what gave the Fed the impression that the models were ready enough to be the primary measure for bank capital?A.5. Throughout the development and implementation of Basel II, large U.S. commercial and investment banks touted their sophisticated systems for measuring and managing risks, and urged regulators to align regulatory capital requirements with banks' own risk measurements. The FDIC consistently expressed concerns that the U.S. and international regulatory communities collectively were putting too much reliance on financial institutions' representations about the quality of their risk measurement and management systems.Q.6. Moreover, how can the regulators know what ``adequately capitalized'' means if regulators rely on models that we now know had material problems?A.6. The FDIC has had long-standing concerns with Basel II's reliance on model-based capital standards. If Basel II had been implemented prior to the recent financial crisis, we believe capital requirements at large institutions would have been far lower going into the crisis and our financial system would have been worse off as a result. Regulators are working internationally to address some weaknesses in the Basel II capital standards and the Basel Committee has announced its intention to develop a supplementary capital requirement to complement the risk based requirements.Q.7. Can you tell us what main changes need to be made in the Basel II framework so that it effectively calculates risk? Should it be used in conjunction with a leverage ratio of some kind?A.7. The Basel II framework provides a far too pro-cyclical capital approach. It is now clear that the risk mitigation benefits of modeling, diversification and risk management were overestimated when Basel II was designed to set minimum regulatory capital requirements for large, complex financial institutions. Capital must be a solid buffer against unexpected losses, while modeling by its very nature tends to reflect expectations of losses looking back over relatively recent experience. The risk-based approach to capital adequacy in the Basel II framework should be supplemented with an international leverage ratio. Regulators should judge the capital adequacy of banks by applying a leverage ratio that takes into account off-balance-sheet assets and conduits as if these risks were on-balance-sheet. Institutions should be required to hold more capital through the cycle and we should require better quality capital. Risk-based capital requirements should not fall so dramatically during economic expansions only to increase rapidly during a downturn. The Basel Committee is working on both of these concepts as well as undertaking a number of initiatives to improve the quality and level of capital. That being said, however, the Committee and the U.S. banking agencies do not intend to increase capital requirements in the midst of the current crisis. The plan is to develop proposals and implement these when the time is right, so that the banking system will have a capital base that is more robust in future times of stress. ------ CHRG-110hhrg46596--313 Mr. Kashkari," It is hard to know for sure. It is conceivable that the financial and banking system would not function. Imagine if you went to your ATM and couldn't get money out of your checking account, or your money just wasn't available, or your 401(k) was worth half as much as it was the day before. It is hard to know. Mr. Clay. Based on AIG failing. " Mr. Kashkari," AIG is a trillion-dollar institution with transactions and counterparties around the United States. We took this action to make sure that a collapse did not happen because the consequences were grave. And now, because we had to step in to stabilize them, we have tried to provide as much protection for the taxpayers as possible. So now the taxpayers own 80 percent of the company. The new management's job is to do an orderly disposition of some of the businesses, to generate cash to pay back the taxpayers so that we are made whole. " CHRG-110hhrg46593--131 Secretary Paulson," Okay. Let me, first of all, take your questions or comments one at a time. First of all, when we came to Congress, we came to Congress saying the financial system was on the verge of collapse, and there was clearly a need to recapitalize the system. The strategy we laid out to do that was a strategy to buy illiquid assets. During the 2 weeks--and I commend Congress, this is not a complaint on my part, giving us the authority as quickly as they did. But during the 2 weeks, the situation changed materially during that 2-week period. And I went through that in my-- " CHRG-111hhrg55814--291 Mr. Manzullo," Ostensibly, but if you read the CFPA Act, it is so broad. I can see a huge fight going on over who is going to do something, and then this bill says the Fed can move unilaterally without talking to the people who have authority on it. The second question, Mr. Sullivan, I do not want you to fall asleep over there, no one has asked you any questions. Your testimony I think is very, very pointed. On page 5, you identify the blame that many in this town refuse to recognize. When you start at--on page 5, line 3, ``The insurance industry in general does not pose a systemic risk to the nation's financial markets to the extent we have seen in the bank and securities sectors. Rather, insurance companies are more often the recipients or conduits of risk. Mortgage and title insurance, for example, do not generate systemic risk. They simply facilitate underlying loan transactions.'' Is not the problem with the financial collapse that we have had in this country due to the fact that these subprime mortgages were allowed to take place with very little underwriting standard supervision? " CHRG-111hhrg52261--101 Mr. MacPhee," Thank you, Chairman Velazquez and Ranking Member Graves. I am pleased to represent the 5,000 members of the Independent Community Bankers of America at this timely and important hearing. Just over one year ago, due to the failure of some of the Nation's largest firms to manage their high-risk activities, key elements of the Nation's financial system nearly collapsed. Community banks and small businesses, the cornerstone of our local economies, have suffered as a result of the financial crisis and the recession sparked by megabanks and unregulated financial players. In my State of Michigan, we face the Nation's highest unemployment rate of 15.2 percent. Yet community banks like mine stick to commonsense lending and serve our customers and communities in good times and bad. The bank has survived the Depression and many recessions in our more than 100-year history, and it proudly serves the community through the financial crisis today--without TARP money, I might add. The financial crisis, as you know, was not caused by well-capitalized, highly regulated commonsense community banks. Community banks are relationship lenders and do the right thing by their customers. Therefore, financial reform must first do no harm to the reputable actors like community banks and job-creating small businesses. For their size, community banks are enormous small business lenders. While community banks represent about 12 percent of all bank assets, they make 31 percent of the small business loans less than $1 million. Notably half of all small business loans under $100,000 are made by community banks. While many megabanks have pulled in their lending and credit, the Nation's community banks are lending leaders. According to an ICBA analysis of the FDIC's second quarter banking data, community banks with less that $1 billion in assets were the only segment of the industry to show growth in net loans and leases. The financial crisis was driven by the anti-free-market logic of allowing a few large firms to concentrate unprecedented levels of our Nation's financial assets, and they became too big to fail. Unfortunately, a year after the credit crisis was sparked, too-big-to-fail institutions have gotten even bigger. Today, just four megafirms control nearly half of the Nation's financial assets. This is a recipe for a future disaster. Too-big-to-fail remains a cancer on our financial system. We must take measures to end too-big-to-fail by establishing a mechanism to declare an institution in default and appoint a conservator or receiver that can unwind the firm in an orderly manner. The only way to truly protect consumers, small businesses, our financial system, and the economy is to enact a solution to end too-big-to-fail. To further protect taxpayers, financial reform should also place a systemic risk premium on large, complex financial firms that have the potential of posing a systemic risk. All FDIC-insured affiliates of large, complex financial firms should pay a systemic risk premium to the FDIC to compensate for the increased risk they pose. ICBA strongly supports the Bank Accountability and Risk Assessment Act of 2009, introduced by Representative Gutierrez. In addition to a systemic risk premium, the legislation would create a system for setting rates for all FDIC-insured institutions that is more sensitive to risk than the current system and would strengthen the deposit insurance fund. ICBA strongly opposes reform that will result in a single Federal bank regulatory agency. A diverse and competitive financial system with regulatory checks and balances will best serve the needs of small business. Community bankers agree that consumer protection is the cornerstone of or financial system. However, ICBA has significant concerns with the proposed Consumer Financial Protection Agency. Such a far-reaching expansion of government can do more harm than good by unduly burdening our Nation's community bankers, who did not engage in the deceptive practices targeted by the proposal. It could jeopardize the availability of credit and choice of products, and shrink business activity. In conclusion, to protect and grow our Nation's small businesses and economy, it is essential to get financial reform right. The best financial reforms will protect small businesses from being crushed by the destabilizing effects when a giant financial institution stumbles. Financial reforms that preserve and strengthen the viability of community banks are key to a diverse and robust credit market for small business. Thank you. " CHRG-110hhrg46593--181 Mr. Bernanke," Certainly, this situation has sometimes been represented as a failure of capitalism. I don't think that is right. The problem is that our financial system, there have been problems of regulation and problems of execution that have created a crisis in the financial system. We have seen, in many cases, historically and in other countries, that a collapse in the financial system can bring down an otherwise very strong economy. So our efforts have been very focused on stabilizing the financial system. And as that situation is rectified, going forward, we need to really think hard about our supervision and regulation and make sure we get it right. But I don't think that this is an indictment of the broad market system. " CHRG-111shrg56376--16 Chairman Dodd," Let me just ask you and the other panelists to comment on this. Clearly, we are looking back in the rearview mirror as to what happened, and that is certainly a motivation here. But it is not the sole motivation. It is not just a question of addressing the problems that occurred, but going forward, in the 21st century, in a very different time, in a global economy today--we saw the implications of what happened not only here in this country but around the world. The idea that we would maintain the same architecture we have for decades is not only a question about what has occurred and whether or not the system responded well enough to it, but looking forward as to whether or not this architecture and structure is going to be sufficient to protect the safety and soundness in a very different economic environment than existed at the time these agencies emerged through the process of growth over the years. It seems to me that is just as important question as looking back. Ms. Bair. I think it is a very important question, and I am very glad you are having these hearings. But I do not think that this is going to solve the problems that led to this crisis. Looking at the performance of other models in European countries that have a single regulator, the performance is not particularly good. I do think there is a profound risk of regulatory capture by very large institutions if you collapse regulatory oversight into one single entity. I think having multiple voices is beautiful. We testified before this Committee on the Advanced Approaches under Basel II. We resisted that, and we slowed it down. And because of that, our banks--commercial banks, FDIC-insured banks--had not transitioned into that new system, which would have significantly lowered the amount of capital they would have had going into this crisis, unlike what happened in Europe and with investment banks. So we think having multiple voices can actually strengthen regulation and guard against regulatory capture. If you have a single monopoly regulator, there is not going to be another regulator out there saying, ``We are going to have a higher standard,'' ``We are going to be stronger,'' or ``We are going to question that.'' I think you lose that with a single regulator. So you should look carefully at the European models and how they functioned during the crisis. " CHRG-109shrg24852--92 Chairman Greenspan," Let me be very explicit. It has to do with the extent of leverage. In commercial banks, for example, I should say capital is several multiples, many multiples higher than what the GSE's are holding. As a consequence, banks do not, in our judgment, raise the level of systemic risk that the GSE's raise. It is a different order of magnitude largely because of, one, the size of the leverage and two, the extent to which the financial markets grant the GSE's effective U.S. Treasury status with respect to their bond issuance, when they do not do for commercial banks. Senator Corzine. Okay, so if it were capital, then risk capital associated with the underlying assets should put them on an equal playing field, I would think. If their regulator chose risk capital measures---- " fcic_final_report_full--67 DEREGULATION REDUX CONTENTS Expansion of banking activities: “Shatterer of Glass-Steagall” ............................  Long-Term Capital Management: “That’s what history had proved to them” ....................................................  Dot-com crash: “Lay on more risk” .....................................................................  The wages of finance: “Well, this one’s doing it, so how can I not do it?” .............  Financial sector growth: “I think we overdid finance versus the real economy” ...................................  EXPANSION OF BANKING ACTIVITIES: “SHATTERER OF GLASS STEAGALL” By the mid-s, the parallel banking system was booming, some of the largest commercial banks appeared increasingly like the large investment banks, and all of them were becoming larger, more complex, and more active in securitization. Some academics and industry analysts argued that advances in data processing, telecom- munications, and information services created economies of scale and scope in fi- nance and thereby justified ever-larger financial institutions. Bigger would be safer, the argument went, and more diversified, innovative, efficient, and better able to serve the needs of an expanding economy. Others contended that the largest banks were not necessarily more efficient but grew because of their commanding market positions and creditors’ perception they were too big to fail. As they grew, the large banks pressed regulators, state legislatures, and Congress to remove almost all re- maining barriers to growth and competition. They had much success. In  Con- gress authorized nationwide banking with the Riegle-Neal Interstate Banking and Branching Efficiency Act. This let bank holding companies acquire banks in every state, and removed most restrictions on opening branches in more than one state. It preempted any state law that restricted the ability of out-of-state banks to compete within the state’s borders.  Removing barriers helped consolidate the banking industry. Between  and ,  “megamergers” occurred involving banks with assets of more than  bil- lion each. Meanwhile the  largest jumped from owning  of the industry’s assets  to . From  to , the combined assets of the five largest U.S. banks—Bank of America, Citigroup, JP Morgan, Wachovia, and Wells Fargo—more than tripled, from . trillion to . trillion.  And investment banks were growing bigger, too. Smith Barney acquired Shearson in  and Salomon Brothers in , while Paine Webber purchased Kidder, Peabody in . Two years later, Morgan Stanley merged with Dean Witter, and Bankers Trust purchased Alex. Brown & Sons. The assets of the five largest investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—quadrupled, from  trillion in  to  tril- lion in .  CHRG-111shrg56376--125 PREPARED STATEMENT OF JOHN E. BOWMAN Acting Director, Office of Thrift Supervision August 4, 2009I. Introduction Good morning, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for the opportunity to testify today on the Administration's Proposal for Financial Regulatory Reform. It is my pleasure to address the Committee for the first time in my role as Acting Director of the Office of Thrift Supervision (OTS). We appreciate this Committee's efforts to improve supervision of financial institutions in the United States. We share the Committee's commitment to reforms to prevent any recurrence of our Nation's current financial problems. We have studied the Administration's Proposal for Financial Regulatory Reform and are pleased to address the questions you have asked us about specific aspects of that Proposal. Specifically, you asked for our opinion of the merits of the Administration's Proposal for a National Bank Supervisor and the elimination of the Federal thrift charter. You also requested our opinion on the elimination of the exceptions in the Bank Holding Company Act for thrifts and certain special purpose banks and about the Federal Reserve System's prudential supervision of holding companies.II. Goals of Regulatory Restructuring The recent turmoil in the financial services industry has exposed major regulatory gaps and other significant weaknesses that must be addressed. Our evaluation of the specifics of the Administration's Proposal is predicated on whether or not those elements address the core principles OTS believes arc essential to accomplishing true and lasting reform: 1. Ensure Changes to Financial Regulatory System Address Real Problems--Proposed changes to financial regulatory agencies should be evaluated based on whether they would address the causes of the economic crisis or other true problems. 2. Establish Uniform Regulation--All entities that offer financial products to consumers must be subject to the same consumer protection rules and regulations, so under-regulated entities cannot gain a competitive advantage over their more regulated counterparts. Also, complex derivative products, such as credit default swaps, should be regulated. 3. Create Ability To Supervise and Resolve Systemically Important Firms--No provider of financial products should be too big to fail, achieving through size and complexity an implicit Federal Government backing to prevent its collapse--and thereby gaining an unfair advantage over its more vulnerable competitors. 4. Protect Consumers--One Federal agency should have as its central mission the regulation of financial products and that agency should establish the rules and standards for all consumer financial products rather than the current, multiple number of agencies with fragmented authority and a lack of singular accountability. As a general matter the OTS supports all of the fundamental objectives that are at the heart of the Administration's Proposal. By performing an analysis based on these principles, we offer OTS' views on specific provisions of the Administration's Proposal.III. Administration Proposal To Establish a National Bank Supervisor We do not support the Administration's Proposal to establish a new agency, the National Bank Supervisor (NBS), by eliminating the Office of the Comptroller of the Currency, which charters and regulates national banks, and the OTS, which charters Federal thrifts and regulates thrifts and their holding companies. There is little dispute that the ad hoc framework of financial services regulation cobbled together over the last century-and-a-half is not ideal. The financial services landscape has changed and the economic crisis has revealed gaps in the system that must be addressed to ensure a sustainable recovery and appropriate oversight in the years ahead. We believe other provisions within the Administration's proposal would assist in accomplishing that goal. While different parts of the system were created to respond to the needs of the time, the current system has generally served the Nation well over time, despite economic downturns such as the current one. We must ensure that in the rush to address what went wrong, we do not try to ``fix'' nonexistent problems nor attempt to fix real problems with flawed solutions. I would like to dispel the two rationales that have been alleged to support the proposal to eliminate the OTS: (1) The OTS was the regulator of the purportedly largest insured depository institutions that failed during the current economic turmoil, and, (2) Financial institutions ``shopping'' for the most lenient regulator allegedly flocked to OTS supervision and the thrift charter. Both of those allegations are false. There are four reasons why the first allegation is untrue: First, failures by insured depository institutions have been no more severe among OTS-regulated thrifts than among institutions supervised by other Federal banking regulators. OTS-regulated Washington Mutual, which failed in September 2008 at no cost to the deposit insurance fund, was the largest bank failure in U.S. history because anything larger has been deemed ``too big to fail.'' By law, the Federal Government can provide ``open-bank assistance'' only to prevent a failure. Institutions much larger than Washington Mutual, for example, Citigroup and Bank of America, had collapsed, but the Federal Government prevented their failure by authorizing open bank assistance. The ``too big to fail'' institutions are not regulated by the OTS. The OTS did not regulate the largest banks that failed; the OTS regulated the largest banks that were allowed to fail. Second, in terms of numbers of bank failures during the crisis, most banks that have failed have been State-chartered institutions, whose primary Federal regulator is not the OTS. Third, the OTS regulates financial institutions that historically make mortgages for Americans to buy homes, By law, thrift institutions must keep most of their assets in home mortgages or other retail lending activities, The economic crisis grew out of a sharp downturn in the residential real estate market, including significant and sustained home price depreciation, a protracted decline in home sales and a plunge in rates of real estate investment. To date, this segment of the market has been hardest hit by the crisis and OTS-regulated institutions were particularly affected because their business models focus on this segment. Fourth, the largest failures among OTS-regulated institutions during this crisis concentrated their mortgage lending in California and Florida, two of the States most damaged by the real estate decline, These States have had significant retraction in the real estate market, including double-digit declines in home prices and record rates of foreclosure, \1\ Although today's hindsight is 20/20, no one predicted during the peak of the boom in 2006 that nationwide home prices would plummet by more than 30 percent.--------------------------------------------------------------------------- \1\ See, Office of Thrift Supervision Quarterly Market Monitor, May 7, 2009, (http://files.ots.treas.gov/131020.pdf).--------------------------------------------------------------------------- The argument about regulator shopping, or arbitrage, seems to stem from the conversion of Countrywide, which left the supervision of the OCC and the Board of Governors of the Federal Reserve System (FRB) in March 2007--after the height of the housing and mortgage boom--and came under OTS regulation, Countrywide made most of its high-risk loans through its holding company affiliates before it received a thrift charter. An often-overlooked fact is that a few months earlier, in October 2006, Citibank converted two thrift charters from OTS supervision to the OCC. Those two Citibank charters totaled more than $232 billion--more than twice the asset size of Countrywide ($93 billion)--We strongly believe that Citibank and Countrywide applied to change their charters based on their respective business models and operating strategies. Any suggestion that either company sought to find a more lenient regulatory structure is without merit. In the last 10 years (1999-2008), there were 45 more institutions that converted away from the thrift charter (164) than converted to the thrift charter (119). Of those that converted to the OTS, more than half were State-chartered thrifts (64). In dollar amounts during the same 10-year period, $223 billion in assets converted to the thrift charter from other charter types and $419 billion in assets converted from the thrift charter to other charter types. We disagree with any suggestion that banks converted to the thrift charter because OTS was a more lenient regulator. Institutions chose the charter type that best fits their business model. If regulatory arbitrage is indeed a major issue, it is an issue between a Federal charter and the charters of the 50 States, as well as among the States. Under the Administration's Proposal, the possibility of such arbitrage would continue. The OTS is also concerned that the NBS may tend, particularly in times of stress, to focus most of its attention on the largest institutions, leaving midsize and small institutions in the back seat. It is critical that all regulatory agencies be structured and operated in a manner that ensures the appropriate supervision and regulation of all depository institutions, regardless of size.IV. Administration Proposal To Eliminate the Thrift Charter The OTS does not support the provision in the Administration's Proposal to eliminate the Federal thrift charter and require all Federal thrift institutions to change their charter to the National Bank Charter or State bank. We believe the business models of Federal banks and thrift institutions are fundamentally different enough to warrant two distinct Federal banking charters. It is important to note that elimination of the thrift charter would not have prevented the current mortgage meltdown, nor would it help solve current problems or prevent future crises. Savings associations generally are smaller institutions that have strong ties to their communities. Many thrifts never made subprime or Alt-A mortgages; rather they adhered to traditional, solid underwriting standards. Most thrifts did not participate in the private originate-to-sell model; they prudently underwrote mortgages intending to hold the loans in their own portfolios until the loans matured. Forcing thrifts to convert from thrifts to banks or State chartered savings associations would not only be costly, disruptive, and punitive for thrifts, but could also deprive creditworthy U.S. consumers of the credit they need to become homeowners and the extension of credit this country needs to stimulate the economy. We also strongly support retaining the mutual form of organization for insured institutions. Generally, mutual institutions are weathering the current financial crisis better than their stock competitors. The distress in the housing markets has had a much greater impact on the earnings of stock thrifts than on mutual thrifts over the past year. For the first quarter 2009, mutual thrills reported a return on average assets (ROA) on 0.42 percent, while stock thrifts reported an ROA of 0.04 percent. We see every reason to preserve the mutual institution charter and no compelling rationale to eliminate it. OTS also supports retention of the dual banking system with both Federal and State charters for banks and thrifts. This system has served the financial markets in the United States well. The States have provided a charter option for banks and thrifts that have not wanted to have a Federal charter. Banks and thrifts should be able to choose whether to operate with a Federal charter or a State charter.V. Administration Proposal To Eliminate the Exceptions in the Bank Holding Company Act for Thrifts and Special Purpose BanksA. Elimination of the Exception in the Bank Holding Company Act for Thrifts Because a thrill is not considered a ``bank'' under the Bank Holding Company Act of 1956 (BHCA), \2\ the FRB does not regulate entities that own or control only savings associations. However, the OTS supervises and regulates such entities pursuant to the Home Owners Loan Act (HOLA).--------------------------------------------------------------------------- \2\ 12 U.S.C. 1841(c)(2)(B) and (j).--------------------------------------------------------------------------- As part of the recommendation to eliminate the Federal thrift charter, the Administration Proposal would also eliminate the savings and loan holding company (SLHC). The Administration's draft legislation repeals section 10 of the HOLA, concerning the regulation of SLHCs and also eliminates the thrift exemption from the definition of ``bank'' under the BHCA. A SLHC would become a bank holding company (BHC) by operation of law and would be required to register with the FRB as a BHC within 90 days of enactment of the act. Notably, these provisions also apply to the unitary SLHCs that were explicitly permitted to continue engaging in commercial activities under the Gramm-Leach-Bliley Act of 1999. \3\ Such an entity would either have to divest itself of the thrift or divest itself of other subsidiaries or affiliates to ensure that its activities are ``financial in nature.'' \4\--------------------------------------------------------------------------- \3\ 12 U.S.C. 1467a(c)(9)(C). \4\ 12 U.S.C. 1843(k).--------------------------------------------------------------------------- The Administration justifies the elimination of SLHCs, by arguing that the separate regulation and supervision of bank and savings and loan holding companies has created ``arbitrage opportunities.'' The Administration contends that the intensity of supervision has been greater for BHCs than SLHCs. Our view on this matter is guided by our key principles, one of which is to ensure that changes to the financial regulatory system address real problems. We oppose this provision because it does not address a real problem. As is the case with the regulation of thrift institutions, OTS does not believe that entities became SLHCs because OTS was perceived to be a more lenient regulator. Instead, these choices were guided by the business model of the entity. The suggestion that the OTS does not impose capital requirements on SLHCs is not correct. Although the capital requirements for SLHCs are not contained in OTS regulations, savings and loan holding company capital adequacy is determined on a case-by-case basis for each holding company based on the overall risk profile of the organization. In its review of a SLHCs capital adequacy, the OTS considers the risk inherent in an enterprise's activities and the ability of capital to absorb unanticipated losses, support the level and composition of the parent company's and subsidiaries' debt, and support business plans and strategies. On average SLHCs hold more capital than BHCs. The OTS conducted an internal study comparing SLHC capital levels to BHC capital levels. In this study. OTS staff developed a Tier 1 leverage proxy and conducted an extensive review of industry capital levels to assess the overall condition of holding companies in the thrift industry. We measured capital by both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio. Based on peer group averages, capital levels (as measured by both the Equity/Assets ratio and a Tier 1 Leverage proxy ratio) at SLHCs were higher than BHCs, prior to the infusion of Troubled Asset Relief Program funds, in every peer group category. The consistency in results between both ratios lends credence to the overall conclusion, despite any differences that might result from use of a proxy formula. As this study shows, the facts do not support the claim that the OTS docs not impose adequate capital requirements on SLHCs. The proposal to eliminate the SLHC exception from the BHCA is based on this and other misperceptions. Moreover, in our view the measure penalizes the SLHCs and thrifts that maintained solid underwriting standards and were not responsible for the current financial crisis. The measure is especially punitive to the unitary SLHCs that will be forced to divest themselves of their thrift or other subsidiaries. We believe SLHCs should be maintained and that the OTS should continue to regulate SLHCs, except in the case of a SLHC that would be deemed to be a Tier 1 Financial Holding Company. These entities should be regulated by the systemic risk regulator.B. Elimination of the Exception in the Bank Holding Company Act for Special Purpose Banks The Administration Proposal would also eliminate the BHCA exceptions for a number of special purpose banks, such as industrial loan companies, credit card banks, [rust companies, and the so-called ``nonbank banks'' grandfathered under the Competitive Equality Banking Act of 1987. Neither the FRB nor OTS regulates the entities that own or control these special purpose banks, unless they also own or control a bank or thrill. As is the case with unitary SLHCs, the Administration Proposal would force these entities to divest themselves of either their special purpose bank or other entities. The Administration's rationale for the provision is to close all the so-called ``loopholes'' under the BHCA and to treat all entities that own or control any type of a bank equally. Once again our opinion on this aspect of the Administration Proposal is guided by the key principle of ensuring that changes to the financial regulatory system address real problems that caused the crisis. There are many causes of the financial crisis, but the inability of the FRB to regulate these entities is not one of them. Accordingly, we do not support this provision. Forcing companies that own special purpose banks to divest one or more of their subsidiaries is unnecessary and punitive. Moreover, it does not address a problem that caused the crisis or weakens the financial system.VI. Prudential Supervision of Holding CompaniesA. In General The Administration's Proposal would provide for the consolidated supervision and regulation of any systemically important financial firm (Tier 1 FHC) regardless of whether the firm owns an insured depository institution. The authority to supervise and regulate Tier 1 FHCs would be vested in the FRB. The FRB would be authorized to designate Tier 1 FHCs if it determines that material financial distress at the company could pose a threat, globally or in the United States, to financial stability or the economy during times of economic stress. \5\ The FRB, in consultation with Treasury, would issue rules to guide the identification Tier 1 FHCs. Tier 1 FHCs would be subjected to stricter and more conservative prudential standards than those that apply to other BHCs, including higher standards on capital, liquidity, and risk management. Tier 1 FHCs would also be subject to Prompt Corrective Action.--------------------------------------------------------------------------- \5\ The FRB would be required to base its determination on the following criteria: (i) the amount and nature of the company's financial assets; (ii) the amount and types of the company's liabilities, including the degree of reliance on short-term funding; (iii) the extent of the company's off-balance sheet exposures; (iv) the extent of the company's transactions and relationships with other major financial companies: (v) the company's importance as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the financial system; (vi) the recommendation, if any, of the Financial Services Oversight Council; and (vii) any other factors that the Board deems appropriate. Title II, Section 204. Administration Draft Legislation. http://www.financialstability.gov/docs/regulatoryreform/07222009/titleII.pdf.--------------------------------------------------------------------------- The Proposal also calls for the creation of a Financial Services Oversight Council (Council) made up of the Secretary of the Treasury and all of the Federal financial regulators. Among other responsibilities, the Council would make recommendations to the FRB concerning institutions that should be designated as Tier 1 FHCs. Also, the FRB would consult the Council in setting material prudential standards for Tier 1 FHCs and in setting risk management standards for systemically important systems and activities regarding payment, clearing and settlement. The Administration's Proposal provides a regime to resolve Tier 1 FHCs when the stability of the financial system is threatened. The resolution authority would supplement and be modeled on the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act. The Secretary of the Treasury could invoke the resolution authority only after consulting with the President and upon the written recommendation of two-thirds of the members of the FRB, and the FDIC or SEC as appropriate. The Secretary would have the ability to appoint a receiver or conservator for the tailing firm. In general, that role would be filled by the FDIC, though the SEC could be appointed in certain cases. In order to fund this resolution regime, the FDIC would be authorized to impose risk-based assessments on Tier 1 FHCs. OTS's views on these aspects of the Administration Proposal is guided by our key principle that any financial reform package should create the ability to supervise and resolve all systemically important financial firms. The U.S. economy operates on the principle of healthy competition. Enterprises that are strong, industrious, well-managed and efficient succeed and prosper. Those that fall short of the mark struggle or fail and other, stronger enterprises take their places. Enterprises that become ``too big to fail'' subvert the system when the Government is forced to prop up failing, systemically important companies in essence, supporting poor performance and creating a ``moral hazard.'' The OTS supports this aspect of the Proposal and agrees that there is a pressing need for a systemic risk regulator with broad authority to monitor and exercise supervision over any company whose actions or failure could pose unacceptable risk to financial stability. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies, including, but not limited to, companies involved in banking, securities, and insurance. We also support the establishment of a strong and effective Council. Each of the financial regulators would provide valuable insight and experience to the systemic risk regulator. We also strongly support the provision providing a resolution regime for all Tier 1 FHCs. Given the events of recent years, it is essential that the Federal Government have the authority and the resources to act as a conservator or receiver and to provide an orderly resolution of systemically important institutions, whether banks, thrifts, bank holding companies or other financial companies. The authority to resolve a distressed Tier 1 FHC in an orderly manner would ensure that no bank or financial firm is ``too big to fail.'' A lesson learned from recent events is that the failure or unwinding of systemically important companies has a far reaching impact on the economy, not just on financial services. The continued ability of banks, thrifts, and other entities in the United States to compete in today's global financial services marketplace is critical. The systemic risk regulator should be charged with coordinating the supervision of conglomerates that have international operations. Safety and soundness standards, including capital adequacy and other factors, should be as comparable as possible for entities that have multinational businesses,B. Role of the Prudential Supervisor in Relation to the Systemic Risk Regulator You have asked for our views on what we consider to be the appropriate role of the prudential supervisor in relation to the systemic risk regulator. In other words, what is the proper delineation of responsibilities between the agencies? Generally, we believe that for systemically important institutions, the systemic risk regulator should supplement, not supplant, the primary Federal bank supervisor. In most cases the work of the systemic regulator and the prudential regulator will complement one another, with the prudential regulator focused on the safety and soundness of the depository institution and the systemic regulator focused more broadly on financial stability globally or in the United States. One provision in the Proposal provides the systemic risk regulator with authority to establish, examine, and enforce more stringent standards for subsidiaries of Tier 1 FHCs--including depository institution subsidiaries--to mitigate systemic risk posed by those subsidiaries. If the systemic risk regulator issues a regulation, it must consult with the prudential regulator. In the case of an order, the systemic regulator must: (1) have reasonable cause to believe that the functionally regulated subsidiary is engaged in conduct, activities, transactions, or arrangements that could pose a threat to financial stability or the economy globally or in the United States; (2) notify the prudential regulator of its belief, in writing, with supporting documentation included and with a recommendation that the prudential regulator take supervisory action against the subsidiary; and (3) not been notified in writing by the prudential regulator of the commencement of a supervisory action, as recommended, within 30 days of the notification by the systemic regulator. We have some concerns with this provision in that it supplants the prudential regulator's authority over depository institution subsidiaries of systemically significant companies. On balance, however, we believe such a provision is necessary to ensure financial stability. We recommend that the provision include a requirement that before making any determination, the systemic regulator consider the effects of any contemplated action on the Deposit Insurance Fund and the United States taxpayers.C. Regulation of Thrifts and Holding Companies on a Consolidated Basis You have asked for OTS's views on whether a holding company regulator should be distinct from the prudential regulator or whether a consolidated prudential bank supervisor could also regulate holding companies. \6\--------------------------------------------------------------------------- \6\ With respect to this question we express our opinion only concerning thrifts and their holding companies. We express no opinion as to banks and BHCs.--------------------------------------------------------------------------- The OTS supervises both thrifts and their holding companies on a consolidated basis. Indeed, SLHC supervision is an integral part of OTS oversight of the thrift industry. OTS conducts holding company examinations concurrently with the examination of the thrift subsidiary, supplemented by offsite monitoring. For the most complex holding companies, OTS utilizes a continuous supervision approach. We believe the regulation of the thrift and holding company has enabled us to effectively assess the risks of the consolidated entity, while retaining a strong focus on protecting the Deposit Insurance Fund. The OTS has a wealth of expertise regulating thrifts and holding companies. We have a keen understanding of small, medium-sized and mutual thrifts and their holding companies. We are concerned that if the FRB became the regulator of these holding companies, it would focus most of its attention on the largest holding companies to the detriment of small and mutual SLHCs. With regard to holding company regulation, OTS believes thrifts that have nonsystemic holding companies should have strong, consistent supervision by a single regulator. Conversely, a SLHC that would be deemed to be a Tier 1 FHC should be regulated by the systemic regulator. This is consistent with our key principle that any financial reform package should create the ability to supervise and resolve all systemically important financial firms.VII. Consumer Protection The Committee did not specifically request input regarding consumer protection issues and the Administration's Proposal to create a Consumer Financial Protection Agency (CFPA); however, we would like to express our views because adequate protection of consumers is one of the key principles that must be addressed by effective reform. Consumer protection performed consistently and judiciously fosters a thriving banking system to meet the financial services needs of the Nation. The OTS supports the creation of a CFPA that would consolidate rulemaking authority over all consumer protection regulations in one regulator. The CFPA should be responsible for promulgating all consumer protection regulations that would apply uniformly to all entities that offer financial products, whether a federally insured depository institution, a State bank, or a State-licensed mortgage broker or mortgage company. Making all entities subject to the same rules and regulations for consumer protection could go a long way towards accomplishing OTS's often stated goal of plugging the gaps in regulatory oversight that led to a shadow banking system that was a significant cause of the current crisis. Although we support the concept of a single agency to write all consumer rules, we strongly believe that consumer protection-related examinations, supervision authority and enforcement powers for insured depository institutions should be retained by the FBAs and the National Credit Union Administration (NCUA). In addition to rulemaking authority, the CFPA should have regulation, examination and enforcement power over entities engaged in consumer lending that are not insured depository institutions. Regardless of whether a new consumer protection agency is created, it is critical that, for all federally insured depository institutions, the primary Federal safety and soundness regulator retain authority for regulation, examination, and enforcement of consumer protection regulations.VIII. Conclusion In conclusion, we support the goals of the Administration and this Committee to create a reformed system of financial regulation that fills regulatory gaps and prevents the type of financial crisis that we have just endured. Thank you again, Mr. Chairman, Ranking Member Shelby, and Members of the Committee for the opportunity to testify on behalf of the OTS. We look forward to working with the Members of this Committee and others to create a system of financial services regulation that promotes greater economic stability for providers of financial services and the Nation. CHRG-111shrg52619--173 PREPARED STATEMENT OF SCOTT M. POLAKOFF Acting Director, Office of Thrift Supervision March 19, 2009Introduction Good morning Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for inviting me to testify on behalf of the Office of Thrift Supervision (OTS) on Modernizing Bank Supervision and Regulation. It has been pointed out many times that our current system of financial supervision is a patchwork with pieces that date to the Civil War. If we were to start from scratch, no one would advocate establishing a system like the one we have cobbled together over the last century and a half. The complexity of our financial markets has in some cases reached mind-boggling proportions. To effectively address the risks in today's financial marketplace, we need a modern, sophisticated system of regulation and supervision that applies evenly across the financial services landscape. The economic crisis gripping this nation and much of the rest of the world reinforces the theme that the time is right for an in-depth, careful review and meaningful, fundamental change. Any restructuring should take into account the lessons learned from this crisis. Of course, the notion of regulatory reform is not new. When financial crisis strikes, it is natural to look for the root causes and logical fixes, asking whether the nation's regulatory framework allowed problems to occur, either because of gaps in oversight, a lack of vigilance, or overlaps in responsibilities that bred a lack of accountability. Since last year, a new round of studies, reports and recommendations have entered the public arena. In one particularly notable study in January 2009--Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U. S. Financial Regulatory System--the Government Accountability Office (GAO) listed four broad goals of financial regulation: Ensure adequate consumer protections, Ensure integrity and fairness of markets, Monitor the safety and soundness of institutions, and Ensure the stability of the overall financial system. The OTS recommendations discussed in this testimony align with those goals. Although a review of the current financial services regulatory framework is a necessary exercise, the OTS recommendations do not represent a realignment of the current regulatory system. Rather, these recommendations represent a fresh start, using a clean slate. They present the OTS vision for the way financial services regulation in this country should be. Although they seek to remedy some of the problems of the past, they do not simply rearrange the current regulatory boxes. What we are proposing is fundamental change that would affect virtually all of the current federal financial regulators. It is also important to note that these are high-level recommendations. Before adoption and implementation, many details would need to be worked out and many questions would need to be answered. To provide all of those details and answer all of those questions would require reams beyond the pages of this testimony. The remaining sections of the OTS testimony begin by describing the problems that led to the current economic crisis. We also cite some of the important lessons learned from the OTS's perspective. The testimony then outlines several principles for a new regulatory framework before describing the heart of the OTS proposal for reform.What Went Wrong? The problems at the root of the financial crisis fall into two groups, nonstructural and structural. The nonstructural problems relate to lessons learned from the current economic crisis that have been, or can be, addressed without changes to the regulatory structure. The structural problems relate to gaps in regulatory coverage for some financial firms, financial workers and financial products.Nonstructural Problems In assessing what went wrong, it is important to note that several key issues relate to such things as concentration risks, extraordinary liquidity pressures, weak risk management practices, the influence of unregulated entities and product markets, and an over-reliance on models that relied on insufficient data and faulty assumptions. All of the regulators, including the OTS, were slow to foresee the effects these risks could have on the institutions we regulate. Where we have the authority, we have taken steps to deal with these issues. For example, federal regulators were slow to appreciate the severity of the problems arising from the increased use of mortgage brokers and other unregulated entities in providing consumer financial services. As the originate-to-distribute model became more prevalent, the resulting increase in competition changed the way all mortgage lenders underwrote loans, and assigned and priced risk. During the then booming economic environment, competition to originate new loans was fierce between insured institutions and less well regulated entities. Once these loans were originated, the majority of them were removed from bank balance sheets and sold into the securitization market. These events seeded many residential mortgage-backed securities with loans that were not underwritten adequately and that would cause significant problems later when home values fell, mortgages became delinquent and the true value of the securities became increasingly suspect. Part of this problem stemmed from a structural issue described in the next section--inadequate and uneven regulation of mortgage companies and brokers--but some banks and thrifts that had to compete with these companies also started making loans that were focused on the rising value of the underlying collateral, rather than the borrower's ability to repay. By the time the federal bank regulators issued the nontraditional mortgage guidance in September 2006, reminding insured depository institutions to consider borrowers' ability to repay when underwriting adjustable-rate loans, numerous loans had been made that could not withstand a severe downturn in real estate values and payment shock from changes in adjustable rates. When the secondary market stopped buying these loans in the fall of 2007, too many banks and thrifts were warehousing loans intended for sale that ultimately could not be sold. Until this time, bank examiners had historically looked at internal controls, underwriting practices and serviced loan portfolio performance as barometers of safety and soundness. In September 2008, the OTS issued guidance to the industry reiterating OTS policy that for all loans originated for sale or held in portfolio, savings associations must use prudent underwriting and documentation standards. The guidance emphasized that the OTS expects loans originated for sale to be underwritten to comply with the institution's approved loan policy, as well as all existing regulations and supervisory guidance governing the documentation and underwriting of residential mortgages. Once loans intended for sale were forced to be kept in the institutions' portfolios, it reinforced the supervisory concern that concentrations and liquidity of assets, whether geographically or by loan type, can pose major risks. One lesson from these events is that regulators should consider promulgating requirements that are counter-cyclical, such as conducting stress tests and lowering loan-to-value ratios during economic upswings. Similarly, in difficult economic times, when house prices are not appreciating, regulators could permit loan-to-value (LTV) ratios to rise. Other examples include increasing capital and allowance for loan and lease losses in times of prosperity, when resources are readily available. Another important nonstructural problem that is recognizable in hindsight and remains a concern today is the magnitude of the liquidity risk facing financial institutions and how that risk is addressed. As the economic crisis hit banks and thrifts, some institutions failed and consumers whose confidence was already shaken were overtaken in some cases by panic about the safety of their savings in insured accounts at banks and thrifts. This lack of consumer confidence resulted in large and sudden deposit drains at some institutions that had serious consequences. The federal government has taken several important steps to address liquidity risk in recent months, including an increase in the insured threshold for bank and thrift deposits. Another lesson learned is that a lack of transparency for consumer products and complex instruments contributed to the crisis. For consumers, the full terms and details of mortgage products need to be understandable. For investors, the underlying details of their investments must be clear, readily available and accurately evaluated. Transparency of disclosures and agreements should be addressed. Some of the blame for the economic crisis has been attributed to the use of ``mark-to-market'' accounting under the argument that this accounting model contributes to a downward spiral in asset prices. The theory is that as financial institutions write down assets to current market values in an illiquid market, those losses reduce regulatory capital. To eliminate their exposure to further write-downs, institutions sell assets into stressed, illiquid markets, triggering a cycle of additional sales at depressed prices. This in turn results in further write-downs by institutions holding similar assets. The OTS believes that refining this type of accounting is better than suspending it. Changes in accounting standards can address the concerns of those who say fair value accounting should continue and those calling for its suspension. These examples illustrate that nonstructural problems, such as weak underwriting, lack of transparency, accounting issues and an over-reliance on performance rather than fundamentals, all contributed to the current crisis.Structural Problems The crisis has also demonstrated that gaps in regulation and supervision that exist in the mortgage market have had a negative impact on the world of traditional and complex financial products. In recent years, the lack of consistent regulation and supervision in the mortgage lending area has become increasingly apparent. Independent mortgage banking companies are state-chartered and regulated. Currently, there are state-by-state variations in the authorities of supervising agencies, in the level of supervision by the states and in the licensing processes that are used. State regulation of mortgage banking companies is inconsistent and varies on a number of factors, including where the authority for chartering and oversight of the companies resides in the state regulatory structure. The supervision of mortgage brokers is even less consistent across the states. In response to calls for more stringent oversight of mortgage lenders and brokers, a number of states have debated and even enacted licensing requirements for mortgage originators. Last summer, a system requiring the licensing of mortgage originators in all states was enacted into federal law. The S.A.F.E. Mortgage Licensing Act in last year's Housing and Economic Recovery Act is a good first step. However, licensing does not go far enough. There continues to be significant variation in the oversight of these individuals and enforcement against the bad actors. As the OTS has advocated for some time, one of the paramount goals of any new framework should be to ensure that similar bank or bank-like products, services and activities are scrutinized in the same way, whether they are offered by a chartered depository institution, or an unregulated financial services provider. The product should receive the same review, oversight and scrutiny regardless of the entity offering the product. Consumers do not understand--nor should they need to understand--distinctions between the types of lenders offering to provide them with a mortgage. They deserve the same service, care and protection from any lender. The ``shadow bank system,'' where bank or bank-like products are offered by nonbanks using different standards, should be subject to as rigorous supervision as banks. Closing this gap would support the goals cited in the GAO report. Another structural problem relates to unregulated financial products and the confluence of market factors that exposed the true risk of credit default swaps (CDS) and other derivative products. CDS are unregulated financial products that lack a prudential derivatives regulator or standard market regulation, and pose serious challenges for risk management. Shortcomings in data and in modeling certain derivative products camouflaged some of those risks. There frequently is heavy reliance on rating agencies and in-house models to assess the risks associated with these extremely complicated and unregulated products. In hindsight, the banking industry, the rating agencies and prudential supervisors, including OTS, relied too heavily on stress parameters that were based on insufficient historical data. This led to an underestimation of the economic shock that hit the financial sector, misjudgment of stress test parameters and an overly optimistic view of model output. We have also learned there is a need for consistency and transparency in over-the-counter (OTC) CDS contracts. The complexity of CDS contracts masked risks and weaknesses. The OTS believes standardization and simplification of these products would provide more transparency to market participants and regulators. We believe many of these OTC contracts should be subject to exchange-traded oversight, with daily margining required. This kind of standardization and exchange-traded oversight can be accomplished when a single regulator is evaluating these products. Congress should consider legislation to bring such OTC derivative products under appropriate regulatory oversight. One final issue on the structural side relates to the problem of regulating institutions that are considered to be too big and interconnected to fail, manage, resolve, or even formally deem as problem institutions when they encounter serious trouble. We will discuss the pressing need for a systemic risk regulator with the authority and resources adequate to the meet this enormous challenge later in this testimony. The array of lessons learned from the crisis will be debated for years. One simple lesson is that all financial products and services should be regulated in the same manner regardless of the issuer. Another lesson is that some institutions have grown so large and become so essential to the economic well-being of the nation that they must be regulated in a new way.Guiding Principles for Modernizing Bank Supervision and Regulation The discussion on how to modernize bank supervision and regulation should begin with basic principles to apply to a bank supervision and consumer protection structure. Safety and soundness and consumer protection are fundamental elements of any regulatory regime. Here are recommendations for four other guiding principles: 1. Dual banking system and federal insurance regulator--The system should contain federal and state charters for banks, as well as the option of federal and state charters for insurance companies. The states have provided a charter option for banks and thrifts that have not wanted to have a national charter. A number of innovations have resulted from the kind of focused product development that can occur on a local level. Banks would be able to choose whether to hold a federal charter or state charter. For large insurance companies, a federal insurance regulator would be available to provide more comprehensive, coordinated and effective oversight than a collection of individual state insurance regulators. 2. Choice of charter, not of regulator--A depository institution should be able to choose between state or federal banking charters, but if it selects a federal charter, its charter type and regulator should be determined by its operating strategy and business model. In other words, there would be an option to choose a business plan and resulting charter, but that decision would then dictate which regulator would supervise the institution. 3. Organizational and ownership options--Financial institutions should be able to choose the organizational and ownership form that best suits their needs. Mutual, public or private stock and subchapter S options should continue to be available. 4. Self-sustaining regulators--Each regulator should be able to sustain itself financially through assessments. Funding the agencies differently could expose bank supervisory decisions to political pressures, or create conflicts of interest within the entity controlling the purse strings. An agency that supervises financial institutions must control its funding to make resources available quickly to respond to supervision and enforcement needs. For example, when the economy declines, the safety-and-soundness ratings of institutions generally drop and enforcement actions rise. These changes require additional resources and often an increase in hiring to handle the larger workload. 5. Consistency--Each federal regulator should have the same enforcement tools and the authority to use those tools in the same manner. Every entity offering financial products should also be subject to the same set of laws and regulations.Federal Bank Regulation The OTS proposes two federal bank regulators, one for banks predominately focused on consumer-and-community banking products, including lending, and the other for banks primarily focused on commercial products and services. The business models of a commercial bank and a consumer-and-community bank are fundamentally different enough to warrant these two distinct federal banking charters. The consumer-and-community bank regulator would supervise depository institutions of all sizes and other companies that are predominately engaged in providing financial products and services to consumers and communities. Establishing such a regulator would address the gaps in regulatory oversight that led to a shadow banking system of unevenly regulated mortgage companies, brokers and consumer lenders that were significant causes of the current crisis. The consumer-and-community bank regulator would also be the primary federal regulator of all state-chartered banks with a consumer-and-community business model. The regulator would work with state regulators to collaborate on examinations of state-chartered banks, perhaps on an alternating cycle for annual state and federal examinations. State-chartered banks would pay a prorated federal assessment to cover the costs of this oversight. In addition to safety and soundness oversight, the consumer-and-community bank regulator would be responsible for developing and implementing all consumer protection requirements and regulations. These regulations and requirements would be applicable to all entities that offer lending products and services to consumers and communities. The same standards would apply for all of these entities, whether a state-licensed mortgage company, a state bank or a federally insured depository institution. Noncompliance would be addressed through uniform enforcement applied to all appropriate entities. The current crisis has highlighted consumer protection as an area where reform is needed. Mortgage brokers and others who interact with consumers should meet eligibility requirements that reinforce the importance of their jobs and the level of trust consumers place in them. Although the recently enacted licensing requirements are a good first step, limitations on who may have a license are also necessary. Historically, federal consumer protection policy has been based on the premise that if consumers are provided with enough information, they will be able to choose products and services that meet their needs. Although timely and effective disclosure remains necessary, disclosure alone may not be sufficient to protect consumers against abuses. This is particularly true as products and services, including mortgages, have become more complex. The second federal bank regulator--the commercial bank regulator--would charter and supervise banks and other entities that primarily provide products and services to corporations and companies. The commercial bank regulator would have the expertise to supervise banks and other entities predominately involved in commercial transactions and offering complex products. This regulator would develop and implement the regulations necessary to supervise these entities. The commercial bank regulator would supervise issuers of derivative products. Nonbank providers of the same products and services would be subject to the same rules and regulations. The commercial bank regulator would not only have the tools necessary to understand and supervise the complex products already mentioned, but would also possess the expertise to evaluate the safety and soundness of loans that are based on suchthings as income streams and occupancy rates, which are typical of loans for projects such as shopping centers and commercial buildings. The commercial bank regulator would also be the primary federal supervisor of state-chartered banks with a commercial business model, coordinating with the states on supervision and imposing federal assessments just as the consumer-and-communityregulator would. Because most depositories today are engaged in some of each of these business lines, the predominant business focus of the institution would govern which regulator would be the primary federal regulator. In determining the federal supervisor, a percentage of assets test could apply. If the operations of the institution or entity changed for a significant period of time, the primary federal regulator would change. More discussion and analysis would be needed to determine where to draw the line between institutions qualifying as commercial banks and institutions qualifying as consumer and community banks.Holding Company Regulation The functional regulator of the largest entity within a diversified financial company would be the holding company regulator. The holding company regulator would have authority to monitor the activities of all affiliates, to exercise enforcement authority and to impose information-sharing arrangements between entities in the holding company structure and their functional regulators. To the extent necessary for the safety and soundness of the depository subsidiary or the holding company, the regulator would have the authority to impose capital requirements, restrict activities, issue source-of support requirements and otherwise regulate the operations of the holding company and the affiliates.Systemic Risk Regulation The establishment of a systemic risk regulator is an essential outcome of any initiative to modernize bank supervision and regulation. OTS endorses the establishment of a systemic risk regulator with broad authority to monitor and exercise supervision over any company whose actions or failure could pose a risk to financial stability. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies, including but not limited to companies involved inbanking, securities and insurance. For systemically important institutions, the systemic risk regulator would supplement, not supplant, the holding company regulator and the primary federal bank supervisor. A systemic regulator would have the authority and resources to supervise institutions and companies during a crisis situation. The regulator should have ready access to funding sources that would provide the capability to resolve problems at these institutions, including providing liquidity when needed. Given the events of the past year, it is essential that such a regulator have the ability to act as a receiver and to provide an orderly resolution to companies. Efficiently resolving a systemically important institution in a measured, well-managed manner is an important element in restructuring the regulatory framework. A lesson learned from recent events is that the failure or unwinding of systemically important companies has a far reaching impact on the economy, not just on financial services. The continued ability of banks and other entities in the United States to compete in today's global financial services marketplace is critical. The systemic risk regulator would be charged with coordinating the supervision of conglomerates that have international operations. Safety and soundness standards, including capital adequacy and other factors, should be as comparable as possible for entities that have multinational businesses. Although the systemic risk regulator would not have supervisory authority over nonsystemically important banks, the systemic regulator would need access to data regarding the health and activities of these institutions for purposes of monitoring trendsand other matters.Conclusion Thank you again, Mr. Chairman, Ranking Member Shelby, and Members of the Committee, for the opportunity to testify on behalf of the OTS on Modernizing Bank Supervision and Regulation. We look forward to continuing to work with the members of this Committee and others to fashion a system of financial services regulation that better serves all Americans and helps to ensure the necessary clarity and stability for this nation's economy. ______ CHRG-111hhrg53245--133 Mr. Watt," Thank you, Mr. Chairman. Ms. Rivlin, I confess I am having a little trouble understanding what you would do. You talk about a ``macro system stabilizer'' and then you talk about a ``systemically important'' or somebody who is over--I thought that what you were proposing was akin to what the Obama Administration has proposed, that the Fed be put in charge of the kinds of things that you indicate a ``macro system stabilizer'' would do, but you seem to have some concerns about that. Can you clarify what it is you are proposing? Ms. Rivlin. Yes. I am proposing the exact opposite of what the Obama Administration is proposing. We both recognize that there are two kinds of tasks here. One is spotting problems in the system that might lead to excessive boom or a crash. " fcic_final_report_full--620 Lucinda Brickler et al., “Re: another option we should present re triparty?” July 13, 2008. 89. John Thain, interview by FCIC, September 17, 2010. 90. Christopher Tsuboi, examiner, bank supervision/operational risk, FRBNY, email to Alejandro La- Torre, assistant vice president, Credit, Investment and Payment Risk Group, FRBNY, “memo re: Lehman’s inter-company default scenario,” September 13, 2008. 91. Scott Alvarez, email to Ben Bernanke et al., “Re: Fw: today at 7:00 p.m. w/Chairman Bernanke, Vice Chairman Kohn and Others,” September 13, 2008. 92. Scott Alvarez, email to Mark VanDerWeide, “Re: tri-party,” September 13, 2008. 93. Bart McDade, interview by FCIC, August 9, 2010. 94. Baxter, interview. 95. Paulson, On the Brink, p. 207. 96. Baxter, interview; Robert Diamond, interview by FCIC, November 15, 2010. 97. Paulson, On the Brink, pp. 212–13. 98. Financial Services Authority of the United Kingdom, “Statement of the Financial Services Author- ity” before the Lehman bankruptcy examiner, p. 9, paragraph 48. 99. Paulson, On the Brink, pp. 209–10. See also Baxter, interview. 100. Baxter, interview. 101. Jim Wilkinson, email to Jes Staley, September 14, 2008, 7:46 A . M . 102. Jim Wilkinson, email to Jes Staley, September 14, 2008, 9:00 A . M . 103. Paulson, On the Brink, p. 210. 104. Alistair Darling, quoted in United Kingdom Press Association, “Darling Vetoed Lehman Bros Takeover,” Belfast Telegraph , October 9, 2010. 105. H. Rodgin Cohen, interview by FCIC, August 5, 2010. 106. Bart McDade, interview by FCIC, August 9, 2010. 107. Alex Kirk, interview by FCIC, August 16, 2010; McDade, interview, August 9, 2010. 108. Baxter, interview. 109. Thomas C. Baxter, letter to FCIC, October 15, 2010, attaching Exhibit 6, James P. Bergin, email to William Dudley et al., “Bankruptcy,” September 14, 2008. See also Kirk, interview. 110. Ibid., attaching Exhibit 5, Lehman Brothers Holdings Inc., “Minutes of the Board of Directors, September 14, 2008,” p. 2. 111. Ibid., attaching Exhibits 2 and 8. 617 112. On September 15, 2008, LBI borrowed $28 billion from PDCF against $31.7 billion of collateral; on September 16, 2008, LBI borrowed $19.7 billion against $23 billion of collateral; and on September 17, 2008, LBI borrowed $20.4 billion against $23.3 billion of collateral. See Valukas, 4:1399 and nn. 5374–75. 113. Kirk, interview. 114. Miller, interview. 115. Kirk, interview. 116. Miller, interview. In his interview, Kirk told FCIC staff that he thought there were more than 1 million derivatives contracts. 117. McDade, interview, August 9, 2010. 118. Baxter, interview. 119. Harvey R. Miller, written testimony for the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 2: Lehman Brothers, September 1, 2010, p. 8. 120. Miller, interview. 121. Ibid. 122. Ibid. 123. Ben S. Bernanke, closed-door session with FCIC, November 17, 2009. 124. Ibid. 125. Henry M. Paulson Jr., written testimony for the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, p. 55. 126. Miller, written testimony for the FCIC, September 1, 2010, p. 14. 127. Ibid., p. 18. 128. Ibid., pp. 6, 12–13, 15, 11, 15. 129. Bernanke, testimony before the FCIC, September 2, 2010, transcript, p. 23. 130. Ben Bernanke, email to Kevin Warsh, member, Board of Governors of the Federal Reserve Sys- tem, September 14, 2008. 131. Bernanke, testimony before the FCIC, September 2, 2010, p. 22. 132. Ibid., p. 24. 133. Ben Bernanke, “U.S. Financial Markets,” testimony before the Senate Committee on Banking, CHRG-111shrg53822--88 PREPARED STATEMENT OF PETER J. WALLISON * Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute May 6, 2009 Chairman Dodd, Ranking member Shelby and members of the Committee:--------------------------------------------------------------------------- * The views expressed in this testimony are those of the author alone and do not necessarily represent those of the American Enterprise Institute.--------------------------------------------------------------------------- I am very pleased to have this opportunity to appear before this Committee to discuss one of the most important issues currently facing our country. The financial crisis will eventually end. The legislation that Congress adopts to prevent a similar event in the future is likely to be with us for 50 years. The terms ``too big to fail'' and ``systemically important'' are virtually interchangeable. The reason that we might consider some financial institutions ``too big to fail'' (TBTF) is that their failure could produce substantial losses or other ill effects elsewhere in the economy--a systemic breakdown of some kind. Thus, if a firm is systemically important, it is also likely to be TBTF. Understanding the virtual identity between these two terms is essential, because we should not be concerned about business failures unless they can have knock-on effects that could involve the whole economy or the whole financial system. There is real danger that policymakers will confuse efforts to prevent simple business failures with efforts to prevent systemic breakdowns. It is to the credit of the Obama administration that they have not claimed that the bankruptcy of General Motors would cause a systemic breakdown, even though GM's failure could cause widespread losses throughout the economy. In this testimony, I will discuss the GM case frequently, as a way of testing whether we have adequate concepts for determining whether a financial firm is TBTF. If GM is not TBTF it raises questions whether any nonbank financial firm--no matter how large--is likely to be TBTF. The discussion that follows will specifically address the four issues that Chairman Dodd outlined in his letter of invitation: Whether a new regulatory framework is desirable or feasible to prevent institutions from becoming ``too big to fail'' and posing the risk of systemic harm to the economy and financial system; Whether existing financial organizations considered ``too big to fail'' should be broken up; What requirements under a new regulatory framework are necessary to prevent or mitigate risks associated with institutions considered ``too big to fail;'' for example, new capital and disclosure requirements, as well as restrictions on size, affiliations, transactions, and leverage; and How to improve the current framework for resolving systemically important non-bank financial companies.Is it desirable or feasible to develop a regulatory framework that will prevent firms from becoming TBTF or posing a risk of systemic harm? A regulatory framework that will prevent companies from becoming TBTF--or causing systemic breakdowns if they fail--is only desirable or feasible if Congress can clearly define what it means by systemic harm or TBTF. If Congress cannot describe in operational terms where to draw the line between ordinary companies and companies that are TBTF--or if it cannot define what it means by ``systemic harm''--it would not be good policy to give the power to do so to a regulatory agency. The standard, ``I know it when I see it'' may work when a systemic event is imminent, but not for empowering a regulatory agency to designate TBTF or systemically important firms in advance. If Congress does so, the likelihood of severe and adverse unintended consequences is quite high. First, if a firm is designated in advance as TBTF (that is, as systemically important), it will have competitive advantages over other firms in the same industry and other firms with which it competes outside its industry. This is true because the TBTF designation confers important benefits. The most significant of these is probably a lower cost of funding, arising from the market's recognition that the risk of loss is significantly smaller in firms that the government will not allow to fail than it is in firms that might become bankrupt. Lower funding costs will translate inevitably--as it did in the case of Fannie Mae and Freddie Mac--into market dominance and consolidation. Market sectors in which TBTF firms are designated will come to be dominated and controlled by the large TBTF firms, and smaller firms will gradually be squeezed out. Ironically, this will also result in consolidation of risk in fewer and fewer entities, so that the likelihood of big firm collapses becomes greater and each collapse more disruptive. In some markets, status as TBTF has another advantage--the appearance of greater stability than competitors. In selling insurance, for example, firms that are designated as systemically important will be able to tell potential customers that they are more likely to survive and meet their obligations than firms that have not been so designated. Accordingly, if there is to be a system of designating certain firms as systemically important, it is necessary to be able to state with some clarity what standards the agency must use to make that decision. Leaving the agency with discretion, without definitive standards, would be courting substantial unintended consequences. The natural tendency of a regulator would be to confer that designation broadly. Not only does this increase the regulator's size and power, but it also minimizes the likelihood--embarrassing for the regulator--that a systemic event will be caused by a firm outside the designated circle. Accordingly, the ability of Congress to define what it means by a TBTF firm would be important to maintain some degree of competitive vigor in markets that would otherwise be threatened by the designation of one or more large firms as systemically important and thus TBTF. Second, apart from competitive considerations, it is necessary to consider the possibility that ordinary business failures might be prevented even though they would not have caused a systemic breakdown if they occurred. Again, the tendency of regulators in close cases will be to exercise whatever power they have to seize and bail out failing firms that might be TBTF. The incentives all fall in this direction. If a systemic breakdown does occur, the regulator will be blamed for failing to recognize the possibility, while if a firm is bailed out that would not in fact have caused a systemic breakdown, hardly anyone except those who are forced to finance it (a matter to be discussed later) will complain. This makes bailouts like AIG much more likely unless Congress provides clear guidelines on how a regulator is to identify a TBTF or systemically important firm. The stakes for our competitive system are quite high in this case, because bailouts are not only costly, but they have a serious adverse effect on the quality of companies and managements that continue to exist. If firms are prevented from failing when they are not TBTF or otherwise systemically important, all other firms are weakened. This is because our competitive market system improves--and consumers are better served--through the ``creative destruction'' that occurs when bad managements and bad business models are allowed to fail. When that happens, the way is opened for better managements and business models to take their place. If failures are prevented when they should not be, the growth of the smaller but better managed and more innovative firms will be hindered. Overall, the quality and the efficiency of the firms in any market where this occurs will decline. Finally, setting up a mechanism in which companies that should be allowed to fail are rescued from failure will introduce significant moral hazard into our financial system. This is true even if the shareholders of a rescued firm are wiped out in the process. Shareholders are not the group whose views we should be worried about when we consider moral hazard. Shareholders, like managements, benefit from risk-taking, which often produces high profits as well as high rates of failure. The class of investors we should be thinking about are creditors, who get no benefits whatever from risk-taking. They are the one who are in the best position to exercise market discipline, and they do so by demanding higher rates of interest when they see greater risk-taking in a potential borrower. To the extent that the wariness of creditors is diminished by the sense that a company may be rescued by the government, there will be less market discipline by creditors and increased moral hazard. The more companies that are added to the list of firms that might be rescued, the greater the amount of moral hazard that has been introduced to the market. The administration's plan clearly provides for possible rescue, since it contemplates either a receivership (liquidation) or a conservatorship (generally a way to return a company to health and normal operations). Accordingly, although it is exceedingly important for Congress to be clear about when a company may be designated as TBTF, it will be very difficult to do so. This is illustrated by the GM case. GM is one of the largest companies in the U.S.; its liquidation, if it occurs, could cause a massive loss of jobs not only at GM itself but at all the suppliers of tires, steel, fabrics, paints, and glass that go into making a car, all the dealers that sell the cars, all the banks that finance the dealers, and all the communities, localities, and states throughout the U.S. that depend for their revenues on the taxes paid by these firms and their employees. In other words, there would be very serious knock-on effects from a GM failure. Yet, very few people are suggesting that GM is TBTF in the same way that large financial institutions are said to be TBTF. What is the difference? This question focuses necessary attention on two questions: what it means to be TBTF and the adequacy of the bankruptcy system to resolve large firm failures. If GM is not TBTF, why not? The widespread losses throughout the economy would certainly suggest a systemic effect, but if that is not what we mean by a systemic effect, what is it that we are attempting to prevent? On the other hand, if that is what we mean by a systemic effect, should the government then have the power to resolve all large companies--and not just financial firms--outside the bankruptcy system? The fact that GM may ultimately go into bankruptcy and be reorganized under Chapter 11 suggests that the bankruptcy system is adequate for large financial nonbank institutions, unless the propensity of nonbank financial institutions to create systemic breakdowns can be distinguished from that of operating companies like GM. Later in this testimony, I will argue that this distinction cannot be sustained. The forgoing discussion highlights the difficulty of defining both a systemic event and a systemically important or TBTF firm, and also the importance of defining both with clarity. Great harm could come about if Congress--without establishing any standards--simply authorizes a regulatory agency to designate TBTF companies, and authorizes the same or another agency to rescue the companies that are so designated. My answer, then, to the Committee's first question is that--given the great uncertainty about (i) what is a systemic event, (ii) how to identify a firm that is TBTF, and (iii) what unintended consequences would occur if Congress were not clear about these points--it would be neither desirable nor feasible to set up a structure that attempts to prevent systemic harm to the economy by designating systemically important firms and providing for their resolution by a government agency rather than through the normal bankruptcy process. Nevertheless, it would not be problematic to create a body within the executive branch that generally oversees developments in the market and has the responsibility of identifying systemic risk, wherever it might appear to be developing within the financial sector. The appropriate body to do this would be the President's Working Group (PWG), which consists of most of the major Federal financial supervisors and thus has a built-in market-wide perspective. The PWG currently functions under an executive order, but Congress could give it a formal charter as a government agency with responsibility for spotting systemic risk as well as coordinating all financial regulatory activity in the executive branch.Breaking up systemically significant or TBTF firms There could be constitutional objections to a breakup--based on the takings and due process--unless there are clear standards that justify it. I am not a constitutional lawyer, but a fear that a company might create a systemic breakdown if it fails does not seem adequate to take the going concern value of a large company away from its shareholders. As we know from antitrust law, firms can be broken up if they attempt to monopolize and under certain other limited circumstances. But in those cases, there are standards for market dominance and for the requisite intent to use it in order to create a monopoly--and both are subject to rigorous evidentiary standards. As I pointed out above, there are no examples that define a systemic risk or why one company might cause it and another might not. Accordingly, providing authority for a government agency to break up companies that are deemed to be systemically risky could be subject to constitutional challenge. In addition, as a matter of policy, breaking up large institutions would seem to create many more problems than it would solve. First, there is the question of breaking up successful companies. If companies have grown large because they are successful competitors, it would be perverse to penalize them for that, especially when we aren't very sure whether they would in fact cause a systemic breakdown if they failed. In addition, our economy is made up of large as well as small companies. Large companies generally need large financial institutions to meet their financing needs. This is true whether we are talking about banks, securities firms, insurance companies, finance companies, or others. Imagine a large oil company trying to insure itself against property or casualty losses with a batch of little insurance companies. The rates it would have to pay would be much higher, if it could get full coverage at all. Or imagine the same oil company trying to pay its employees worldwide without a large U.S. bank with worldwide operations, or the same company trying to place hundreds of millions of dollars in commercial paper each week through small securities firms without a global reach. There are also international competitive factors. If other countries did not break up their large financial institutions, our large operating companies would probably move their business to the large foreign financial institutions that could meet their needs. Leaving our large operating companies without an alternative source of funding could also be problematic, in the event that a portion of the financial markets becomes unavailable--either in general or for a specific large firm. The market for asset-backed securities closed down in the summer of 2007 and hasn't yet reopened. Firms that used to fund themselves through this market were then compelled to borrow from banks or to use commercial paper or other debt securities. This is one of the reasons that the banks have been reluctant to lend to new customers; they have been saving their cash for the inevitable withdrawals by customers that had been paying over many years for lines of credit that they could use when they needed emergency funds. The larger firms might not have been able to find sufficient financial resources if the largest banks or other financial institutions had been broken up. The breakup of large financial firms would create very great risks for our economy, with few very benefits, especially when we really have no idea whether any particular firm that might be broken up actually posed a systemic risk or would have created a systemic breakdown if it had failed.Are there regulatory actions we can take to mitigate or prevent systemic risk caused by TBTF companies? For the reasons outlined below, it is my view that only the failure of a large commercial bank can create a systemic breakdown, and that nonbank financial firms--even large ones--are no more likely than GM to have this effect. For that reason, I would not designate any nonbank financial institution (other than a commercial bank) as systemically important, nor recommend safety and soundness supervision of any financial institutions other than those where market discipline has been impaired because they are backed by the government, explicitly or implicitly. The track record of banking regulation is not good. In the last 20 years we have had two very serious banking crises, including the current one, when many banks failed and adversely affected the real economy. The amazing thing is that--despite this record of failure--the first instinct of many people in Washington it is to recommend that safety and soundness regulation be extended to virtually the entire financial system through the regulation and supervision of systemically important (or TBTF) firms. After the S&L debacle and the failure of almost 1600 commercial banks at the end of the 1980s and the beginning of the 1990s, Congress adopted the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), a tough regulatory statute that many claimed would put an end to banking crises. Yet today we are in the midst of a banking crisis that some say could be as bad as that of the Great Depression, perhaps even worse. If banks were not backed by the government--through deposit insurance, a lender of last resort, and exclusive access to the payment system--their risk-taking would probably be better controlled by market discipline exerted by creditors. But given the government support they receive, and its effect in impairing market discipline, regulation and supervision of their safety and soundness is the only sensible policy. Nevertheless, there are some reasonable steps that could be taken to improve bank regulation and to mitigate the possibility that the failure of a large bank might in the future have a significant adverse effect on other economic actors. For the reasons outlined above, I don't think that restrictions on size are workable, and they are likely to be counterproductive. The same thing is true of restrictions on affiliations and transactions, both of which will impose costs, impair innovation, and reduce competition. Since we have no idea whether any particular firm will cause a systemic breakdown if it fails, it does not seem reasonable to impose all these burdens on our financial system for very little demonstrable benefit. Restrictions on leverage can be effective, but I see them as an element of capital regulation, as discussed below. A good example of the unintended consequences of imposing restriction on affiliations is what has happened because of the restrictions on affiliations between banks and commercial firms. As the Committee knows, the Bank Holding Company Act provides that a bank cannot be affiliated with any activity that is not ``financial in nature.'' For many years the banking industry has used this to protect themselves against competition by organizations outside banking, most recently competition from Wal-Mart. They and others have argued that the separation of banking and commerce (actually, after the Gramm-Leach-Bliley Act was adopted in 1999, the principle became the separation of finance and commerce) was necessary to prevent the extension of the so-called Federal ``safety net'' to commercial firms. That idea has now backfired on the banks, because by keeping commercial firms out of the business of investing in banks, they have made it very difficult for banks to raise the capital they need in the current financial crisis. We should not impose restrictions on affiliations unless there is strong evidence that a particular activity is harmful. All such restrictions turn out to be restrictions on competition and ultimately hurt consumers, who must pay higher prices and get poorer services. Because Wal-Mart was unable to compete with banks, many Wal-Mart customers pay more for banking services than they should, and many of them can't get banking services at all. Nevertheless, capital requirements can be used effectively to limit bank risk-taking and growth, and this would be far preferable to other kinds of restrictions. It would make sense to raise bank capital requirements substantially. The only reason banks are able to keep such low capital ratios is that they have government backing. In addition, capital requirements should be raised as banks grow larger, which is in part the result of higher asset values that accompany a growing market. An increase of capital requirements with size would also have the salutary effect of dampening growth by making it more expensive, and it would provide a strong countercyclical brake on the development of asset bubbles. Higher capital requirements as banks grow larger would also induce them to think through whether all growth is healthy, and what lines of business are most suitable and profitable. In addition, as bank profits grow, capital requirements or reserves should also be increased in order to prepare banks for the inevitable time when growth will stop and the decline sets in. Before the current crisis, 10 percent risk-based capital was considered well-capitalized, but it is reasonably apparent now that this level was not high enough to withstand a serious downturn. In addition, regulation should be used more effectively to enhance market discipline. Bank regulators are culturally reluctant to release information on the banks they supervise. This too often leaves market participants guessing about the risks the banks are taking--and wrongly assuming that the regulators are able to control these risks. To better inform the markets, the regulators, working with bank analysts, should develop a series of metrics or indicators of risk-taking that the banks should be required to publish regularly--say, once every month. This would enable the markets to make more informed judgments about bank risk-taking and enhance the effectiveness of market discipline. Rather than fighting market discipline, bank regulators should harness it in this way to supplement their own examination work. Finally for larger commercial banks, especially the ones that might create systemic risk if they failed, it would be a good idea to require the issuance of a form of tradable subordinated debt that could not by law be bailed out. The holders of this debt would have a strong interest in better disclosure by banks and could develop their own indicators of risk-taking. As the market perceived that a bank was taking greater risk, the price of these securities would fall and its yield would rise. The spread of that yield over Treasuries would provide a continuing strong signal to a bank's supervisor that the market foresees trouble ahead if the risk-taking continues. Using this data, the supervisor could clamp down on activities that might result in major losses and instability at a later time.Can we improve the current framework for resolving systemically important nonbank financial firms? The current framework for resolving all nonbank financial institutions is the bankruptcy system. Based on the available evidence, there is no reason to think that it is inadequate for performing this task or that these institutions need a government-administered resolution system. Because of the special functions of banks, a special system for resolving failed banks is necessary, but as discussed below banks are very different from other financial institutions. The creation of a government-run system will increase the likelihood of bailouts of financial institutions and prove exceedingly costly to the financial industry or to the taxpayers, who are likely to end up paying the costs. The underlying reason for the administration's proposal for a special system of resolution for nonbank financial institutions is the notion that the failure of a large financial firm can create a systemic breakdown. Thus, although many people look at the administration's resolution plan as a means to liquidate systemically important or TBTF firms in an orderly way, it is more likely to be a mechanism for bailing out these firms so that they will not cause a systemic breakdown. The Fed's bailout of AIG is the paradigm for this kind of bailout, which sought to prevent market disruption by using taxpayer funds to prevent losses to counterparties and creditors. As support for its proposal, the administration cites the ``disorderly'' bailout of AIG and the market's panicked reaction to the failure of Lehman Brothers. On examination, these examples turn out to be misplaced. Academic studies after both events show that the market's reaction to both was far more muted than the administration suggests. Moreover, the absence of any recognizable systemic fallout from the Lehman bankruptcy--with the exception of a single money market mutual fund, no other firm has reported or shown any serious adverse effects--provides strong evidence that in normal market conditions the reaction to Lehman's failure would not have been any different from the reaction to the failure of any large company. These facts do not support the notion that a special resolution mechanism is necessary for any financial institutions other than banks. The special character of banks. Although the phrase ``shadow banking'' is thrown around to imply a strong similarity between commercial banks and other financial institutions such as securities firms, hedge funds, finance companies or insurers, the similarity is illusory in most important respects. Anyone can lend; only banks can take deposits. Deposit-taking--not lending--is the essence of banking. By offering deposits that can be withdrawn on demand or used to pay others through an instruction such as a check, banks and other depository institutions have a special and highly sensitive role in our economy. If a bank should fail, its depositors are immediately deprived of the ready funds they expected to have available for such things as meeting payroll obligations, buying food, or paying rent. Banks also have deposits with one another, and small banks often have substantial deposits in larger banks in order to facilitate their participation in the payment system. Because of fear that a bank will not be able to pay in full on demand, banks are also at risk of ``runs''--panicky withdrawals of funds by depositors. Runs can be frightening experiences for the public and disruptive for the financial system. The unique attribute of banks--that their liabilities (deposits) may be withdrawn on demand-is the reason that banks are capable of creating a systemic event if they fail. If bank customers cannot have immediate access to their funds, or if a bank cannot make its scheduled payments to other banks, the others can also be in trouble, as can their customers. That is the basis for a true systemic event. The failure of a bank can leave its customers and other banks without the immediate funds they are expecting to use in their daily affairs. The failure of a large bank can cause other failures to cascade through the economy, theoretically creating a systemic event. I say ``theoretically'' because the failure of a large bank has never in modern times caused a systemic event. In every case where a large bank might have failed and caused a systemic breakdown, it has been rescued by the FDIC. The most recent such case--before the current crisis--was the rescue of Continental Illinois Bank in 1984. The foregoing description of how a large bank's failure can cause a systemic breakdown raises a number of questions about whether and how a systemic breakdown can be caused by the failure of a nonbank financial institution. These financial institutions--securities firms, hedge funds, insurance companies, finance companies, and others--tend to borrow for a specific term or to borrow on a collateralized basis. In this respect, they are just like GM. In common with all other large commercial borrowers, nonbank financial institutions also fund themselves with short-term commercial paper. Unless they are extremely good credits, this paper is collateralized. If they should fail, their creditors can recoup their losses by selling the collateral. Their failures, then, do not cause any immediate cash losses to their lenders or counterparties. Losses occur, to be sure, but in the same way that losses will occur if GM should file for bankruptcy--those who suffer them do not lose the immediate access to cash that they were expecting to use for their current obligations, and thus there is rarely any contagion in which the losses of one institution are passed on to others in the kind of cascade that can occur when a bank fails. It is for this reason that describing the operations of these nondepository institutions as ``shadow banking'' is so misleading. It ignores entirely the essence of banking--which is not simply lending--and how it differs from other kinds of financial activity. Because of the unique effects that are produced by bank failures, the Fed and the FDIC have devised systems for reducing the chances that banks will not have the cash to meet their obligations. The Fed lends to healthy banks (or banks it considers healthy) through what is called the discount window--making cash available for withdrawals by worried customers--and the FDIC will normally close insolvent banks just before the weekend and open them as healthy, functioning new institutions on the following Monday. In both cases, the fears of depositors are allayed and runs seldom occur. The policy question facing Congress is whether it makes sense to extend FDIC bank resolution processes to other financial institutions. For the reasons outlined above, there is virtually no reason to do so for financial institutions other than banks. Before proceeding further, it is necessary to correct some misunderstandings about the effectiveness of the FDIC, which has been presented by the administration and others as a paragon in the matter of resolving banks. The facts suggest a different picture, and should cause policymakers to pause before authorizing the FDIC or any other agency to take over the resolution of nonbank financial institutions. The FDIC and the other bank regulators function under a FDICIA requirement for prompt corrective action (PCA) when a bank begins to weaken. The objective of PCA is to give the FDIC and other supervisors the authority to close a bank before it actually becomes insolvent, thus saving both the creditors and the FDIC insurance fund from losses. It has not worked out that way. Thus far in 2009, there have been 32 reported bank failures for which the FDIC has reported its losses. In these cases, the losses on assets have ranged from 8 percent to 45 percent, with both an average and a weighted average of 28 percent. In 2008, there were 25 bank failures, with losses averaging 25 percent. There may be reasons for these extraordinary losses, including the difficulty of dealing with the primary Federal or state regulator, but the consistency of the losses in the face of the PCA requirement casts some doubt on the notion that even the best Federal resolution agency--dealing with failing insurance companies, securities firms, hedge funds and others--would be able to do a more efficient job than a bankruptcy court. While the failures of the FDIC as a resolution agency are not well known, the weakness of the bankruptcy system as a way of resolving failing financial institutions has been exaggerated. The evidence suggests that the Lehman's bankruptcy filing--as hurried as it was--has resulted in a more orderly resolution of the firm than AIG's rescue by the Fed. As reported by professors Kenneth Ayotte and David Skeel, things moved with dispatch after Lehman filed for bankruptcy under Chapter 11 of the code. Thus, as Ayotte and Skeel note: Lehman filed for Chapter 11 on September 15, 2008. Three days later, Lehman arranged a sale of its North American investment banking business to Barclays, and the sale was quickly approved by the court after a lengthy hearing . . . Its operations in Europe, the Middle East, and Asia were bought by Nomura, a large Japanese brokerage firm. By September 29, Lehman had agreed to sell its investment management business to two private equity firms.\1\--------------------------------------------------------------------------- \1\ Kenneth Ayotte and David A. Skeel, Jr., ``Bankruptcy or Bailouts?'' (March 2, 2009). U of Penn, Inst for Law & Econ Research Paper No. 09-11; Northwestern Law & Econ Research Paper No. 09-05, pp 9-10. Available at SSRN: http://ssrn.com/abstract=1362639.Chapter 11 allows bankrupt debtors to remain in possession of their assets and continue operating while their creditors reach agreement on how best to divide up the firm's assets. It also permits firms to return to financial health if their creditors conclude that this is more likely to result in a greater recovery than a liquidation. In other words, Chapter 11 provides a kind of bailout mechanism, but one that is under the control of the creditors-the parties that have suffered the real losses. Neither the taxpayers nor any other unrelated party is required to put in any funds to work out the failed company. There are many benefits of a bankruptcy that are not likely to come with a system of resolution by a government agency. These include certainty about the rights of the various classes of creditors; a well-understood and time-tested set of procedures; the immediate applicability of well-known stay provisions that prevent the disorderly seizure of collateral; equally well-known exemptions from stay provisions so that certain creditors holding short-term obligations of the failed company can immediately sell their collateral; and well worked out rules concerning when and under what circumstances preferential payments to certain creditors by the bankrupt firm have to be returned to the bankrupt estate. Still, the examples of Lehman Brothers and AIG have had a significant impact on the public mind and a hold on the attitudes of policymakers. It is important to understand these cases, and the limited support they provide for setting up a system for resolving large nonbank financial institutions. The market reactions after the failures of AIG and Lehman are not examples of systemic risk. Secretary Geithner has defended his proposal for a resolution authority by arguing that, if it had been in place, the rescue of AIG last fall would have been more ``orderly'' and the failure of Lehman Brothers would not have occurred. Both statements might be true, but would that have been the correct policy outcome? Recall that the underlying reason for the administration's plan to designate and specially regulate systemically important firms is that the failure of any such company would cause a systemic event--a breakdown in the financial system and perhaps the economy as a whole. If this is the test, it is now reasonably clear that neither AIG nor Lehman is an example of a large firm creating systemic risk or a systemic breakdown. In a widely cited paper and a recent book, John Taylor of Stanford University concluded that the market meltdown and the freeze in interbank lending that followed the Lehman and AIG events in mid-September 2008 did not begin until the Treasury and Fed proposed the initial Troubled Asset Relief Program later in the same week, an action that implied that financial conditions were much worse than the markets had thought.\2\ Taylor's view, then, is that AIG and Lehman were not the cause of the meltdown that occurred later that week. Since neither firm was a bank or other depository institution, this analysis is highly plausible. Few of their creditors were expecting to be able to withdraw funds on demand to meet payrolls or other immediate expenses, and later events and data have cast doubt on whether the failure of Lehman or AIG (if it had not been bailed out) would have caused the losses that many have claimed.--------------------------------------------------------------------------- \2\ John B. Taylor, ``The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong'' Working Paper 14,631, National Bureau of Economic Research, Cambridge, MA, January 2009), 25ff, available at www.nber.org/papers/w14631 (accessed April 8, 2009).John B. Taylor, Getting Off Track: How Government Actsion and Ingterventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press, 2009, pp 25-30.--------------------------------------------------------------------------- In another analysis after the Lehman and AIG events, Ayotte and Skeel concluded that the evidence suggests ``at a minimum, that the widespread belief that the Lehman Chapter 11 filing was the singular cause of the collapse in credit that followed is greatly overstated.''\3\ They also show that that there was very little difference between the market's reaction to Lehman and to AIG, although the former went into bankruptcy and the latter was rescued.--------------------------------------------------------------------------- \3\ Ayotte and Skeel, p 27.--------------------------------------------------------------------------- Advocates of broader regulation frequently state that financial institutions are now ``interconnected'' in a way that they have not been in the past. This idea reflects a misunderstanding of the functions of financial institutions, all of which are intermediaries in one form or another between sources of funds and users of funds. In other words, they have always been interconnected in order to perform their intermediary functions. The right question is whether they are now interconnected in a way that makes them more vulnerable to the failure of one or more institutions than they have been in the past, and there is no evidence of this. The discussion below strongly suggests that there was no need to rescue AIG and that Lehman's failure was problematic only because the market was in an unprecedentedly fragile and panicky state in mid-September 2008. This distinction is critically important. If the market disruption that followed Lehman's failure and AIG's rescue was not caused by these two events, then identifying systemically important firms and supervising them in some special way serves no purpose. Even if the failure of a systemically important firm could be prevented through regulation--a doubtful proposition in light of the current condition of the banking industry--that in itself would not prevent the development of a fragile market, or its breakdown in the aftermath of a serious shock. The weakness or failure of individual firms is not the source of the problem. In terms of a conventional systemic risk analysis, the chaos that followed was not the result of a cascade of losses flowing through the economy as a result of the failure of Lehman or the potential failure of AIG. In the discussion that follows, I show first that Lehman did not cause, and AIG would not have caused, losses to other firms that might have made them systemically important. I then show that both are examples of nonbank financial firms that can be successfully resolved--at no cost to the taxpayers--through the bankruptcy process rather than a government agency. AIG Should Have Been Sent into Bankruptcy. AIG's quarterly report on Form 10-Q for the quarter ended June 30, 2008--the last quarter before its bailout in September--shows that the $1 trillion company had borrowed, or had guaranteed subsidiary borrowings, in the amount of approximately $160 billion, of which approximately $45 billion was due in less than 1 year.\4\ Very little of this $45 billion was likely to be immediately due and payable, and thus, unlike a bank's failure, AIG's failure would not have created an immediate cash loss to any significant group of lenders or counterparties. Considering that the international financial markets have been estimated at more than $12 trillion, the $45 billion due within a year would not have shaken the system. Although losses would eventually have occurred to all those who had lent money to or were otherwise counterparties of AIG, these losses would have occurred over time and been worked out in a normal bankruptcy proceeding, after the sale of its profitable insurance subsidiaries.--------------------------------------------------------------------------- \4\ American International Group, 10-Q filing, June 30, 2008, 95-101.--------------------------------------------------------------------------- Many of the media stories about AIG have focused on the AIG Financial Products subsidiary and the obligations that this group assumed through credit default swaps (CDSs). However, it is highly questionable whether there would have been a significant market reaction if AIG had been allowed to default on its CDS obligations in September 2008. CDSs--although they are not insurance--operate like insurance; they pay off when there is an actual loss on the underlying obligation that is protected by the CDS. It is much the same as when a homeowners' insurance company goes out of business before there has been a fire or other loss to the home. In that case, the homeowner must go out and find another insurance company, but he has not lost anything except the premium he has paid. If AIG had been allowed to default, there would have been little if any near-term loss to the parties that had bought protection; they would simply have been required to go back into the CDS market and buy new protection. The premiums for the new protection might have been more expensive than what they were paying AIG, but even if that were true, many of them had received collateral from AIG that could have been sold in order to defray the cost of the new protection. CDS contracts normally require a party like AIG that has sold protection to post collateral as assurance to its counterparties that it can meet its obligations when they come due. This analysis is consistent with the publicly known facts about AIG. In mid-March, the names of some of the counterparties that AIG had protected with CDSs became public. The largest of these counterparties was Goldman Sachs. The obligation to Goldman was reported as $12.9 billion; the others named were Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion), and Wachovia ($1.5 billion). Recall that the loss of CDS coverage--the obligation in this case--is not an actual cash loss or anything like it; it is only the loss of coverage for a debt that is held by a protected party. For institutions of this size, with the exception of Goldman, the loss of AIG's CDS protection would not have been problematic, even if they had in fact already suffered losses on the underlying obligations that AIG was protecting. Moreover, when questioned about what it would have lost if AIG had defaulted, Goldman said its losses would have been ``negligible.'' This is entirely plausible. Its spokesman cited both the collateral it had received from AIG under the CDS contracts and the fact that it had hedged its AIG risk by buying protection against AIG's default from third parties. Also, as noted above, Goldman only suffered the loss of its CDS coverage, not a loss on the underlying debt the CDS was supposed to cover. If Goldman, the largest counterparty in AIG's list, would not have suffered substantial losses, then AIG's default on its CDS contracts would have had no serious consequences in the market. This strongly suggests that AIG could have been put into bankruptcy with no costs to the taxpayers, and if it had not been rescued its failure would not have caused any kind of systemic risk. On the other hand, it is highly likely that a systemic regulator would have rescued AIG--just as the Fed did--creating an unnecessary cost for U.S. taxpayers and an unnecessary windfall for AIG's counterparties. Lehman's Failure Did Not Cause a Systemic Event. Despite the contrary analyses by Taylor, Skeel, and Ayotte, it is widely believed that Lehman's failure proves that a large company's default, especially when it is ``interconnected'' through CDSs, can cause a systemic breakdown. If that were true, then it might make sense to set up a regulatory structure to prevent a failure by a systemically important company. But it is not true. Even if we accept that Lehman's failure somehow precipitated the market freeze that followed, that says nothing about whether, in normal market conditions, Lehman's failure would have caused the same market reaction. In fact, analyzed in light of later events, it is likely that Lehman's bankruptcy would have had no substantial adverse effect on the financial condition of its counterparties. In other words, the failure would not--in a normal market--have caused the kind of cascade of losses that defines a systemic breakdown. After Lehman's collapse, there is only one example of any other organization encountering financial difficulty because of Lehman's default. That example is the Reserve Fund, a money market mutual fund that held a large amount of Lehman's commercial paper at the time Lehman defaulted. This caused the Reserve Fund to ``break the buck''--to fail to maintain its share price at exactly one dollar--and it was rescued by the Treasury and Fed. The need to rescue the Reserve Fund was itself another artifact of the panicky conditions in the market at the time. That particular fund was an outlier among all funds in terms of its risks and returns.\5\ The fact that there were no other such cases, among money market funds or elsewhere, demonstrates that the failure of Lehman in a calmer and more normal market would not have produced any of the significant knock-on effects that are the hallmark of a systemic event. It is noteworthy, in this connection, that a large securities firm, Drexel Burnham Lambert, failed in 1990 and went into bankruptcy without any serious systemic effects. In addition, when Lehman's CDS obligations were resolved a month after its bankruptcy, they were all resolved by the exchange of only $5.2 billion among all the counterparties, a minor sum in the financial markets and certainly nothing that in and of itself would have caused a market meltdown.--------------------------------------------------------------------------- \5\ Ayotte and Skeel, Op. Cit., p 25, note 73.--------------------------------------------------------------------------- So, what relationship did Lehman's failure actually have to the market crisis that followed? The problems that were responsible for the crisis had actually begun more than a year earlier, when investors lost confidence in the quality of securities--particularly mortgage-backed securities (MBS)--that had been rated AAA by rating agencies. As a result, the entire market for asset-backed securities of all kinds became nonfunctional, and these assets simply could not be sold at anything but a distress price. With large portfolios of these securities on the balance sheets of most of the world's largest financial institutions, the stability and even the solvency of these institutions--banks and others--were in question. In this market environment, Bear Stearns was rescued through a Fed-assisted sale to JPMorgan Chase in March 2008. The rescue was not necessitated because failure would have caused substantial losses to firms ``interconnected'' with Bear, but because the failure of a large financial institution in this fragile market environment would have caused a further loss of confidence--by investors, creditors, and counterparties--in the stability of other financial institutions. This phenomenon is described in a 2003 article by professors George Kaufman and Kenneth Scott, who write frequently on the subject of systemic risk. They point out that when one company fails, investors and counterparties look to see whether the risk exposure of their own investments or counterparties is similar: ``The more similar the risk-exposure profile to that of the initial [failed company] economically, politically, or otherwise, the greater is the probability of loss and the more likely are the participants to withdraw funds as soon as possible. The response may induce liquidity and even more fundamental solvency problems. This pattern may be referred to as a `common shock' or `reassessment shock' effect and represents correlation without direct causation.''\6\ In March 2008, such an inquiry would have been very worrisome; virtually all large financial institutions around the world held, to a greater or lesser extent, the same assets that drove Bear toward default.--------------------------------------------------------------------------- \6\ George G. Kaufman and Kenneth Scott, ``What Is Systemic Risk and Do Regulators Retard or Contribute to It?'' The Independent Review 7, no. 3 (Winter 2003). Emphasis added.--------------------------------------------------------------------------- Although the rescue of Bear temporarily calmed the markets, it led to a form of moral hazard--the belief that in the future governments would rescue all financial institutions larger than Bear. Market participants simply did not believe that Lehman, just such a firm, would not be rescued. This expectation was shattered on September 15, 2008, when Lehman was allowed to fail, leading to exactly the kind of reappraisal of the financial health and safety of other institutions described by Kaufman and Scott. That is why the market froze at that point; market participants were no longer sure that the financial institutions they were dealing with would be rescued, and thus it was necessary to examine the financial condition of their counterparties much more carefully. For a period of time, the world's major banks would not even lend to one another. So what happened after Lehman was not the classic case of a large institution's failure creating losses at others--the kind of systemic event that has stimulated the administration's effort to regulate systemically important firms. It was caused by the weakness and fragility of the financial system as a whole that began almost a year earlier, when the quality of MBS and other asset-backed securities was called into question and became unmarketable. If Lehman should have been bailed out, it was not because its failure would have caused losses to others--the reason for the designation of systemically important or TBTF firms--but because the market was in an unprecedented condition of weakness and fragility. The correct policy conclusion arising out of the Lehman experience is not to impose new regulation on the financial markets, but to adopt policies that will prevent the correlation of risks that created a weak and fragile worldwide financial market well before Lehman failed. Thus, Lehman didn't cause, and AIG (if it had been allowed to fail) wouldn't have caused, a systemic breakdown. They are not, then, examples of why it is necessary to set up a special resolution system, outside the bankruptcy process, to resolve them or other large nonbank financial firms. Moreover, and equally important, a focus on Lehman and AIG as the supposed sources of systemic risk is leading policymakers away from the real problem, which is the herd and other behavior that causes all financial institutions to become weak at the same time. The funding question. There is also the question of how a resolution system of the kind the administration has proposed would be financed. Funds from some source are always required if a financial institution is either resolved or rescued. The resolution of banks is paid for by a fund created from the premiums that banks pay for deposit insurance; only depositors are protected, and then only up to $250,000. Unless the idea is to create an industry--supported fund of some kind for liquidations or bailouts, the administration's proposal will require the availability of taxpayer funds for winding up or bailing out firms considered to be systemically important. If the funding source is intended to be the financial industry itself, it would have to entail a very large levy on the industry. The funds used to bail out AIG alone are four times the size of the FDIC fund for banks and S&Ls when that fund was at its highest point--about $52 billion in early 2007. If the financial industry were to be taxed in some way to create such a fund, it would put all of these firms--including the largest--at a competitive disadvantage vis-a-vis foreign competitors and would, of course, substantially raise consumer prices and interest rates for financial services. The 24 percent loss rate that the FDIC has suffered on failed banks during the past year should provide some idea of what it will cost the taxpayers to wind up or (more likely) bail out failed or failing financial institutions that the regulators flag as systemically important. The taxpayers would have to be called upon for most, if not all, of the funds necessary for this purpose. So, while it might be attractive to imagine the FDIC will resolve financial institutions of all kinds more effectively than the way it resolves failed or failing banks, a government-run resolution system opens the door for the use of taxpayer funds to unnecessary bailouts of companies that would not cause systemic breakdowns if they were actually allowed to fail. Sometimes it is argued that bank holding companies (BHCs) must be made subject to the same resolution system as the banks themselves, but there is no apparent reason why this should be true. The whole theory of separating banks and BHCs is to be sure that BHCs could fail without implicating or damaging the bank, and this has happened frequently. If a holding company of any kind fails, its subsidiaries can remain healthy, just as the subsidiaries of a holding company can go into bankruptcy without the parent becoming insolvent. If a holding company with many subsidiaries regulated by different regulators should go into bankruptcy, there is no apparent reason why the subsidiaries cannot be sold off if they are healthy and functioning, just as Lehman's broker-dealer and other subsidiaries were promptly sold off after Lehman declared bankruptcy. If there is some conflict between regulators, these--like conflicts between creditors--would be resolved by the bankruptcy court. Moreover, if the creditors, regulators, and stakeholders of a company believe that it is still a viable entity, Chapter 11 of the Bankruptcy Code provides that the enterprise can continue functioning as a ``debtor in possession'' and come out of the proceeding as a slimmed-down and healthy business. Several airlines that are functioning today went through this process, and--ironically--some form of prepackaged bankruptcy that will relieve the auto companies of their burdensome obligations is one of the options the administration is considering for that industry. (Why bankruptcy is considered workable for the auto companies but not financial companies is something of a mystery.) In other words, even if it were likely to be effective and efficient--which is doubtful--a special resolution procedure for financial firms is unlikely to achieve more than the bankruptcy laws now permit. In addition to increasing the likelihood that systemically important firms will be bailed out by the government, the resolution plan offered by the administration will also raise doubts about priorities among lenders, counterparties, shareholders, and other stakeholders when a financial firm is resolved or rescued under the government's control. In bankruptcy, the various classes of creditors decide, under the supervision of a court, how to divide the remaining resources of the bankrupt firm, and whether the firm's business and management are sufficiently strong to return it to health. In an FDIC resolution, insured depositors have a preference over other creditors, but it is not clear who would get bailed out and who would take losses under the administration's plan. One of the dangers is that politically favored groups will be given preferences, depending on which party is in power at the time a systemically important firm is bailed out. Perhaps even more important, the FDIC's loss rate even under PCA demonstrates that the closing down of losing operations is slow and inefficient when managed by the government. Under the bankruptcy laws, the creditors have strong incentives to close a failing company and stop its losses from growing. As the FDIC experience show, government agencies have a tendency to forbear, allowing time for the losses in a failing firm to grow even greater. Given that bailouts are going to be much more likely than liquidations, especially for systemically important firms, a special government resolution or rescue process will also undermine market discipline and promote more risk-taking in the financial sector. In bailouts, the creditors will be saved in order to prevent a purported systemic breakdown, reducing the risks that creditors believe they will be taking in lending to systemically important firms. Over time, the process of saving some firms from failure will weaken all firms in the financial sector. Weak managements and bad business models should be allowed to fail. That makes room for better managements and better business models to grow. Introducing a formal rescue mechanism will only end up preserving bad managements and bad business models that should have been allowed to disappear while stunting or preventing the growth of their better-managed rivals. Finally, as academic work has shown again and again, regulation suppresses innovation and competition and adds to consumer costs. Accordingly, there is no need to establish a special government system for resolving nonbank financial institutions, just as there is no need to do so for large operating companies like GM. If such a system were to be created for financial institutions other than banks--for which a special system is necessary--the unintended consequences and adverse results for the economy and the financial system would far outweigh any benefits. ______ FOMC20080625meeting--213 211,MR. PARKINSON.," I can't answer that, but that's a good question. I mean, the basic problem here is that you have a tremendous demand for investments that have essentially the characteristics of Treasury bills, but the supply of Treasury bills isn't nearly as large as that demand coming from money market mutual funds and from investment of cash collateral on securities lending and other kinds of secured financing. Over time, the marketplace has come up with synthetic Treasury bills of various sorts, but those short-term investments have been created outside the banking system by and large because the inability to pay interest on demand deposits doesn't allow them to be provided by the banking system. Now, if that prohibition were removed, I think you would see banks offering things that would be competing with overnight repos, overnight commercial paper, and other sorts of things that are outside the banking system that are meeting these needs. In terms of the effects on stability, whether that leaves us in a better place obviously would depend on how good a job we do of regulating maturity transformation by the commercial banking system. An interesting question there is--whenever I hear Art give his presentation and look at these stress tests we're applying to the investment banks, even under current conditions, when they're not offering overnight interest-bearing deposits--how well our banks would fare if we tested them against these standards. But I think your observation and your question are good ones. " CHRG-111hhrg48867--36 Mr. Plunkett," Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. I am Travis Plunkett, legislative director of the Consumer Federation of America, and I appreciate the opportunity to testify today about how to better protect the financial system as a whole and the broader economy from systemic risk. I would like to make three key points: First, systemic regulation isn't just a matter of designating and empowering a risk regulator, as important as that may be. It involves a comprehensive plan to reduce systemic risk, including immediate steps both to reinvigorate day-to-day safety and soundness in consumer and investor protection regulation of financial institutions and to address existing systemic risk, in particular by shutting down the shadow banking system once and for all. Second, systemic risk regulation should not rely only on a crisis management approach or focus on flagging a handful of large institutions that are deemed too big to fail. Rather, it must be an ongoing day-to-day obligation of financial regulators focused on reducing the likelihood of a systemic failure triggered by any institution or institutions in the aggregate. Third, CFA has not endorsed a particular systemic regulatory structure, but if Congress chooses to designate the Fed as a systemic regulator, it must take steps to address several problems inherent in this approach, including the Fed's lack of transparency and accountability and the potential for conflicts between the roles of setting monetary policy and regulating for systemic risk. The fact that we could have prevented the current crisis without a systemic regulator provides a cautionary lesson about the limits of an approach that is just focused on creating new regulatory structures. It is clear that regulators could have prevented or greatly reduced the severity of the current crisis using basic consumer protection and safety and soundness authority. Unless we abandon a regulatory philosophy based on a rational faith in the ability of markets to self-correct, whatever we do on systemic risk regulation is likely to have a limited effect. The flip side of this point, the positive side, suggests that simply closing the loopholes in the current regulatory structure, reinvigorating Federal regulators in doing an effective job of the day-to-day task of soundness and investor and consumer protection will go a long way to eliminating the greatest threats to the financial system. Chairman Frank and several members of this committee have been leaders in talking about the importance of a comprehensive approach to systemic risk regulation and have focused on executive compensation as a factor that contributes to systemic risk. We agree about the compensation practices that encourage excessive risk-taking and about the need to bring currently unregulated financial activities under the regulatory umbrella. The experiences of the past year have demonstrated conclusively the ineffectiveness of managing systemic risk only when the Nation finds itself on the brink of a crisis. It is of paramount importance in our view that any new plan provide regulators with ongoing day-to-day authority to curb systemic risk. The goal of regulation should not be focused only or even primarily on the potential bailout of systemically significant institutions. Rather, it should be designed to ensure that all risks that could threaten the broader financial system are quickly identified and addressed to reduce the likelihood that a systemically significant institution will fail and to provide for the orderly failure of nonbank financial institutions. Regardless of which structure Congress chooses to adopt, we urge you to build incentives into the system to discourage institutions from becoming too big or too interconnected to fail. One way to do this is to subject financial institutions to risk-based capital requirements and premium payments designed to deter those practices that magnify risks, such as growing too large, holding risky assets, increasing leverage, or engaging in other activities deemed risky by regulators. To increase the accountability of regulators and reduce the risk of groupthink, we also recommend that you create a high level systemic risk advisory council made up of academics and other independent analysts from a variety of disciplines. Once again, I appreciate the opportunity to appear before you today and look forward to answering questions. [The prepared statement of Mr. Plunkett can be found on page 101 of the appendix.] " Mr. Kanjorski," [presiding] Thank you very much, Mr. Plunkett. Mr. Silvers. STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL, AFL- CHRG-110hhrg46591--284 Mr. Bartlett," Congressman, I might add that you are not going to get down to one regulator, nor should you, but there should be fewer regulators than there are now. More importantly, the system of regulation should be coordinated between one another. There are literally hundreds of regulators for financial services, and it is the gaps that cause the problem. One other admonition: I would hope that the committee and the Congress and the industry do not sort of fall into the traditional fights of large versus small. It is not large versus small; it is a continuum of size, just like every other industry. Nor should they pit one sector against another, the traditional thrift versus bank, insurance versus bank versus securities dealers. The fact is that it is an integrated financial services system that needs to be regulated as an integrated financial services system for safety, for soundness, for systemic regulation, and for business conduct. Therein lies the answer. " CHRG-111hhrg52397--6 Mr. Ackerman," If we could step into our time machines and go back in time before the near collapse of AIG, I have little doubt that we would have near unanimous support for regulating credit default swaps. But of course we cannot go back in time, we cannot stop AIG from overextending itself, and the next crisis will not stem from AIG's credit default swap portfolio. Our financial regulatory structure is like a tattered quilt made up of dozen of patches, each representing a State and Federal supervisor, agency, some patches overlapping, and we now know some areas completely bare. Preventing the next crisis will require more than simply sewing yet another patch onto the quilt. Regardless of how meritorious the proposals to regulate and clear out these derivatives may be, we need a regulator with the ability to see the complete picture, not just the OTC derivatives market, not just the exchanges, not just the banking system, but all of it. We need a regulator who has the ability to see trends in the OTC derivative markets that independently might not be worrisome but when paired with information pertaining to the reserves of our banks could be cause for concern. And we need the regulator to have the ability to act appropriately and expeditiously to address systemic risk. And so in my view merely granting the SEC or the CFDC the authority to regulate and to clear out these products is near-sighted and inadequate. If we are to learn from this financial crisis, any legislation that seeks to regulate OTC products must be paired with a systemic risk regulator. I thank you and I yield back the balance of my time. " fcic_final_report_full--377 In sum, the sharp contraction in the OTC derivatives market in the fall of  greatly diminished the ability of institutions to enter or unwind their contracts or to effectively hedge their business risks at a time when uncertainty in the financial sys- tem made risk management a top priority. WASHINGTON MUTUAL: “IT ’S YOURS” In the eight days after Lehman’s bankruptcy, depositors pulled . billion out of Washington Mutual, which now faced imminent collapse. WaMu had been the subject of concern for some time because of its poor mortgage-underwriting standards and its exposures to payment-option adjustable-rate mortgages (ARMs). Moody’s had down- graded WaMu’s senior unsecured debt to Baa, the lowest-tier investment-grade rat- ing, in July, and then to junk status on September , citing “WAMU’s reduced financial flexibility, deteriorating asset quality, and expected franchise erosion.”  The Office of Thrift Supervision (OTS) determined that the thrift likely could not “pay its obligations and meet its operating liquidity needs.”  The government seized the bank on Thursday, September , , appointing the Federal Deposit Insurance Corporation as receiver; many unsecured creditors suffered losses. With assets of  billion as of June , , WaMu thus became the largest insured depository institu- tion in U.S. history to fail—bigger than IndyMac, bigger than any bank or thrift failure in the s and s. JP Morgan paid . billion to acquire WaMu’s banking oper- ations from the FDIC on the same day; on the next day, WaMu’s parent company (now minus the thrift) filed for Chapter  bankruptcy protection. FDIC officials told the FCIC that they had known in advance of WaMu’s troubles and thus had time to arrange the transaction with JP Morgan. JP Morgan CEO Jamie Dimon said that his bank was already examining WaMu’s assets for purchase when FDIC Chair- man Sheila Bair called him and asked, “Would you be prepared to bid on WaMu?” “I said yes we would,” Dimon told the FCIC. “She called me up literally the next day and said—‘It’s yours.’ . . . I thought there was another bidder, by the way, the whole time, otherwise I would have bid a dollar—not [. billion], but we wanted to win.”  The FDIC insurance fund came out of the WaMu bankruptcy whole. So did the uninsured depositors, and (of course) the insured depositors. But the FDIC never contemplated using FDIC funds to protect unsecured creditors, which it could have done by invoking the “systemic risk exception” under the FDIC Improvement Act of . (Recall that FDICIA required that failing banks be dismantled at the least cost to the FDIC unless the FDIC, the Fed, and Treasury agree that a particular company’s collapse poses a risk to the entire financial system; it had not been tested in  years.) Losses among those creditors created panic among the unsecured creditors of other struggling banks, particularly Wachovia—with serious consequences. Nevertheless, FDIC Chairman Bair stood behind the decision. “I absolutely do think that was the right decision,” she told the FCIC. “WaMu was not a well-run institution.” She char- acterized the resolution of WaMu as “successful.”  fcic_final_report_full--306 As noted, the Fed had announced a new program, the Term Securities Lending Facility (TSLF), on the Tuesday before Bear’s collapse, but it would not be available until March . The TSLF would lend a total of up to  billion of Treasury securi- ties at any one time to the investment banks and other primary dealers—the securi- ties affiliates of the large commercial banks and investment banks that trade with the New York Fed, such as Citigroup, Morgan Stanley, or Merrill Lynch—for up to  days. The borrowers would trade highly rated securities, including debt in govern- ment-sponsored enterprises, in return for Treasuries. The primary dealers could then use those Treasuries as collateral to borrow cash in the repo market. Like the Term Auction Facility for commercial banks, described earlier, the TSLF would run as a regular auction to reduce the stigma of borrowing from the Fed. However, after Bear’s collapse, Fed officials recognized that the situation called for a program that could be up and running right away. And they concluded that the TSLF alone would not be enough. So, the Fed would create another program first. On the Sunday of Bear’s collapse, the Fed announced the new Primary Dealer Credit Facility—again invoking its au- thority under () of the Federal Reserve Act—to provide cash, not Treasuries, to investment banks and other primary dealers on terms close to those that depository institutions—banks and thrifts—received through the Fed’s discount window. The move came “just about  minutes” too late for Bear, Jimmy Cayne, its former CEO, told the FCIC.  Unlike the TSLF, which would offer Treasuries for  days, the PDCF offered overnight cash loans in exchange for collateral. In effect, this program could serve as an alternative to the overnight tri-party repo lenders, potentially providing hundreds of billions of dollars of credit. “So the idea of the PDCF then was . . . anything that the dealer couldn’t finance—the securities that were acceptable under the discount win- dow—if they couldn’t get financing in the market, they could get financing from the Federal Reserve,” said Seth Carpenter, deputy associate director in the Division of Monetary Affairs at the Federal Reserve Board. “And that way, you don’t have to worry. And by providing that support, other lenders know that they’re going to be able to get their money back the next day.”  By charging the Federal Reserve’s discount rate and adding additional fees for reg- ular use, the Federal Reserve encouraged dealers to use the PDCF only as a last re- sort. In its first week of operation, this program immediately provided over  billion in cash to Bear Stearns (as bridge financing until the JP Morgan deal officially closed), Lehman Brothers, and the securities affiliate of Citigroup, among others. However, as the immediate post-Bear concerns subsided, use of the facility declined after April and ceased completely by late July.  Because the dealers feared that mar- kets would see reliance on the PDCF as an indication of severe distress, the facility carried a stigma similar to the Fed’s discount window. “Paradoxically, while the PDCF was created to mitigate the liquidity flight caused by the loss of confidence in an investment bank, use of the PDCF was seen both within Lehman, and possibly by the broader market, as an event that could trigger a loss of confidence,” noted the Lehman bankruptcy examiner.  CHRG-111hhrg53248--27 Secretary Geithner," Chairman Frank, Ranking Member Bachus, and members of the committee, thanks for giving me the chance to come before you today. Let me first begin by commending you for the important work you have already undertaken to help build consensus on financial reform. We have an opportunity to bring about fundamental change to our financial system, to provide greater protection for consumers and for businesses. We share a responsibility to get this right and to get this done. On June 17th, the President outlined a proposal for comprehensive change of the basic rules of the road for the financial system. These proposals were designed to lay the foundation for a safer, more stable financial system, one less vulnerable to booms and busts, less vulnerable to fraud and manipulation. The President decided we need to move quickly while the memory of the searing damage caused by this crisis was still fresh and before the impetus to reform faded. These proposals have led to an important debate about how best to reform this system, how to achieve a better balance between innovation and stability. We welcome this debate, and we will work closely with the Congress to help shape a comprehensive and strong package of legislative changes. My written testimony reviews the full outlines of these proposals. I just want to focus my opening remarks on two central areas for reform. The first is our proposal for a Consumer Financial Protection Agency. We can all agree, I believe, that in the years leading up to the current crisis, our consumer protection regime fundamentally failed. It failed because our system allowed a range of institutions to escape effective supervision. It failed because our system was fragmented, fragmenting responsibility for consumer protection over numerous regulators, creating opportunities for evasion. And it failed because all of the Federal financial services regulators have higher priorities than consumer protection. The result left millions of Americans at risk, and I believe for the first time in the modern history of financial crises in our country, we face an acute crisis, a crisis which brought the financial system to the edge of collapse in significant part because of failures in consumer protection. The system allowed--this system allowed the extreme excesses of the subprime mortgage lending boom, loans without proof of income, employment or financial assets that it reset to unaffordable rates that consumers could not understand and that have contributed to millions of Americans losing their homes. Those practices built up over a long period of time. They peaked in 2006. But it took Federal banking agencies until June of 2007 after the peak to reach consensus on supervisory guidance that would impose even general standards on the sale and underwriting of subprime mortgages. And it took another year for these agencies to settle on a simple model disclosure for subprime mortgages. These actions came too late to help consumers and homeowners. The basic standards of protection were too weak. They were not effectively enforced, and accountability was diffused. We believe that the only viable solution is to provide a single entity in the government with a clear mandate for consumer protection and financial products and services with clear authority to write rules and to enforce those rules. We proposed to give this new agency jurisdiction over the entire marketplace. This will provide a level playing field where the reach of Federal oversight is extended for the first time to all financial firms. This means the agency would send examiners into nonbanks as well as to banks reviewing loan files and interviewing sales people. Consumers will be less vulnerable to the type of race-to-the-bottom standard that was produced by allowing institutions without effective supervision to compete alongside banks. We believe that effective protection requires consolidated authority to both write and enforce rules. Rules written by those not responsible for enforcing them are likely to be poorly designed with insufficient feel for the needs of consumers and for the realities of the market. Rule-writing authority without enforcement authority would risk creating an agency that is too weak dominated by those with enforcement authority. And leaving enforcement authority divided as it is today among this complicated mix of supervisors and other authorities would risk continued opportunities for evasion and uneven protections. Our proposals are designed to preserve the incentives and opportunities for innovation. Many of the practices of consumer lending that led to this crisis gave innovation a bad name. What they claim was innovation was often just predation. But we want to make it possible for future innovations and financial products to come with less risk of damage. We need to create an agency that restores the confidence of consumers and the confidence of financial investors with authority to prevent abusive and unfair practices while at the same time promoting innovation and consumer access to financial products. The second critical imperative to reform is to create a more stable system. In the years leading up to this crisis, our regime, our regulatory framework, permitted an excess buildup of leverage both outside the banking system and within the banking system. The shock absorbers that are critical to preserving the stability to the system, these are shock absorbers in the form of capital requirements, margin, liquidity requirements, were inadequate to withstand the force of the global recession. They left the system too weak to withstand the failure of a major financial institution. Addressing this challenge will require very substantial changes. It will require putting in place stronger constraints on risk taking with stronger limits on leverage and more conservative standards for funding and liquidity management. These standards need to be enforced more broadly across the financial system overall, covering not just all banks but institutions that present potential risk to the stability of the financial system. This will require bringing the markets that are critical to the provision of credit and capital, the derivatives markets, the securitization markets and the credit rating agencies, within a broad framework or oversight. This will require reform to compensation practices to reduce incentives for excessive risk taking in the future. This will require much stronger cushions or shock absorbers in the critical centralized financial infrastructure, so that the system as a whole is less vulnerable to contagion and is better able to withstand the pressures that come with financial shocks and the risk of failure of large institutions. And this will require stronger authority to manage the failure of these institutions. Resolution authority is essential to any credible plan to make it possible to limit moral hazard risk in the future and to limit the need for future bailouts. Alongside these changes, we need to put in place some important changes to the broader oversight framework. Our patchwork, antiquated balkanized segmented structure of oversight responsibility created large gaps in coverage, allowed institutions to shop for the weakest regulator, and left authorities without the capacity to understand and stay abreast of the changing danger of risk in our financial system. To address this, we proposed establishing a council responsible for looking at the financial system as a whole. No single entity can fully discharge this responsibility. Our proposed Financial Services Oversight Council would bring together the heads of all the major Federal financial regulatory agencies, including the Federal Reserve, the SEC, etc. This council would be accountable to the Congress for making sure that we have in place strong protections for the stability of the financial system; that policy is closely coordinated across responsible agencies; that we adapt the safeguards and protections as the system changes in the future and new sources of risk emerge; and that we are effectively cooperating with countries around the world in enforcing strong standards. This council would have the power to gather information from any firm or market to help identify emerging risks, and it would have the responsibility to recommend changes in laws and regulation to reduce future opportunities for arbitrage, to help ensure we put in place and maintain over time strong safeguards against the risk of future crises. The Federal Reserve will have an important role in this framework. It will be responsible for the consolidated supervision of all large interconnected firms whose failure could threaten the stability of this system, regardless of whether they own a depository institution. The Fed, in our judgment, is the only regulatory body with the experience, the institutional knowledge, and the capacity to do this. This is a role the Fed largely already plays today. And while our plan does clarify this basic responsibility and gives clear accountability to the Fed for this responsibility, it also takes away substantial authority. We propose to take away from the Fed today responsibility for writing rules for consumer protection, and for enforcing those rules, and we propose to require the Fed to receive written approval from the Secretary of the Treasury before exercising its emergency lending authority. Now, we look forward to refining these recommendations through the legislative process. To help advance this process, we have already provided detailed draft legislative language to the Hill on every piece of the President's reform package. " CHRG-111shrg62643--132 Chairman Dodd," Thank you, Senator. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Thank you, Chairman Bernanke, for your service. I always believe the starting point always has consequence, and I hear a lot about spending, which I agree is a challenge and something we need to tackle, but I also hear it in the abstract. So let me just do a very quick history line with you. You came to us in the end of 2008 with Secretary Paulson and you said to this Congress, we need to act or otherwise we will have financial institutions collapse and that collapse will mean an entire systemic risk to the entire country and maybe we will even have a global financial meltdown. Is that true? " fcic_final_report_full--609 Practices,” October 2007. 136. Frederic Mishkin, interview by FCIC, October 1, 2010. 137. Dudley, interview. 138. Ibid. 139. Ibid. 140. Standard & Poor’s, “Detailed Results of Subprime Stress Test of Financial Guarantors,” Ratings- Direct, February 25, 2008. 141. Alan Roseman, interview by FCIC, May 17, 2010. 142. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” internal memo to Erik Sirri and others, November 6, 2007, p. 3. 143. Roseman, interview, May 17, 2010. 144. SEC, “Risk Management of Consolidated Supervised Entities,” internal memo to Erik Sirri and others, January 2, 2008, p. 2. 145. Bill Lockyer, State of California 2008 Debt Affordability Report: Making the Municipal Bond Mar- ket Work for Taxpayers in Turbulent Times (October 1, 2008), p. 4. 146. John J. McConnell and Alessio Saretto, “Auction Failures and the Market for Auction Rate Secu- rities” (The Krannert School of Management, Purdue University, April 2009), p. 10. 147. Erik R. Sirri, director of Trading and Markets, U.S. Securities and Exchange Commission, “Municipal Bound Turmoil: Impact on Cities, Towns and States,” testimony before the House Financial Services Committee, 110th Cong., 2nd sess., March 12, 2008. 148. Georgetown University, “Annual Financial Report, 2008–2009,” p. 5. 149. Jacqueline Doherty, “The Sad Story of Auction-Rate Securities, Barrons, May 26, 2008. 150. “SEC Finalizes ARS Settlements with Bank of America, RBC, and Deutsche Bank,” SEC press re- lease, June 3, 2009. Chapter 15 1. “Prime Asset,” 2007 Upper HedgeWorld Prime Brokerage League Table, accessible at Gregory Zuckerman, “Hedge Funds, Once a Windfall, Contribute to Bear’s Downfall,” Wall Street Journal , March 17, 2008. 2. Jeff Mayer and Thomas Marano, “Fixed Income Overview,” March 29, 2007, p. 8, produced by JP Morgan. 3. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar- ket (Bethesda, MD: Inside Mortgage Finance, 2009), pp. 18–25. 4. FCIC staff estimates, based on Moody’s CDO EMS database. Different numbers are provided in Jeff Mayer and Thomas Marano, “Fixed Income Overview,” March 29, 2007, p. 16. 5. Samuel Molinaro, interview by FCIC, April 9, 2010; Michael Alix, interview by FCIC, April 8, 2010. 6. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memorandum to Robert Colby and others, May 8, 2006. 7. Robert Upton, interview by FCIC, April 13, 2010. 8. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memorandum to Erik Sirri and others, March 1, 2007. 9. Ibid. 10. Bear Stearns, “Fitch Presentation,” PowerPoint slides, August 2007. 11. Upton, interview. 12. Bear Stearns, Form 10-K for the year ended November 30, 2007, filed January 29, 2008, pp. 52, 22. 13. Upton, interview. 14. Ibid. 15. Standard & Poor’s, Global Credit Portal RatingsDirect, “Research Update: Bear Stearns Cos. Inc. Outlook Revised to Negative; ‘A+/A-1’ Rating Affirmed,” August 3, 2007. 16. Jimmy Cayne, interview by FCIC, April 21, 2010. 17. Matthew Eichner, interview by FCIC, April 14, 2010. 18. Wendy de Monchaux, interview by FCIC, April 27, 2010; Steven Meyer, interview by FCIC, April 22, 2010. 19. Mike Alix, interview by FCIC, April 8, 2010. 20. Eichner, interview. 21. Timeline Regarding Bear Stearns Companies Inc., April 3, 2008, produced by SEC. 22. SEC Office of Inspector General, Office of Audits, “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, September 25, 2008, pp. ix–x. 23. Michael Halloran, interview by FCIC. 24. Cayne, interview. 25. Samuel Molinaro, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session 1: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 43; Cayne, interview. 26. “Changes in Approved Commercial Paper List—10/01/2007–12/31/2007” and “Changes in Ap- proved Commercial Paper List—1/01/2008–3/31/2008,” produced by Federated Advised Funds. 27. Federal Reserve Bank of New York, “Tri-Party Repo Infrastructure Reform,” white paper, May 17, 2010, p. 7. 28. Seth Carpenter, interview by FCIC, September 20, 2010. 29. Information provided by Federated to the FCIC. 30. Scott Goebel, Kevin Gaffney, and Norm Lind (Fidelity employees), interview by FCIC, February 25, 2010. 31. Steve Meier, executive vice president State Street Global Advisors, interview by FCIC, March 15, 2010. 32. Timeline Regarding the Bear Stearns Companies Inc., April 3, 2008, pp. 1–2, provided to the fcic_final_report_full--447 The role of Fannie Mae and Freddie Mac in causing the crisis The government-sponsored enterprises Fannie Mae and Freddie Mac were elements of the crisis in several ways: • They were part of the securitization process that lowered mortgage credit quality standards. • As large financial institutions whose failures risked contagion, they were massive and multidimensional cases of the too big to fail problem. Policymakers were un- willing to let them fail because: – Financial institutions around the world bore significant counterparty risk to them through holdings of GSE debt; – Certain funding markets depended on the value of their debt; and – Ongoing mortgage market operation depended on their continued existence. • They were by far the most expensive institutional failures to the taxpayer and are an ongoing cost. There is vigorous debate about how big a role these two firms played in securitiza- tion relative to “private label” securitizers. There is also vigorous debate about why these two firms got involved in this problem. We think both questions are less impor- tant than the multiple points of contact Fannie Mae and Freddie Mac had with the fi- nancial system. These two firms were guarantors and securitizers, financial institutions holding enormous portfolios of housing-related assets, and the issuers of debt that was treated like government debt by the financial system. Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways. THE SYSTEM FREEZING Following the shock and panic, financial intermediation operated with escalating frictions. Some funding markets collapsed entirely. Others experienced a rapid blowout in spreads following the shock and stabilized slowly as the panic subsided and the government stepped in to backstop markets and firms. We highlight three funding markets here: • Interbank lending. Lending dynamics changed quickly in the federal funds market where banks loan excess reserves to one another overnight. Even large banks were unable to get overnight loans, compounding an increasingly re- stricted ability to raise short-term funds elsewhere. • Repo. By September , repo rates increased substantially, and haircuts bal- looned. Nontraditional mortgages were no longer acceptable collateral. • Commercial paper. The failure of Lehman and the Reserve Primary Fund breaking the buck sparked a run on prime money market mutual funds. Money market mutual funds withdrew from investing in the commercial paper mar- ket, leading to a rapid increase in funding costs for financial and nonfinancial firms that relied on commercial paper. CHRG-110hhrg46596--93 Mr. Kashkari," Congresswoman, thank you for asking. This is a very important topic. And, if you will permit me, I am going to give you three parts to the answer. The first part is Secretary Paulson came to the Congress to ask for this legislation to prevent a financial collapse. And if you will permit me, imagine how many foreclosures we would have had if we had allowed the financial system to collapse, number one. Number two, we continue to work very hard at Treasury, within the Administration, with the Federal Reserve, in consultation with the transition team, looking at various foreclosure mitigation policies-- Ms. Waters. Taking back my time, why haven't you adopted the Sheila Bair program? " CHRG-111shrg52619--208 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOSEPH A. SMITH, JR.Q.1. The convergence of financial services providers and financial products has increased over the past decade. Financial products and companies may have insurance, banking, securities, and futures components. One example of this convergence is AIG. Is the creation of a systemic risk regulator the best method to fill in the gaps and weaknesses that AIG has exposed, or does Congress need to reevaluate the weaknesses of federal and state functional regulation for large, interconnected, and large firms like AIG?A.1. The current economic crisis has shown that our financial regulatory structure in the United States was incapable of effectively managing and regulating the nation's largest institutions, such as AIG. Institutions, such as AIG, that provide financial services similar to those provided by a bank, should be subject to the same oversight that supervises banks. CSBS believes the solution, however, is not to expand the federal government bureaucracy by creating a new super regulator. Instead, we should enhance coordination and cooperation among federal and state regulators. We believe regulators must pool their resources and expertise to better identify and manage systemic risk. The Federal Financial Institutions Examination Council (FFIEC) provides a vehicle for working toward this goal of seamless federal and state cooperative supervision.Q.2. Recently there have been several proposals to consider for financial services conglomerates. One approach would be to move away from functional regulation to some type of single consolidated regulator like the Financial Services Authority model. Another approach is to follow the Group of 30 Report which attempts to modernize functional regulation and limit activities to address gaps and weaknesses. An in-between approach would be to move to an objectives-based regulation system suggested in the Treasury Blueprint. What are some of the pluses and minuses of these three approaches?A.2. Each of the models discussed would result in further consolidation of the financial industry, and would create institutions that would be inherently too big to fail. If we allowed our financial industry to consolidate to only a handful of institutions, the nation and the global economy would be reliant upon those institutions to remain functioning. CSBS believes all financial institutions must be allowed to fail if they become insolvent. Currently, our system of financial supervision is inadequate to effective supervise the nation's largest institutions and to resolve them in the event of their failure. More importantly, however, consolidation of the industry would destroy the community banking system within the United States. The U.S. has over 8,000 viable insured depository institutions to serve the people of this nation. The diversity of our industry has enabled our economy to continue despite the current recession. Community and regional banks have continued to make credit available to qualified borrowers throughout the recession and have prevented the complete collapse of our economy.Q.3. If there are institutions that are too big to fail, how do we identify that? How do we define the circumstance where a single company is so systemically significant to the rest of our financial circumstances and our economy that we must not allow it to fail?A.3. A specific definition for ``too big to fail'' will be difficult for Congress to establish. Monetary thresholds will eventually become insufficient as the market rebounds and works around any asset-size restrictions, just as institutions have avoided deposit caps for years now. Some characteristics of an institution that is ``too big to fail'' include being so large that the institution's regulator is unable to provide comprehensive supervision of the institution's lines of business or subsidiaries. An institution is also ``too big to fail'' if a sudden collapse of the institution would have a devastating impact upon separate market segments.Q.4. We need to have a better idea of what this notion of too big to fail is--what it means in different aspects of our industry and what our proper response to it should be. How should the federal government approach large, multinational, and systemically significant companies?A.4. The federal government should utilize methods to prevent companies from growing too big to fail, either through incentives and disincentives (such as higher regulatory fees and assessments for higher amounts of assets or engaging in certain lines of business), denying certain business mergers or acquisitions that allow a company to become ``systemic,'' or through establishing anti-trust laws that prevent the creation of financial monopolies. Congress should also grant the Federal Deposit Insurance Corporation (FDIC) resolution authority over all financial firms, regardless of their size or complexity. This authority will help instill market discipline to these systemic institutions by providing a method to close any institution that becomes insolvent. Finally, Congress should consider establishing a bifurcated system of supervision designed to meet the needs not only of the nation's largest and most complex institutions, but also the needs of the smallest community banks.Q.5. What does ``fail'' mean? In the context of AIG, we are talking about whether we should have allowed an orderly Chapter 11 bankruptcy proceeding to proceed. Is that failure?A.5. CSBS believes failures and resolutions take on a variety of forms based upon the type of institution and its impact upon the financial system as a whole. In the context of AIG, an orderly Chapter 11 bankruptcy would have been considered a failure. But it is more important that we do not create an entire system of financial supervision that is tailored only to our nation's largest and most complex institutions. It is our belief the greatest strength of our unique financial structure is the diversity of the financial industry. The U.S. banking system is comprised of thousands of financial institutions of vastly different sizes. Therefore, legislative and regulatory decisions that alter our financial regulatory structure or financial incentives should be carefully considered against how those decisions affect the competitive landscape for institutions of all sizes. ------ CHRG-111hhrg52406--39 Mr. Yingling," Thank you, Mr. Chairman, Mr. Bachus, and members of the committee for inviting me to testify on behalf of the banking industry. Members of this committee are looking at this consumer agency proposal from the point of view of consumers, who should be paramount in your deliberations, but today I would also ask you to take a look at this issue from an additional point as well. While banks of all sizes would be negatively impacted, please think of your own local community banks. These banks never made one subprime loan, and they have the trust of their local consumers. As this committee has frequently noted, these community banks are already overwhelmed with regulatory costs that are slowly but surely strangling them. Yet last week, these community banks found the Administration proposing a potentially massive new regulatory burden. While the shadow banking industry, which includes those most responsible for the crisis, is covered by the new agency, their regulatory and enforcement burden is, based on history, likely to be much less. The proposed new agency is to rely first on State regulation and enforcement. Yet we all know that the budgets for such State enforcement will be completely inadequate to do the job. Therefore, the net result will be that the community banks will pay greatly increased fees to fund a system that falls disproportionately and unfairly on them. The new agency would have vast and unprecedented authority to regulate in detail all bank consumer products. The agency is even instructed to create its own products, whatever it decides is plain vanilla, and mandate that banks offer them. Further, the agency is urged to give the products it designs regulatory preference over the bank's own products. The agency is even encouraged to require a statement by consumers that the consumer was offered and turned down the government's product first. Thus, community banks, whether it fits their business model or not, would be required to offer government-designed products, which would be given a preference over the bank's own products. On disclosure, the proposal goes beyond simplification, which is badly needed to require that all bank communication with consumers be ``reasonable.'' This term is so vague that no banker would know what to do with it, but not to worry. The proposal would allow, even encourage, thousands of banks and others to preclear communications with the agency. So, before a community bank runs an ad in the local newspaper or sends a customer a letter, it would apparently need to preclear it with the regulator to be legally safe. CRA enforcement is also, apparently, to be increased on these community banks, although they already strongly serve their communities, and that is not to mention the inherent conflicts that will occur between the prudential regulator and the consumer regulator with the banks caught in the middle. Please recognize that all of this--cost, conflicting requirements, and uncertainty--would be placed on community banks that in no way contributed to the financial crisis. More generally, the fundamental flaw in the proposal is that consumer regulation and safety and soundness regulation cannot be separated. You cannot separate a business from its product. A good example is check hold periods. Customers would like the shortest possible holds, but this desire needs to be balanced with the complex operational issues in clearing checks and with the threat of fraud, which costs banks, and ultimately consumers, billions of dollars. Another example is the Bank Secrecy Act, which protects against money laundering and terrorist financing. These critical regulations must be coordinated with consumer and safety and soundness regulation. Take the account opening process. A consumer regulator would focus on simplicity in disclosures, while the prudential regulator would also want to consider the potential for fraudulent activity and for implementing the Bank Secrecy Act to protect against terrorist financing. What is the bank in the middle supposed to do? What about conflicts over CRA lending? We agree that CRA has not led to material safety and soundness concerns, but that is because it is under one regulator. There is often debate about individual CRA loans as to the right balance between outreach and sound lending. However, that debate, that tension, is resolved in a straightforward manner because the same agency is in charge of CRA and of safety and soundness. To separate the two is a recipe for conflicting demands, with the bank again caught in the middle. The great majority of consumer problems, as has been noted by both Democrats and Republicans on this committee, occurred outside the highly regulated traditional banks, but there are legitimate issues relating to banks as well. In that regard, my written testimony outlines some concepts that we hope you will consider to address the banking side of it. Thank you, Mr. Chairman. [The prepared statement of Mr. Yingling can be found on page 235 of the appendix.] " CHRG-110shrg50417--150 Mr. Palm," Happy to. I think anyone who thinks that the regulatory system in the United States and elsewhere is not in need of reform has not been around for the last 6 months. That would be my first point. We fully support a thoughtful approach to putting together a new regulatory system. Whether that is one super regulator as described, which you mentioned you might be in favor of, or, you know, a tripartite one, one of which consists of investor protection separate from I will call it the soundness of the particular financial institution, et cetera, you know, can be debated. Either system in theory can be made to work. I think the current system--and obviously we are new to being a bank. One of the things that first struck me was the fact that--actually, being a lawyer of sorts, I first got a book out which told me all the different types of organizations you were regulated by if you were in a particular business, and it was mind-numbing, including both regulatory arbitrage as well as--it is not even necessarily arbitrage. It is just people found themselves regulated by different people, having different rules, and so on, and some, from what I can tell, not regulated at all, full stop. So I think it is very important to modernize and move forward. Certainly, the FSA system in London has lots of positives to it. On the other hand, if you step back for a second, even that system obviously did not save their economy from the consequences of what is going on now. So I think you want to have functional based regulation, and as I think Mr. Zubrow alluded to, systemic institutions, i.e., institutions who have global scale, you need to really have people who look after them as an entirety and understand their overall operations. We think that is important. Senator Crapo. Thank you. Dr. Wachter. Ms. Wachter. Yes, it is critically important going forward for the long run to restructure our regulatory system, and there is regulatory arbitrage, and that needs to be part of the issue that is addressed. And I do want to here agree again with Mr. Eakes. The insufficient oversight and lack of reserving for CDS issued by AIG was a critical part of the problem that we are facing today. I want to make two other points. One point, this is a global phenomenon now. We are going to need global cooperation on regulation, and it cannot just be in one nation because, as we see, capital flows are global. Second, again, FSA was not a cure-all. The U.K. had over the same period, not as much as we, but erosion of credit standards, and FSA did not see that happening or could not stop it; and at the same time as erosion of credit standards, a housing asset boom. This U.K. crisis is similar to the Japan crisis, is similar to the Asian financial crisis. So it is not just a better environment for regulation, a better structure, but it is better regulation. Senator Crapo. Thank you. Ms. Finucane. I think I will just reiterate what I think you have heard from the other banks, which is we do believe that there needs to be greater transparency for a regulator. I am not sure that we would support one super regulator. Maybe there is too much risk in that, and there are complications. Consumer regulation versus capital markets might be too big a breadth, so I think we would consider that. The last thing I would just say is clearly from the banks, I think the bank holding company structure has been what seems to be victorious in the long run, so we would start from there as well. Senator Crapo. Thank you. " CHRG-110shrg50409--55 Mr. Bernanke," Well, a part of what has been happening--and this goes back to Senator Menendez's question about the role of the subprime crisis and so on--is that there was, if you will, a credit boom or a credit bubble where there was an overextension of credit in a lot of areas. There has been a big reversal of attitudes. Banks and other financial institutions are scaling back on their credit risk. They are deleveraging. They are raising capital. And that adjustment process is part of what is happening now that is creating the drag on economic growth. So it is harder to get a mortgage, it is harder to get a business loan. And until we come to a more stable situation where banks are comfortable with their credit standards and their balance sheets, the leveraging process is going to continue and is part of what we are seeing here. Senator Tester. And very quickly, because my time is over, do you--I mean, we have heard figures of 150 banks potentially going down because, I assume, of this adjustment that you just talked about. Do you guys have any projections on what kind of impact banking institutions going down, how many there potentially could be in the next year or do you not want to comment on that? " CHRG-111hhrg48868--94 The Chairman," This may be beyond the scope of what the GAO got involved in, but you know, Ms. Williams, that the rationale for the intervention by the Federal Reserve was to prevent systemic risk if there was a total collapse. Does the GAO have any opinion on whether or not that was a valid fear or was that beyond the scope of your mandate? Ms. Williams. It really is beyond the scope of our study. We were attempting to identify what the goal was. " fcic_final_report_full--490 III. THE U.S. GOVERNMENT ’S ROLE IN FOSTERING THE GROWTH OF THE NTM MARKET The preceding section of this dissenting statement described the damage that was done to the financial system by the unprecedented number of defaults and delinquencies that occurred among the 27 million NTMs that were present there in 2008. Given the damage they caused, the most important question about the financial crisis is why so many low quality mortgages were created. Another way to state this question is to ask why mortgage standards declined so substantially before and during the 1997-2007 bubble, allowing so many NTMs to be created. This massive and unprecedented change in underwriting standards had to have a cause—some factor that was present during the 1990s and thereafter that was not present in any earlier period. Part III addresses this fundamental question. The conventional explanation for the financial crisis is the one given by Fed Chairman Bernanke in the same speech at Morehouse College quoted at the outset of Part II: Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain . One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done, involving, for example, little or no down payment by the borrower or insuffi cient consideration by the lender of the borrower’s ability to make the monthly payments . Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation. [Emphasis supplied] 59 In other words, the liquidity in the world financial market caused U.S. banks to compete for borrowers by lowering their underwriting standards for mortgages and other loans. Lenders became careless. Regulators failed. Unregulated originators made bad loans. One has to ask: is it plausible that banks would compete for borrowers by lowering their mortgage standards? Mortgage originators—whether S&Ls, commercial banks, mortgage banks or unregulated brokers—have been competing for 100 years. That competition involved offering the lowest rates and the most benefits to potential borrowers. It did not, however, generally result in 59 Speech at Morehead College April 14, 2009. 485 or involve the weakening of underwriting standards. Those standards—what made up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to homebuyers who could provide a downpayment of at least 10-to-20 percent and had good credit records, jobs and steady incomes. Because of its inherent quality, this loan was known as a prime mortgage. CHRG-110hhrg46593--39 Secretary Paulson," Well, then let me be very, very forthcoming to you. Because the intent of the TARP, when we came here, was to stabilize the system to prevent a collapse. That is what we talked about; we talked about the financial system. And what I have said today here, I was very careful when I said what turning the corner meant. I said I believe that meant that we have stabilized the financial system and prevented a collapse. I was also very clear in saying we have a lot of work ahead of us, and the recovery of the financial system is a lot of work to get the markets going again. So now let's look at the TARP. When we came here, the purpose was that: getting capital in the financial system. We came forward with--the strategy was buying illiquid assets. That was the strategy. The purpose was clear. We worked with Congress, and we wanted those additional authorities. Don't forever believe that we did not want--we were working to maximize the authorities we have and the tools we have. And when the facts changed and the circumstances changed, we changed the strategy. We didn't implement a flawed strategy; we implemented a strategy that worked. Now, to get to your question--and I think what the American people need, in terms of confidence, is a realistic assessment of where we are, sticking with what our objective was to begin with. Now, look at the autos. Again, you haven't seen any lack of consistency on my part with regard to the autos. The TARP was aimed at the financial system. That is what the purpose is. That is what we talked about with the TARP. Okay, now, in terms of autos, I have said repeatedly I think it would be not a good thing, it would be something to be avoided, having one of the auto companies fail, particularly during this period of time. We have asked Congress--you know, and Congress has worked to deal with this. But I believe that any solution must be a solution that leads to long-term viability, sustainable viability here. And so, again, I don't see this as the purpose of the TARP. Congress passed legislation that dealt with the financial system's stability. And, again, you know, there are other ways. And, you know, you also appropriated money for the auto industry and the Department of Energy bill. Another alternative may be to modify that. " CHRG-110hhrg46596--349 Mr. Kashkari," Congressman, when we talk about the regulators assessing viability, I am speaking about the Capital Purchase Program. It is $250 billion for a healthy bank. AIG was a separate program. That is the systemically significant failing institution program, where the regulators were not assessing viability, the regulators were assessing what would happen if we had allowed them to collapse. Mr. Miller of North Carolina. That was my impression as well, that it had nothing to do with viability. And that was the gist of your answers to Mr. Clay's questions a couple of minutes ago. There was a story in The New York Times on November 11th that talked about the systemic risk and about making good on derivative contracts by AIG. The usual rule in the economy is when you do business with somebody and you can't perform the contracts, you lose. But those who were in derivative contracts with AIG aren't losing; that the money that we put into AIG is being used to pay them in full. Lynn Turner was quoted as saying, ``We are funding someone on the other side.'' And the article said that neither AIG nor the Treasury was identifying who the significant counterparties were for AIG. Did The New York Times just not look on your Web site? Have you identified who those counterparties are? And if you have not, why have you not? " CHRG-110hhrg45625--156 Mr. Bernanke," Well, first, I am not comparing the current situation with the Great Depression, but a lot of what you said, there is some relevance. In particular, the Great Depression was triggered by a series of financial crises. Stock market crash, collapse of the banks, and the effects on credit and on money were a very big part of what happened then. Now we have a very, very different financial system. It is much more sophisticated and complicated, it is much more global. We also have a much bigger and more diversified economy. But what that episode illustrates, as do many other episodes in history, is that when the financial system becomes dysfunctional, the effects on the real economy are very palpable. Now you point to other things, like preventing free trade and excessive regulation, etc. Those things also have adverse effects on the economy. But I would say that the financial crisis was fairly central in that Depression episode. It is not a question of abandoning free markets. I think right now we have to deal with the fact that mistakes were made by both the private and public sectors. We need to put that fire out. Going forward, we need to figure out a good balance between market forces that allows for innovation and growth, but with an appropriate balance and market-disciplined regulatory structure that is appropriate and will work to avoid these kind of situations arising in the future. " FinancialCrisisInquiry--12 Excessive leverage by many U.S. investment banks, foreign banks, commercial banks, and even consumers pervaded the system. This included hedge funds, private equity firms banks and non-banks using off-balance sheet vehicles. There were also several structural risks and imbalances that grew in the lead-up to the crisis. There was an over reliance on short- term financing to support illiquid long-term assets, and over time, certain financing terms became too lax. Another factor in the crisis was clearly a regulatory system. I want to be clear I do not believe the regulators. While they obviously have a critical role to play, the responsibility for companies’ actions rest solely on the companies’ management. But we should also look to see what could have been done better in the regulatory system. We have known that our system is poorly organized with overlapping responsibilities. Many regulators did not have the statutory authority they needed to address the failure of large global financial companies. Much of the mortgage business was not regulated or lacked uniform treatment. Basel II capital standards allowed too much leverage in investment banks and other firms and not incorporate liquidity at all. The extraordinary growth and high leverage of the GSEs also added to the risk. We also learned that our system has many embedded pro-cyclical biases, a number of which proved harmful in times of economic stress. Loan loss reserving methodologies caused reserves to be at their lowest levels at a time when high provisioning might be needed the most. Certain regulatory capital standards are also pro-cyclical, and continuous downgrades by credit agencies also required many financial institutions to raise more capital. When all is said and done, I believe it will be found that macro economic factors will have been some of the fundamental underlying cause of the crisis. Huge trade and financing imbalances caused large distortions in interest rates and consumption. As for J.P. Morgan Chase, the last year and a half was the most challenging period in our company’s history. I’m immensely proud of the way our employees continued to serve our customers through this difficult time. Throughout the financial crisis, we never posted a quarterly loss. We served as a safe haven for depositors. We worked closely with the federal government. And we remained an active lender. CHRG-111hhrg53240--6 Mr. Bachus," I thank the chairman. I thank you for convening this hearing on consumer protection and the role of the Federal Reserve. And I would like to personally welcome Governor Elizabeth Duke. I guess ``welcome'' is a good word. You are welcome. Obviously, you have a difficult task any time you face a subcommittee. And I am not sure who selected you as the one to come up here, but I think it was a very capable decision. At one point in her distinguished career, she was the head of the community banking for one of our long-based Birmingham banks. And I thank you for being here. As we heard in this morning's hearing, and it is likely to come out in this hearing, proponents of the Administration's proposal to create a Consumer Financial Protection Agency are contending that there was a massive failure in consumer protection on the part of the Federal Reserve, and that failure led to the collapse of the global economy. I think that is an oversimplification and unduly unjust criticism. And there is lots to criticize about the Fed's response to the growth and the collapse of the subprime mortgage market, as well as the agency's handling of the credit crisis and the turmoil in the financial markets. In addition, we all agree that comprehensive reform of our financial regulatory system is needed. But I think it is, or should be, clear to all of us that last September, the challenges that the central bank faced were without precedent and that Chairman Bernanke and the Federal Reserve, in combination with the other regulators, the Administration, and the Congress acted with good intentions, and I believe averted a much more catastrophic economic collapse. I am not sure this Congress and the people we represent fully realize that they did some very good work. Both the Democrats' regulatory reform proposal and a plan we have put forth strips the Federal Reserve of its consumer protection mandate. And it does that although--with both the subprime lending regulations in 2007, and the credit card regulations of the Fed advanced in 2008 were very good. In fact, in a bipartisan way, both the chairman of the full committee and I as ranking member and most of the members complimented you on that work and, I think, had--I think they were very good. The difference in the Republican plan is that it streamlines and consolidates the functions of the four bank regulators, including consumer protection, into a single umbrella agency; and this creates clear lines of accountability and prevents regulatory authorities from passing the buck. In contrast, the Democrats' plan adds a massive new layer of bureaucracy with broad undefined and arbitrary powers to a brand-new agency with absolutely no experience. It is a plan that continues the kind of turf battles that undermine rather than promote effective consumer protection. In closing, let me say that I understand that Governor Duke will be suggesting some other approaches and I think other approaches probably will carry the day, given the Fed's extensive regulatory expertise and their recent successes in this regard, we have a responsibility to carefully consider them and judge them on the merits. Thank you, Mr. Chairman. " CHRG-111hhrg53234--153 Mr. Meyer," Thank you very much. And thank you for giving me this opportunity to testify before you this afternoon. The independence of central banks with respect to monetary policy is absolutely essential. Policies that are focused on financial stability, on the other hand, require a more cooperative approach, including, in the United States, the central bank, functional regulators of banks and nonbank subsidiaries, and a clear role for the Treasury. But there needs to be a bright line between the more cooperative approach to financial stability policy and the independence of the Fed with respect to monetary policy. Supervising systemically important financial institutions is, of course, a central part of financial stability policy. I don't believe there is a conflict between the current or newly proposed role for the Fed as systemic risk regulator and the traditional role as independent authority on monetary policy. But then, again, I do not see the Treasury proposal as conferring on the Fed vast new authority as systemic risk regulator. The Fed is already bank holding company or consolidated supervisor for all financial institutions that have a bank. Of the systemically important financial institutions today, most are already bank holding companies. Other institutions that might be designated systemically important could be a couple of insurance companies, a few other large financial firms that are not supervised today, and, in principle but not likely in practice initially, very large and highly leveraged hedge funds. It also should be recognized that there are functional supervisors of the bank and the investment banking and insurance subsidiaries of bank holding companies, and they do much of the heavy lifting in overseeing the risks in their respective parts of the bank holding company. There has always been a debate about whether the Fed's role in bank and bank holding company supervision complements or conflicts with its role in monetary policy. One of the cases for a complementary role is that the Fed's responsibility as hands-on supervisor of some banks and all bank holding companies provides firsthand information about the state of the banking sector, which can be a valuable input into the assessment of the economic outlook, especially in periods of extreme stress like today. The counterargument is that the Fed's concern for the health of the banking system, derived from its role as bank and bank holding company supervisor, can encourage the Fed at times to sacrifice its macro-objectives in order to help the banking system when it is ailing. When I was on the Board, I never witnessed any conflict in practice between these two roles. I don't see why the debate should change as a result of the marginal increase in supervisory reach under the Treasury proposal. A basic premise for my view is that a central bank should always have a hands-on role in bank supervision. First, central banks always have at least an informal responsibility for monitoring systemic risk, and the banking system is a major source of such risk. Second, the central bank is always a source of liquidity to and lending to banks, and must therefore have firsthand knowledge of their creditworthiness, and this is especially true at times of stress. Finally, the central bank will always be called upon to cooperate with Treasury at times of interventions in particular institutions where the Fed will sometimes provide the liquidity, and Treasury should take all the credit risk. Given the Fed's role already as consolidated supervisor of most systemically important financial institutions, the choice may be whether to remove the Fed from its role in banking supervision altogether, or expand its role modestly to cover all systemically important financial institutions. This seems like an obvious choice for me. I also don't see the need to isolate these two functions from each other within the Federal Reserve, at least more than they are today. Now, if the Fed were getting substantial new powers as systemic regulator and had to devote considerable new resources to this new responsibility, then it seems reasonable that it should give up some of its current responsibilities. If something is to be given up, the most obvious choice is consumer protection and community affairs. These are not seen around the world as core responsibilities of central banks. In addition, the case for giving up consumer protection and community affairs is strengthened by the Treasury proposal to unify these responsibilities in a single agency. The bottom line is that the Fed is the best choice for consolidated supervision of systemically important financial institutions in addition to its role as independent authority on monetary policy, and these joint roles are much more complementary than they are conflicting. Indeed, there is a very natural fit between these two roles. Thank you. [The prepared statement of Dr. Meyer can be found on page 77 of the appendix.] " CHRG-111shrg49488--103 Mr. Nason," That is a great and very difficult question. If you go back to Bear Stearns, Bear Stearns was under a consolidated supervisory system that was administered by the SEC, so they did have liquidity and capital requirements that were different than the banking system, but they were under some type of conglomerate supervision. I think generally if you are a systemically important institution, it is hard to argue that you should not be under some type of systemic supervision to prevent hurting the general economy. What gets harder is where do you draw the line between which types of institutions gets safety and soundness supervision and which do not? For example, a very easy case is some hedge funds, you can make an argument that they are systemically important because of their size or concentration in particular markets. They could probably be subjected to some type of supervision. Should all hedge funds be subjected to that type of supervision? The case is harder the smaller they become. So the way that we cut it in the Blueprint is that institutions would all need to be licensed, chartered, and under the supervision of our systemic regulator. But that type of systemic regulation was different than traditional prudential safety and soundness regulation. Senator Collins. It, of course, gets very complicated very quickly because if you designate certain financial institutions as systemically important and, thus, make them subject to safety and soundness regulation, you are also sending a message that they are too big to fail--a very bad message to send because then you are creating moral hazard. This is so complicated to figure out the right answer here, but I do think it is significant that the Canadian banks, with their higher capital requirements and the ability to hold lower-return assets, lower-risk assets, and lower leverage ratios compared to American banks, were healthier. They did not fail. So, clearly, there has got to be a lesson for us there. Mr. Clark, I know we are running out of time, but I do want to talk to you further about the lending practices. I completely agree with my colleague from Missouri that part of the problem with the American mortgage system was that risk and responsibility were divorced, so you had a mortgage broker who was making the loan, gets his or her cut, then sells it to the bank, which gets its cut, which then sells it to the secondary market. Everyone is getting a financial reward, but ultimately no one is responsible for the mortgage if it goes bad. There is no skin in the game, which I think is a big problem, although difficult to solve because of the liquidity issues that Mr. Nason raised. But there are other key differences as well that you talked to me about when we were in my office, and they had to do with downpayment levels, mortgage insurance, and deductibility of interest. Could you discuss some of the differences between Canadian and American mortgage lending? " CHRG-111hhrg54867--60 Mr. Gutierrez," The time of the gentleman has expired. I recognize myself for 5 minutes. Secretary Geithner, a year ago, you were--Mr. Paulson and Mr. Bernanke, Lehman Brothers was about to collapse and go into bankruptcy. How much did the 30:1 leverage have to do with Lehman Brothers and its collapse? " CHRG-111hhrg55814--158 Secretary Geithner," Congressman, there is one part of that quote you omitted, which is, I said, monetary policy around the world was too loose, too long. But I think it's very, you're right to say that this crisis was not just about the judgment of individuals to borrow too much or banks to lend too much. It wasn't just about failures in regulation supervision. It was partly because you had a set of policies pursued around the world that created a large credit boom, asset price boom. And I think you're right to emphasis that getting those judgments better in the future is an important part of the solution. Dr. Paul. Okay. On the issue that it's worldwide and we don't have the full responsibility, there's a big issue when you are running and managing the reserve currency in the world and other countries are willing to take those dollars and use those as their asset and expand and monetize their own debt, so it's all, we're not locked in a narrow economy, it's a worldwide economy and it's our dollar policy and our spending habits and our debt that really generated this worldwide crisis. That's why it's not a national crisis; it's a worldwide crisis. " CHRG-111shrg54789--121 Mr. Yingling," Thank you, Mr. Chairman. I appreciate your introduction. It may be my high-water mark this morning, but I really appreciate it. Thank you, Senator Shelby and Members of the Committee. It would be expected that your Committee would look at this proposal from the point of view of consumers, who should be paramount in your consideration. However, the ABA believes that this proposal is not, unfortunately, the best approach for consumers and will actually undermine consumer choice, competition, and the availability of credit. But I would also ask you to look at this issue from an additional point of view. While banks of all sizes would be negatively impacted, think of your local community banks and credit unions, for that matter. These banks never made one subprime loan, yet these community banks have found the Administration proposing a potentially massive new regulatory burden. While the shadow banking industry, which includes those most responsible for the crisis, is covered by the new agency, their regulatory and enforcement burden is, based on history, likely to be much less. The proposed new agency will rely first on State enforcement, and yet we all know that the budgets for such State enforcement are completely inadequate to do the job. Therefore, innocent community banks will have greatly increased fees to fund a system that falls disproportionately and unfairly on them. The agency would have vast and unprecedented authority to regulate in detail all bank consumer products. The agency is even instructed to create its own products and mandate that banks offer them. And Senator Corker, this is the part that was missing from your discussion with the Secretary. The agency is urged to give the products it designs regulatory preference over the bank's own products. The agency is even encouraged to require a statement by the consumer acknowledging that the consumer was offered and turned down the Government's product first, and every nongovernment product would be subject to more regulation than the Government product. Community banks, whether it fits their business model or not, would be required to offer Government-designed products, which would be given preference over their own products. On disclosure, the proposal goes beyond simplification, which is needed, to require that all bank communication with consumers be, quote, ``reasonable.'' This is a term that is so vague that no banker and no lawyer would know what to do with it. But not to worry. The proposal offers to allow thousands of banks and thousands of nonbanks to preclear communications with the agency. So before a community bank runs an ad in the local newspaper or sends a customer a letter, it would need to preclear it with the new agency. All this cost, regulation, conflicting requirements, and uncertainty would be placed on community banks that in no way contributed to the crisis. The fundamental flaw in the proposal is that consumer regulation and safety and soundness regulation are two sides of the same coin. You cannot separate a business from its products. The simple example is check-hold periods. Customers would like the shortest possible hold, but this desire needs to be balanced with complex operational issues in check clearing and with the threat of fraud, which costs banks and ultimately consumers billions of dollars. The breadth of this proposal is, in many respects, shocking. Every financial consumer law Congress has ever enacted and every existing regulation is rendered to a large degree moot, mere floors. No one will know for years what the new rules are and what they mean. When developing products and making loans, providers must rely on legal rules of the road, but now everything will be changed, subject to vast and vague powers of this new agency and anything States may want to add. This problem is exacerbated by the use of new, untested terminology, again such as the requirement that disclosures be reasonable, whatever that means, which will take years to be defined in regulation and court decisions. If industry has no idea what the rules will be, what the terms will mean, and how broad legal liability will be, there is no doubt what will happen. Innovative products will be put on the shelf and credit will be less available. We agree that improvements need to be made. The great majority of the problems occurred outside the highly regulated traditional banks, but there are legitimate issues relating to banks, as well. We want to work with Congress to address these concerns and implement improvements, and in that regard, my written testimony outlines concepts that should be considered. I do want to put one fact back on the table that Secretary Barr referred to, and that is as we look at this and as we look at preemption, as we look at where the problems were, 94--this is the Administration's own numbers--94 percent of the high-cost mortgages occurred outside the traditional banking industry in areas that are either unregulated, lightly regulated, or in theory supposed to be regulated at the State level. Thank you, Mr. Chairman. Senator Reed [presiding]. Thank you, Mr. Yingling. Mr. Plunkett, please.STATEMENT OF TRAVIS B. PLUNKETT, LEGISLATIVE DIRECTOR, CONSUMER CHRG-111hhrg53244--198 Mr. Foster," The title of this hearing involves monetary policy, but the subject seems to be the overall health of the economy. And I am struck by the underemphasis in this discussion of the importance of the real estate market, which I believe was the dominant driving force in this economic downturn. Much more wealth has been destroyed by the drop in real estate values than in the stock market or the near collapse of our banking system. And the same was also true of the Great Depression, where more wealth was destroyed in the real estate bust following the stock market crash than the stock market crash itself. And so I have sort of two questions along these lines. First, do you think it might be appropriate to have more information in future releases of this about the real estate market and projections? And also, if you could say a little bit about what the Fed does in terms of projecting. How much manpower do you put into looking forward projections of the real estate market, given what I believe is of extreme importance to future economic conditions. " CHRG-111hhrg53238--52 Mr. Menzies," Thank you, Mr. Chairman, and members of the committee. As you mentioned, I am president and CEO of Easton Bank and Trust, just 42 miles east of here. We are a $150 million community bank, and I am honored to be the volunteer chairman of the Independent Community Bankers of America, who represent 5,000 community-bank-only members at this important hearing. Less than a year ago, due to the failure of our Nation's largest institutions to adequately manage their highly risky activities, key elements of the Nation's financial system nearly collapsed. Even though our system of locally owned and controlled community banks were not in similar danger, the resulting recession and credit crunch has now impacted the cornerstone of our local economies: community banks. This was, as you know, a crisis driven by a few unmanageable financial entities that nearly destroyed our equity markets, our real estate markets, our consumer loan markets and the global finance markets, and cost American consumers over $7 trillion in net worth. ICBA commends you and President Obama for taking the next step to reduce the chances that taking risky and irresponsible behavior by large or unregulated institutions will ever again lead us into economic calamity. ICBA supports identifying specific institutions that may pose systemic risk and systemic danger and subjecting them to stronger supervision, capital, and liquidity requirements. Our economy needs more than just an early warning system. It needs a real cop on the beat. The President's plan could be enhanced by assessing fees on systemically dangerous holding companies for their supervisory costs and to fund, in advance, not after the fact, a new systemic risk fund. ICBA also strongly supports H.R. 2897, introduced by Representative Gutierrez. This bill would impose an additional fee on banks affiliated with systemically dangerous holding companies and better account for the risk these banks pose, while strengthening the deposit insurance fund. These strong measures are not meant to punish those institutions for being large, but to guard against the risk they do create. These large institutions would be held accountable and discouraged from becoming too-big-to-fail. But to truly prevent the kind of financial meltdown we faced last fall and to truly protect consumers, the plan must go further. It should direct systemic-risk authorities to develop procedures to downsize the too-big-to-fail institutions in an orderly way. This will enhance the diversity and flexibility of our Nation's financial system, which has proven extremely valuable in the current crisis. In that regard, ICBA is pleased the Administration plan maintains the State bank system and believes that any bill should retain the thrift charter. Both charters enable community banks to follow business plans that are best adapted to their local markets and pose no systemic risk. Unregulated individuals and companies perpetrated serious abuses on millions of American consumers. Community banks already do their utmost to serve consumers and comply with consumer protections. Consumers should be protected. Any new legislation must ensure that unregulated or unsupervised people in institutions are subject to examinations just like community banks. My written testimony outlines serious challenges with the proposed Consumer Protection Agency, which we oppose in its current form. For example, we strongly believe that rural writing and supervision for community banks should remain with agencies that also must take safety and soundness into account. Clearly a financial institution that does not adhere to consumer protection rules also has safety and soundness problems. And we, too, are grateful, Mr. Chairman, with your statement that you are committed to preventing conflict between safety and soundness and consumer protection. If we truly want to protect consumers, Congress must enact legislation that effectively ends the too-big-to-fail system, because these institutions are too-big-to-manage and too-big-to-supervise. And we are grateful for your hearings on Monday, Mr. Chairman. ICBA urges Congress to add an Assistant Secretary for Community Financial Institutions at the Treasury Department to provide an internal voice for Main Street concerns. H.R. 2676, introduced by Representative Dennis Cardoza, will provide that important balance between Wall Street and Main Street within the Treasury. Mr. Chairman, community banks are the very fabric of our Nation. We fund growth, we drive new business. Over half of all the small business loans under $100,000 in America are made by community banks. We help families buy homes and finance educations. We, too, are victims of the current financial situation, but we are committed to help the people and businesses of our communities, and we will be a significant force in the economic recovery. Thank you, sir. [The prepared statement of Mr. Menzies can be found on page 158 of the appendix.] " CHRG-111shrg56376--33 Chairman Dodd," Thank you very much. Senator Brown. Senator Brown. Thank you. I was a little surprised by Senator Shelby's question, considering the positions that you have all taken. Let me look at this in kind of a different way. The public has a general understanding. The investing public and the victims of this financial disaster, which is my whole State and most of this country, has a general understanding that regulation of financial institutions, putting it mildly, fell far short. Some have the belief that the most, I think the most egregious institutions found an agency that was too easy on them. In Washington, we call that regulator shopping. They just think that the Government, for whatever reason, was too easy on Wall Street greed. And I hear each of you. There may be some turf issues, and that may be a cynical way to look at it and I apologize if that is the way you take it, but I hear the--I see the President's plan, the President's proposed bank supervision framework. I hear each of you disputing major parts of it. How would you explain to the American public what the next step is? How do we fill the financial gaps in our financial regulatory system if consolidation of regulators is not the best move? How do you explain to the public why four very smart people playing very important roles in our financial institution regulatory system and an Administration that, I think, has equally smart people that understand this, why is there not more agreement? How do you explain in understandable terms, if you were talking directly to the American people now, not to this Committee, what we should do to fill these gaps so these kinds of egregious, awful things don't happen again? I will start with you, Ms. Bair. Ms. Bair. Well, I think there was arbitrage, but it was between the bank and the nonbank sectors. It was excess leverage with investment banks and hedge funds and other types of vehicles versus the higher leverage in risk-based capital requirements that we had for commercial banks. On consumer protection, it was third-party mortgage originators that were not affiliated with insured depository institutions originating loans being funded by Wall Street funding vehicles. The third-party mortgage originators were pretty much outside of any type of prudential or consumer protection standards that were within the purview of the banking regulators. So I think it is unfortunate the word ``bank'' is used for just about every institution, but in my world, a bank is an FDIC-insured institution. While we all made mistakes, the insured depository institution sector has held up pretty well. This is why you saw in December so many financial companies fleeing to become bank holding companies and trying to grow their insured institutions, because that was the sector that was left standing, which is hard for the FDIC because our exposure has increased significantly. We have tried to do the things we need to do to stabilize the system. But, this has increased our exposure significantly. As I have testified before, the arbitrage is between the banks and the nonbanks. Having a consumer agency with a focus especially on examination and enforcement of the nonbank sector and having a Systemic Risk Council that would have the authority to define systemic issues or systemic institutions, whether or not they voluntarily want to come in under the more stringent regulatory regime we have for banks and bank holding companies. The arbitrage was between the bank and the nonbank sectors. It was not among different types of bank charters, and certainly not between the choice of a State or Federal charter. There are 8,000 community banks in this country. Most of them have a State charter, so consequently, we regulate about 5,000 banks. I don't think they contributed to this, but you have seen traditional resistance among community banks to regulatory consolidation for fear, frankly, which I share, that inevitably there would be a regulatory viewpoint that would be dominated by the larger institutions if everyone was lumped in together. There is a valid reason for State charters. The community banks and State-chartered community banks tend to be more local in their interest and how they conduct their lending. To try to draw that issue into the much larger problems we had with arbitrage between banks and nonbanks and then the lack of regulation of derivatives, I think, is misguided and is not where you should be focusing your efforts or the American public should be focusing its efforts. Senator Brown. Mr. Dugan, your thoughts? " fcic_final_report_full--562 Chapter 2 1. Ben Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, session 1, September 2, 2010, p. 2. 2. Alan Greenspan, “The Evolution of Banking in a Market Economy,” remarks at the Annual Confer- ence of the Association of Private Enterprise Education, Arlington, Virginia, April 12, 1997. 3. Charles Calomiris and Gary Gorton, “The Origins of Banking Panics: Models, Facts, and Bank Regulation,” in Calomiris, U.S. Bank Deregulation in Historical Perspective (Cambridge: Cambridge Uni- versity Press, 2000), pp. 98–100. Prior to the end of the Civil War, banks issued notes instead of holding deposits. Runs on that system occurred in 1814, 1819, 1837, 1839, 1857, and 1861 (ibid., pp. 98–99). 4. R. Alton Gilbert, “Requiem for Regulation Q: What It Did and Why It Passed Away,” Federal Re- serve Bank of St. Louis Review 68, no. 2 (February 1986): 23. 5. FCIC, “Preliminary Staff Report: Shadow Banking and the Financial Crisis,” May 4, 2010, pp. 18– 25. 6. Arthur E. Wilmarth Jr., “The Transformation of the U.S. Financial Services Industry, 1975–2000: Competition, Consolidation, and Increased Risks,” University of Illinois Law Review (2002): 239–40. 7. Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in Financial Markets and Financial Crises, ed. R. Glenn Hubbard (Chicago: University of Chicago Press, 1991), p. 99; Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 236. 8. Federal Reserve Board Flow of Funds Release, table L.208. Accessed December 29, 2010. 9. Kenneth Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve Bank of New York Economic Policy Review 12, no. 1 (May 2006): 32–33, 38–39 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=918498). To implement monetary policy, the Fed- eral Reserve Bank of New York uses the repo market: it sets interest rates by borrowing Treasuries from and lending them to securities firms, many of which are units of commercial banks. 10. Alan Blinder, interview by FCIC, September 17, 2010. 11. Paul Volcker, interview by FCIC, October 11, 2010. 12. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the Council on Foreign Relations, November 19, 2002. 13. Richard C. Breeden, interview by FCIC, October 14, 2010. 14. Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 241 and n. 102. 15. Thereafter, banks were only required to lend on collateral and set terms based upon what the mar- ket was offering. They also could not lend more than 10% of their capital to one subsidiary or more than 20% to all subsidiaries. Order Approving Applications to Engage in Limited Underwriting and Dealing in Certain Securities,” Federal Reserve Bulletin 73, no. 6 (Jul. 1987): 473–508; “Revenue Limit on Bank-Inel- igible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Se- curities,” Federal Register 61, no. 251 (Dec. 30, 1996), 68750–56. 16. Julie L. Williams and Mark P. Jacobsen, “The Business of Banking: Looking to the Future,” Busi- ness Lawyer 50 (May 1995): 798. 17. Fed Chairman Alan Greenspan, prepared testimony before the House Committee on Banking and Financial Services, H.R. 10, the Financial Services Competitiveness Act of 1997, 105th Cong., 1st sess., May 22, 1997. 18. FCIC staff calculations. 19. FCIC staff calculations. 20. FCIC staff calculations using First American/CoreLogic, National HPI Single-Family Combined (SFC). 21. This data series is relatively new. Those series available before 2009 showed no year-over-year na- tional house price decline. First American/CoreLogic, National HPI Single-Family Combined (SFC). 22. For a general overview of the banking and thrift crisis of the 1980s, see FDIC, History of the Eight- ies: Lessons for the Future, vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s (Washington, DC: Federal Deposit Insurance Corporation, 1997). 559 23. Specifically, between 1980 and 1994, 1,617 federally insured banks with $302.6 billion in assets and 1,295 savings and loans with $621 billion in assets either closed or received FDIC or FSLIC assis- tance. See Federal Deposit Insurance Corp., Managing the Crisis: The FDIC and RTC Experience, 1980– 1994 (Aug. 1998), pp. 4, 5. 24. William K. Black, Associate Professor of Economics and Law, University of Missouri–Kansas City, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 4. And see Kitty Calavita, Henry N. Pontell, and Robert H. Till- man, Big Money Crime: Fraud and Politics in the Savings and Loan Crisis (Berkeley: University of Califor- nia Press, 1997), p. 28. 25. FDIC, History of the Eighties: Lessons for the Future, 1:39. 26. U.S. Treasury Department, “Modernizing the Financial System: Recommendations for Safer, More FinancialCrisisInquiry--230 GEORGIOU: Some certain institutions. Right. CHAIRMAN ANGELIDES: Mr. Thomas, you want to take... VICE CHAIRMAN THOMAS: Mr. Chairman, I’ll take a—a minute, and then ask the question in terms of the distribution of the commercial loans vis-à-vis subprime and the rest. We had big banks in. Is there a greater strain on community banks in terms of the commercial loans versus the subprime being consolidated, and taken to a higher level? And that I think is something that should cause a lot of concern. Because if you get a collapse at that level, and we haven’t seen the response to recover or protect at that level, you’re going to have a far more fundamental erosion of locales than you would based upon what happened in the subprime. GEORGIOU: Do you agree with that? ROSEN: I’d say there’s—what you’re really talking about is the construction and development loans. There’s $550 billion of that outstanding, and that is at the smaller bank level. ROSEN: And—and we’ve already seen 170 banks—I guess there’s five or 600 more. VICE CHAIRMAN THOMAS: Oh, yes. ROSEN: And it’s a big number. And there really isn’t the policy response to this other than close them. FinancialCrisisInquiry--391 SOLOMON: Thank you, Chairman—Vice Chairman Angelides and Vice Chairman Thomas and members of the commission. Thank you for asking me to appear before the commission. Before I begin, I want to commend the leadership of the House and the Senate for creating this bipartisan commission to examine the causes of the current financial and economic crisis in the United States. When I entered Wall Street in the early 1960s, security firms and commercial banks had not changed much since the 1930s. Stock ownership was not widespread. Pension funds and endowments did not invest broadly. January 13, 2010 The average volume on the New York Stock Exchange was about the same as 40 years earlier. There wasn’t a large public bond market. The business of commercial banks was lending. The securities firms were usually private partnerships. Investment funds were separate from banks and security firms. I’ve been afforded the opportunity over 50 years to observe the dramatic changes in the financial world from a number of perspectives. My career at Lehman Brothers spanned 29 years. I rose to vice chairman of the firm in the 1980s and was co-chairman of the Investment Banking Division and chairman of the Merchant Banking Division. I have held financial positions in the public sector, as deputy mayor of the city of New York during the financial crisis of the 1970s, and as counselor to the secretary of the treasury in the Carter administration. I have been active on corporate boards, not-for- profit foundation boards, where I’ve been involved in investment decisions. For the past 21 years, I have been chairman of the Peter J. Solomon Company, a private independent investment bank and member of FINRA. Our firm is a throwback to the era of the early 1960s when investment banks functioned as agents and fiduciaries, advising their corporate clients on strategic and financial matters such as mergers and raising of debt and equity capital. Unlike today’s diversified banks, we do not act as principals, nor do we take proprietary positions. We do not trade and we do not lend. For a moment, let me set the scene of the 1960s investment bank. The important partners of Lehman Brothers sat in one large room on the third floor of Number One William Street, the firm’s headquarters. Their partners congregated there not because they were eager to socialize, an open room afforded and enabled the partners to overhear, interact and monitor the activities and particularly the commitments of their partners. Each partner could commit the entire assets of the partnership. You may be interested to know that Lehman’s capital at the time of incorporation in 1970 was $10 million. The wealth and thus the liability of the partners like Robert Lehman exceeded the firm’s stated capital by multiples. Since they were personally liable as partners, they took risk very seriously. January 13, 2010 The financial community changed dramatically in the 1980s. Incorporation and public ownership by security firms enabled them to compete with commercial banks. Innovations like junk bonds, for example, allowed securities firms to lend to non- investment-grade companies. All the firms accelerated the push into global markets, far- flung operations, mathematical modeling, proprietary dealings in debt and equity, and the growing use of leverage and derivatives to hedge risk. As the commission investigates the causes of the 2007-2009 crisis, it is important to remember that market crises occur periodically. To name a few in the last 20 years, the markets have been roiled by Asian, Russian and Mexican crises, the crash of ‘87, the collapse of long-term capital, the 2000 dot-com bubble collapse, and of course, Enron’s bankruptcy. The question before the commission is: What events or actions occurred within the capital markets or the environment which allowed this crisis to become a debacle? First, every legislative and regulatory move in the last 20 years has been towards obliterating the distinctions between providers of financial services and freeing the capital markets. The shining example, of course, is the Gramm-Leach- Bliley Act of 1999, which removed the last vestiges of Glass-Steagall. Second, financial institutions used the more lenient regulatory environment to build scale and extend scope. Citigroup, Bank of America, J.P. Morgan, and Lehman Brothers, for instance, acquired competitors and expanded their operations into new fields. Concentration created institutions too big to fail. Government regulation in terms of oversight and coherence did not keep pace with innovation, leverage and the expanded scope of the banks. Three, access to new capital permitted the banks and security firms to shift the nature of their business away from agency transactions and towards more proprietary trading that took positions in marketable and less liquid securities and assets such as commercial real estate. Combined with greater leverage, earnings volatility increased. January 13, 2010 Fourth, scale, scope and innovation created an interdependency, most noticeable in credit default swaps, disproportionate to the equity capital of all banks. Management misjudged their capabilities and the capabilities of their elaborate risk-management systems, like VaR, to keep their institutions solvent. Even for insiders in those institutions, transparency diminished so much that firms were not prepared for the extraordinary, the so- called black swan event. Paul Volcker has suggested that financial firms might be categorized between activities with ongoing relationships, such as lending, and transactional interactions, such as trading. He has proposed that these functions be separated. A corollary question is whether it would be preferable from a public policy perspective, and adequate from a capital markets point of view, to require proprietary investing to be in private partnerships. Until it went public, for example, Goldman Sachs remained a private partnership and was able to attract sufficient capital and weather a series of large losses. In closing, my hope is that the commission will determine that the 21 st century model is consistent with the need for stable banks and capital markets sufficient to finance the world economy. The commission has an opportunity to approach this challenge in a bipartisan manner and produce unanimous recommendations. These conclusions can have a profound effect on legislation, as did the recommendations of the 9/11 Commission. In doing so, the commission will make a major contribution to the stability of financial markets and we will have a chance to mitigate future crises. Thank you very much. FOMC20071211meeting--82 80,MS. YELLEN.," Thank you, Mr. Chairman. At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage. Subsequent developments have severely shaken that belief. The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering. In addition, the downside threats to growth that then seemed to be tail events now appear to be much closer to the center of the distribution. I found little to console me in the Greenbook. Like the Board staff, I have significantly marked down my growth forecast. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real. Conditions in financial markets have worsened. Rates on a wide array of loans and securities have increased significantly since our last meeting, including those on term commercial paper, term LIBOR, prime jumbo mortgages, and high-yield corporate bonds. CDS spreads from major financial institutions with significant mortgage exposure, including Freddie and Fannie, have risen appreciably. In addition, broad stock indexes are down nearly 5 percent. At the same time, measures of implied volatility in equity, bond, and foreign exchange markets have all moved up, reflecting the greater uncertainty about the economy’s direction. The most recent data on spending have been discouraging as well. Data on house sales, prices, and construction have been downbeat, and foreclosures on subprime loans have moved even higher. Even with efforts such as those facilitated by the Administration to freeze subprime rates, foreclosures look to rise sharply next year, which may dump a large number of houses on a market already swamped with supply. This will exacerbate the downward pressure on house prices and new home construction from already elevated home inventories. Indeed, the ten-city Case-Shiller home-price index has declined more than 5 percent over the past year through September, and futures contracts point to another sizable decline over the next twelve months. I am particularly concerned that we may now be seeing the first signs of spillovers from the housing and financial sectors to the broader economy. Although the job market has remained reasonably healthy so far, real consumer spending in September and October was dead in the water, and households are growing more pessimistic about future prospects. The December reading of consumer sentiment showed another decline, and the cumulative falloff in this measure is becoming alarming. Gains in disposable income have been weakened. With consumer sentiment in the doldrums, house prices on the skids, and energy prices on the rise, consumer spending looks to be quite subdued for some time. This view is echoed by the CEO of a national high-end clothing retailer on our board, who recently emphasized to us that the positive chain store sales data in November were in fact artificially boosted by the Thanksgiving calendar shift and that the underlying trend for his business has worsened notably. My modal forecast foresees the economy barely managing to avoid recession, with growth essentially zero this quarter and about 1 percent next quarter. I expect growth to remain below potential throughout next year, causing the unemployment rate to rise to about 5 percent, much like in the Greenbook. This forecast assumes a 50 basis point decline in the federal funds rate in the near future, placing the real funds rate near the center of the range of estimates of the neutral rate reported in the Bluebook. I should emphasize that I do not place a lot of confidence in this forecast, and, in particular, I fear that we are in danger of sliding into a credit crunch. Such an outcome is illustrated by the credit crunch alternative simulation in the Greenbook. Although I don’t foresee conditions in the banking sector getting as bleak as during the credit crunch of the early 1990s, the parallels to those events are striking. Back then, we saw a large number of bank failures in the contraction of the savings and loan sector. In the current situation, most banks are still in pretty good shape. Instead, it is the shadow banking sector— that is, the set of markets in which a variety of securitized assets are financed by the issuance of commercial paper—that is where the failures have occurred. This sector is all but shut for new business. But bank capital is also an issue. Until the securitization of nonconforming mortgage lending reemerges, financing will depend on the willingness and ability of banks, thrifts, and the GSEs to step in to fill the breach. To the extent they do, that will put further pressure on their capital, which is already under some pressure from write-downs on existing loans and holdings of assets. Banks are showing increasing concern that their capital ratios will become binding and are tightening credit terms and conditions. Several developments suggest to me that this situation could worsen. In addition to the problems plaguing the adjustable-rate subprime mortgages, delinquencies have recently started to move up more broadly—on credit card and auto loans, adjustable-rate prime mortgages, and fixed-rate subprime mortgages. My contacts at large District banks tell me that, because the economy continues to be reasonably healthy and people have jobs, things are still under control. But if house prices and the stock market fall further and the economy appears to be weakening, then they will further tighten the lending conditions and terms on consumer loans to avoid problems down the road, and these fears could be self-fulfilling. If banks only partially replace the collapsed shadow banks or, worse, if they cut back their lending in anticipation of a worsening economy, then the resulting credit crunch could push us into recession. This possibility is presumably increasingly reflected in CDS and low-grade corporate bond spreads. Thus, the risk of recession no longer seems remote, especially since the economy may well already have begun contracting in the current quarter. Indeed, the December Blue Chip consensus puts the odds of a recession at about 40 percent. This estimate is within the range of recession probabilities computed by my staff using models based on the yield curve and other variables. Turning to inflation, data on the core measure continues to be favorable. Wage growth remains moderate, and the recent downward revisions to hourly compensation have relieved some worries there. Inflation expectations remain contained. As I mentioned, I expect some labor market slack to develop, and this should offset any, in my view, modest inflationary pressures from past increases in energy and import prices and help keep core PCE price inflation below 2 percent. Continued increases in energy and import prices pose some upside risk to the inflation outlook, but there are also downside risks to inflation associated with a weakening economy and rising unemployment. To sum up, I believe that the most likely outcome is for the economy to slow significantly in the near term, flirting with recession, and I view the risk to that scenario as being weighted significantly to the downside. In contrast, I expect inflation to remain well contained, and I view those risks as fairly balanced." fcic_final_report_full--66 When the nation’s biggest financial institutions were teetering on the edge of fail- ure in , everyone watched the derivatives markets. What were the institutions’ holdings? Who were the counterparties? How would they fare? Market participants and regulators would find themselves straining to understand an unknown battlefield shaped by unseen exposures and interconnections as they fought to keep the finan- cial system from collapsing. CHRG-111shrg53176--50 Mr. Levitt," Thank you, Chairman Dodd and Ranking Member Shelby, for the opportunity to appear before the Committee this morning. Thank you for your kind words. It is good to be back with former friends and colleagues. When I last appeared before this Committee, I focused my remarks on the main causes of the crisis we are in and the significant role played by deregulation. Today, I would like to focus on the prime victim of deregulation, investors. Their confidence in fair, open, and efficient markets has been badly damaged, and not surprisingly, our markets have suffered. Above all the issues you now face, whether it is public fury over bonus payments or the excesses of companies receiving taxpayer assistance, there is none more important than investor confidence. The public may demand that you act over some momentary scandal, but you mustn't give in to bouts of populist activism. Your goal is to serve the public not by reacting to public anger, but by focusing on a system of regulation which treats all market actors the same under the law, without regard to their position or their status. Many are suggesting we should reimpose Glass-Steagall rules. For six decades, those rules kept the Nation's commercial banks away from the kinds of risky activities of investment banks. While it would be impossible to turn back the clock and reimpose Glass-Steagall, I think we can borrow from some of the principles and apply them to today's environment. The principles ensured are regulation's need to match the market action. Entities engaged in trading securities should be regulated as securities firms, while entities taking deposits and holding loans to maturity should be regulated as depository banks. Regulation, I think, is not one-size-fits-all. Accounting standards must be consistent. The mere mention of accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit the momentary needs of market participants. This is why mark-to-the-market accounting should not be suspended under any condition. The proper role of a securities regulator is to be the guardian of capital markets. Of course, there is an inherent tension at times between securities regulators and banking supervisors. But under no circumstances should securities regulators, especially those at the SEC, be subordinated. You must fund them appropriately, give them the legal tools they need, and hold them accountable to enforce the laws you write. And finally, all such reforms are best done in a complementary, systemic way. You can't do regulation piecemeal. Allow me to illustrate how these principles can be put to work in specific regulatory and policy reforms. First, some have suggested that you create a super-regulator. I suggest you take a diverse approach using the existing strengths of our existing regulatory agencies. For example, the Federal Reserve is a banking supervisor. It has a deep and ingrained culture that is oriented toward the safety and soundness of our banking system. Ultimately, the only solution to the tension is to live with it. when I was at the SEC, there was tension between banking regulators and securities regulators all the time. While this was frustrating for the regulators and the financial institutions themselves, I think it served the overall purposes of reducing systemic risk. Regulatory overlap is not only inevitable, I think it may be desirable. Second, mark-to-the-market or fair value standards should not be suspended. Any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake and contribute greatly to systemic risk. The Chairman of the Federal Reserve, the heads of the major accounting firms maintain that maintenance of mark-to-the-market standards is essential. Third, this Committee and other policymakers seek to mitigate systemic risk. I suggest promoting transparency and information discovery across multiple markets, specifically credit rating agencies, municipal bond issuers, and hedge funds. For years, credit rating agencies have been able to use legal defenses to keep the SEC from inspecting their operations even though they dispense investment advice and sit at a critical nexus of financial information and risk. In addition, these rating agencies operate with significant protections from private rights of actions. These protections need to be reconsidered. In the same manner, the SEC should have a far greater role in regulating the municipal bond market, which consists of State and local government securities. Since the New York City crisis of 1975, this market has grown to a size and complexity few anticipated. It is a ticking time bomb. The amount of corruption, the amount of abuse, the amount of pain caused to municipal workers and will be caused to municipal workers in an environment that is almost totally unregulated is a national scandal. Because of the Tower amendment, many participants, insurers, rating agencies, financial advisors, underwriters, hedge funds, money managers, and even some issuers have abused the protection granted by Congress from SEC regulation. Through multiple scandals and investment debacles hurting taxpayers, we know self-regulation by bankers and brokers through the Municipal Services Rulemaking Board simple does not work. We must level the playing field between the corporate and municipal markets, address all the risks to the financial system. In addition, I would also recommend amending the Investment Advisers Act to give the SEC the right to oversee specific areas of the hedge fund industry and other pockets of shadow markets. These steps would require over-the-counter derivatives market reform, the outcome of which would be the regulation by the SEC of all credit and securities derivatives. To make this regulation possible and efficient, it would make sense, as my predecessor, Chairman Breeden, has said so often, to combine the resources and responsibilities of the SEC and CFTC. Under no condition should the SEC lose any of its current regulatory authority. The Commission is the best friend investors have. The resulting regulatory structure would be flexible, effective in identifying potential systemic risk and supportive of financial innovations and investor choices. Most importantly, these measures would help restore investor confidence by making sure rules are enforced equally and investors are protected from fraud and outright abuse. As we have seen in the debate over mark-to-market accounting rules, there will be strong critics of a strong and consistent regulatory structure, but someone must think of the greater good. That is why this Committee must draw on its heritage of setting aside partisanship and the concerns of those with single interests and affirm the rights of investors whose confidence will determine the health of our markets, our economy, and ultimately our Nation. Thank you. " CHRG-110hhrg34673--6 The Chairman," The gentleman from Texas, the ranking member of the subcommittee. Dr. Paul. Thank you, Mr. Chairman, and welcome, Chairman Bernanke. I am very pleased to be here today as the ranking member. In the midst of a great optimism of monetary policy and how the economy is doing, I still have some concerns. And of course, one of my long-term goals has always been to emphasize maintaining the integrity of the monetary unit, rather than looking superficially at some of our statistics. But I also share the concern of the chairman of the committee of our responsibilities for oversight and your interest as well, Chairman Bernanke, on having the transparency that I think we all desire. Transparency in monetary policy is a goal we should all support. I have often wondered why Congress has so willingly given up this prerogative over monetary policy. Congress, in essence, has ceded total control of the value of our money to a secretive central bank. Congress created the Federal Reserve, yet it had no constitutional authority to do so. We forget that those powers not explicitly granted to the Congress by the Constitution are inherently denied to the Congress, and thus, the authority to establish a central bank was never given. Of course, Jefferson and Hamilton had that debate early on and the debate seemingly was settled in 1913. But transparency and oversight are something else, and they are worth considering. Congress--although not by law--essentially has given up all its oversight responsibilities over the Fed. There are no true audits. Congress knows nothing of the conversations, the plans, and the action taken in concert with other central banks. We get less and less information regarding the money supply each year, especially now that we don't even have access to M3 statistics. The role the Fed plays in the President's secretive working group on financial markets goes essentially unnoticed by Congress. The Federal Reserve shows no willingness to inform Congress voluntarily about how often the working group meets, what action it takes that affects the financial markets, or why it takes these actions. But all these actions directed by the Federal Reserve alter the purchasing power of our money, and that purchasing power is always reduced. The dollar today is worth only 4 cents compared to the dollar that the Federal Reserve started with in 1913. This has significant consequences on our economy and our political stability. All paper currencies are vulnerable to collapse and history is replete with examples of great suffering caused by these collapses, especially to the Nation's poor and middle class. This can lead to political turmoil as well. Even before a currency collapses, the damage done by a fiat system is significant. Our monetary system insidiously transfers wealth from the poor and the middle class to the privileged rich. Wages never keep up with profits on Wall Street and the banks, thus sowing the seeds of class and discontent. When economic trouble hits, free markets and free trade are often blamed, while the harmful effects of a fiat monetary system are ignored. We deceive ourselves that all is well with the economy and ignore the fundamental flaws that are a source of growing discontent among the various groups. Few understand that our consumption and apparent wealth is dependent on a current account deficit running at approximately $800 billion a year. This deficit shows that much of our prosperity is based on borrowing rather than a true increase in production. Statistics show year after year that our productive manufacturing jobs continue to go overseas. This phenomenon is not seen as a consequence of the international fiat money system where the U.S. Government benefits as the issuer of the world reserve currency. Government officials consistently claim that inflation is in check at barely 2 percent, but middle class Americans know that their purchasing power--especially when it comes to housing, energy, medical care, and school tuition--is shrinking much faster than 2 percent per year. Even if prices are held in check in spite of our monetary inflation, concentrating on the CPI statistics distracts from the real issue. We must address the important consequences of the Fed manipulation of interest rates. When interest rates are artificially low, below market rates, insidious malinvestment, and excessive indebtedness inevitably brings about the economic downturns that everyone dreads. We look at GDP figures and reassure ourselves that all is well. Yet a growing number of Americans still do not enjoy the high standard of living that monetary inflation brings to the privileged few. Those who benefit the most are the ones who get to use the newly created credit first-- " fcic_final_report_full--11 Unfortunately—as has been the case in past speculative booms and busts—we witnessed an erosion of standards of responsibility and ethics that exacerbated the fi- nancial crisis. This was not universal, but these breaches stretched from the ground level to the corporate suites. They resulted not only in significant financial conse- quences but also in damage to the trust of investors, businesses, and the public in the financial system. For example, our examination found, according to one measure, that the percent- age of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of  to late . This data indicates they likely took out mortgages that they never had the capacity or intention to pay. You will read about mortgage brokers who were paid “yield spread premiums” by lenders to put borrowers into higher-cost loans so they would get bigger fees, of- ten never disclosed to borrowers. The report catalogues the rising incidence of mort- gage fraud, which flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports—reports of possible finan- cial crimes filed by depository banks and their affiliates—related to mortgage fraud grew -fold between  and  and then more than doubled again between  and . One study places the losses resulting from fraud on mortgage loans made between  and  at  billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September , Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop. And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this crit- ical information was not disclosed. T HESE CONCLUSIONS must be viewed in the context of human nature and individual and societal responsibility. First, to pin this crisis on mortal flaws like greed and hubris would be simplistic. It was the failure to account for human weakness that is relevant to this crisis. CHRG-111hhrg52406--180 Mr. Yingling," Well, you are asking me a question that is broader than your local community banks in North Carolina. You are asking a question about Wall Street. A fair question. I just want to point that out, that I don't represent all those people in hedge funds and that type of thing. I think your analysis of the way it is supposed to work is correct. I think it is quite clear there were problems. I think, for example, and we have testified to this, that the compensation systems were not properly calibrated. And I don't mean to use that as a technical term. Compensation did not include enough consideration of the risk that, say, traders were putting on the system. I think it also shows that there was way too much leverage in the system. It also raises questions about monetary policy, quite frankly. So I would certainly say that there were severe problems, including gaps in regulation, that led us to this problem. The great majority of it outside the traditional banking industry. Mr. Miller of North Carolina. Well, and I recognize the financial sector includes more than just the banking industry and more than just consumer credit. But consumer credit is actually the bulk of all transactions one way or the other. You don't think that consumer credit and the failures of the market to limit profitability and prices in a consumer credit transaction was part of the problem? " FinancialCrisisInquiry--192 These reckless and irresponsible actions by a handful of managers with too much power nearly destroyed our equity, real estate, consumer loan and global financial markets and cost the American people some $12 trillion in net worth. This crisis also has pushed our nation to the brink of insolvency by forcing the federal government to intervene with trillions in capital and loans and commitments to large, complex financial institutions whose balance sheets were overlevereged, lacked adequate liquidity to offset the risks that they had recklessly taken. We’re at the point where some of the world markets are even questioning if the United States dollar should be retained as the world’s reserve currency. All of this was driven by the ill-conceived logic that some institutions should be allowed to exist even if they were too big to manage, too big to regulate, too big to fail, and above the law of the United States of America. By contrast, community banks like mine, highly regulated, stuck to their knitting and had no role in the economic crisis. Even though community banks did not cause the economic crisis, we have been affected by it through a shrinking of our asset base, heavier FDIC assessments, and suffocating examination environments. The work of this commission is important if Congress is already actively advancing dramatic financial sector reforms. The ICBA wants Congress to pass meaningful financial reforms to rein in the financial behemoths and the shadow financial industry to ensure that this crisis like this never happen again to the American people. We need a financial reform that will restore reasonable balance between Wall Street and Main Street. So where are we today? While the financial meltdown and deep global recession may be over, economic growth remains too weak to quickly reverse the massive job losses and asset price damage that is resulting. After more than a year and a half of economic decline, the United States economy grew by a modest 2.2 percent in the third quarter of 2009, unemployment is still at a 26-year high and new hiring remains elusive at this modest growth level. The long, deep recession has dramatically increased the lending risk for all banks, as individuals’ and business credit risk have increased with the declining balance sheets and reduced sales in most cases. CHRG-111hhrg48674--239 Mr. Bernanke," Everything is relative, sir. I mean, the first thing to do was to prevent collapse and meltdown, and that is something--people don't realize how close we came to that. It was a very, very serious risk. We have also mitigated to some extent the contraction, the deleveraging of credit. And I think the credit--the capital which has already been deployed will be constructive and useful in the next stage, proposed this morning by Secretary Geithner. In particular, he is proposing to have that first round of capital convertible into common equity at the--if the bank and the supervisor decide it is appropriate, which may provide additional strength for the banks. " FinancialCrisisReport--161 IV. REGULATORY FAILURE: CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION Washington Mutual Bank (WaMu), with more than $300 billion in assets, $188 billion in deposits, over 2,300 branches in 15 states, and 43,000 employees, was by late 2008 the largest thrift under the supervision of the Office of Thrift Supervision (OTS) and among the eight largest financial institutions insured by the Federal Deposit Insurance Corporation (FDIC). The bank’s collapse in September 2008 came on the heels of the Lehman Brothers bankruptcy filing, accelerating the unraveling of the financial markets. WaMu’s collapse marked one of the most spectacular failures of federal bank regulators in recent history. In 2007, many of WaMu’s home loans, especially those with the highest risk profile, began experiencing increased rates of delinquency, default, and loss. After the subprime mortgage backed securities market collapsed in September 2007, Washington Mutual was unable to sell or securitize subprime loans and its loan portfolio began falling in value. By the fourth quarter of 2007, the bank recorded a loss of $1 billion, and then in the first half of 2008, WaMu lost $4.2 billion more. WaMu’s stock price plummeted against the backdrop of these losses and a worsening financial crisis elsewhere on Wall Street, which was witnessing the forced sales of Countrywide Financial Corporation and Bear Stearns, the government takeover of IndyMac, Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the taxpayer bailout of AIG, and the conversion of Goldman Sachs and Morgan Stanley into bank holding companies. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis. On September 25, 2008, OTS placed Washington Mutual Bank into receivership, and the FDIC, as receiver, immediately sold it to JPMorgan Chase for $1.9 billion. Had the sale not gone through, Washington Mutual’s failure could have exhausted the FDIC’s entire $45 billion Deposit Insurance Fund. OTS records show that, during the five years prior to its collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but failed to do so. OTS, in turn, failed to respond with meaningful enforcement action, choosing instead to continue giving the bank inflated ratings for safety and soundness. Until shortly before the thrift’s failure in 2008, OTS regularly gave WaMu a CAMELS rating of “2” out of “5,” which signaled to the bank and other regulators that WaMu was fundamentally sound. Federal bank regulators are charged with ensuring that U.S. financial institutions operate in a safe and sound manner. However, in the years leading up to the financial crisis, OTS failed to prevent Washington Mutual’s increasing use of high risk lending practices and its origination and sale of tens of billions of dollars in poor quality home loans. The agency’s failure to adequately monitor and regulate WaMu’s high risk lending stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on them to correct the problems identified by OTS with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems were corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results. CHRG-111shrg54675--6 Mr. Hopkins," Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, thank you very much for the opportunity to provide you with the community bank perspective on the impact of the credit crisis in rural areas. My name is Jack Hopkins, and I am President and CEO of CorTrust Bank in Sioux Falls, South Dakota. I am testifying on behalf of the Independent Community Bankers of America, and I serve on the ICBA's Executive Committee. I am a past President of the Independent Community Bankers of South Dakota and have been a banker in South Dakota for 25 years. CorTrust Bank is a national bank with 24 locations in 16 South Dakota communities and assets of $550 million. Eleven of the communities we serve have fewer than 2,000 people. In seven of those communities, we are the only financial institution. The smallest community has a population of 122 people. Approximately 20 percent of our loan portfolio is agricultural lending to businesses that rely heavily on the agricultural economy. CorTrust Bank is also one of the leading South Dakota lenders for the USDA's Rural Housing Service home loan program. Mr. Chairman, as we have often stated before this Committee, community banks played no part in causing the financial crisis fueled by exotic lending products, subprime loans, and complex and highly leveraged investments. However, rural areas have not been immune from rising unemployment, tightening credit markets, and the decline in home prices. We believe that, although the current financial crisis is impacting all financial institutions, most community banks are well positioned to overcome new challenges, take advantage of new opportunities, and reclaim some of the deposits lost to larger institutions over the last decade. A recent Aite study shows that even though some community banks are faced with new lending challenges, they are still lending, especially when compared to larger banks. In fact, while the largest banks saw a 3.23-percent decrease in 2008 net loans and leases, institutions with less than $1 billion in assets experienced a 5.53-percent growth. Mr. Chairman, small businesses are the lifeblood of rural communities. We believe small businesses will help lead us out of the recession and boost needed job growth. Therefore, it is vitally important to focus on the policy needs of the small business sector during this economic downturn. As I mentioned earlier, most of my commercial lending is to small businesses dependent on agriculture. The Small Business Administration programs are an important component of community bank lending. SBA must remain a viable and robust tool in supplying small business credit. The frozen secondary market for small business loans continues to impede the flow of credit to small business. Although several programs have been launched to help unfreeze the frozen secondary market for pools of SBA-guaranteed loans, including the new Term Asset-Backed Securities Loan Facility--TALF and a new SBA secondary market facility, they have yet to be successful due to the program design flaws and unworkable fees. ICBA recommends expanding these programs to allow their full and considerable potential. Several of my colleagues have told us about the mixed messages they received from bank examiners and from policy makers regarding lending. Field examiners have created a very harsh environment that is killing lending as examiners criticize and require banks to write down existing loans, resulting in capital losses. Yet policy makers are encouraging lending from every corner. Some bankers are concerned that regulators will second-guess their desire to make additional loans, and others are under pressure from their regulators to decrease their loan-to-deposit ratios and increase capital levels. Generally, the bankers' conclusions are that ample credit is available for creditworthy borrowers. They would like to make more loans, and they are concerned about the heavy-handedness from the regulators. Finally, Mr. Chairman, community bankers are looking closely at the regulatory reform proposals. ICBA supports the administration's proposal to prevent too-big-to-fail banks or nonbanks from ever threatening the collapse of the financial system again. Community banks support the dual system of State and Federal bank charters to provide checks and balances which promote consumer choice and a diverse and competitive financial system sensitive to the financial institutions of various complexity and size. Washington should allow community banks to work with borrowers in troubled times without adding to the costs and complexity of working with customers. Mr. Chairman, ICBA stands ready to work with you and the Senate Banking Committee on all of the challenges facing the financial system and how we may correct those issues gone awry and buttress those activities that continue to fuel the economies in rural areas. I am pleased to answer any questions you may have. " CHRG-111hhrg53238--145 Mr. Meeks," Thank you, Mr. Chairman. I think that part of what--some of what we are looking at is credibility issues, etc. I would have liked to have heard--and what I think a lot of the members have heard, at least on this side, is that if people are diametrically opposed to a CFPA, I would have liked to have heard and would like to hear in the future how we can make it work, what we can do to make sure that it works. Because, obviously, consumers do need protection. Someone--I don't know whether it was the professor or not, but somebody talked about how there are no foreclosures in Europe. And I don't think you really want to go where they are. Because if you look at Europe in particular, there are generally huge consumer protection programs, and banks primarily offer only vanilla products. And, you know, I am not so sure that I want to go all the way there, because I think that there is some good utilization of some diversity in products. But there has to be a buy in, some kind of way that we need to talk. And I, for one, want to again sit down, as I have with many of you, to talk and to try to figure out so that we can get this thing right. Because I am hoping that we will put a piece of legislation in place that is going to survive the test of time and try to minimize any unintended consequences but make sure that individuals who are in my district, for example, number one in New York City, which is small compared to some of my colleagues in other States, in home foreclosures, and how we can figure out how to make them. Because that is what--people are coming to me. They are saying, how do we fix this thing? I am going to change the area that I am going to, because the question that I really wanted to ask to get your opinion has to deal with the subcommittee of which I am the Chair, and that is dealing with international monetary policy. And I know that many industry organizations and individual financial firms, and from what I am hearing here, agree that we must have some kind of a change and a resolution authority so that there would be a systemic risk manager. The FDIC has typically put forward a successful example of how we can bring this kind of stability to the industry. But several of the key bank failures that brought the global financial system to the brink of collapse were international bank holding companies, with operations in multiple sovereign jurisdictions; and I was wondering if you had any thoughts on whether and how an FDIC-type model could work to manage these type of global banks so that, you know, people get out here, go to another jurisdiction and cause a systemic risk in Europe or other places where we don't have the direct jurisdiction. I was wondering if there were any thoughts on how we could manage that. " CHRG-110hhrg46593--167 Secretary Paulson," Again, I have answered this a couple of times. I will answer it again. I think it is very, very important to stay within the purpose of the TARP, because this is all about protecting the financial system, avoiding collapse and recovery. There is a good deal more that needs to be done before this system is recovered, the market is functioning as normal, credit is flowing, and that will make a big difference. Now, with regard to the auto companies, what we have said, and I think you have heard me say it, you, the Congress has acted. You have a bill that was passed, a $25 billion bill, the Department of Energy--and, again, I urge you to modify that, to have a path for making an investment in a viable company. " CHRG-110hhrg46593--83 Secretary Paulson," Let me just say three things here. First of all, the key to turning around the housing situation and avoiding foreclosures is going to be to keep lending going. If the financial system collapsed, we would have many more foreclosures, number one. Number two, you are seeing a number of big banks take extraordinary actions, and they have announced them, and you could just tick them off, announcing actions they are taking. So they are doing things, number one. And number two, I would say that I believe that our actions to stabilize Fannie Mae and Freddie Mac, who are the biggest source of home financing in America today, have been critical. So there have been real steps that have been taken that make a difference. More needs to be done. I hear your frustration; more needs to be done. And we are going to keep working on it. Ms. Velazquez. Yes, you hear my frustration. And I hope that you understand the pain and the suffering of so many homeowners in this country who are losing their homes. So it is just not enough to say to the banks, ``Here is the money. And, by the way, I trust you.'' Because they are not lending; they are not lending to small businesses. They are not working on a loan modification strategy. You just told Mr. Frank here that you are examining strategy to mitigate foreclosures. You don't have the strategy to mitigate foreclosures; you are examining. Chairwoman Bair does. Are you willing to support her plan? " CHRG-110hhrg46593--10 Secretary Paulson," Thank you very much, Mr. Chairman. Mr. Chairman, Congressman Bachus, and members of the committee, thank you for the opportunity to testify this morning. Six weeks ago, Congress took the critically important step of providing important authorities and resources to stabilize our financial system. Until that time, we faced a financial crisis without the proper tools. With these tools in hand, we took decisive action to prevent the collapse of our financial system. We have not in our lifetimes dealt with a financial crisis of this severity and unpredictability. We have seen the failures or the equivalent of failures of Bear Stearns, IndyMac, Lehman Brothers, Washington Mutual, Wachovia, Fannie Mae, Freddie Mac, and AIG, institutions with a collective $4.7 trillion in assets when this year began. By September, the financial system had seized up, presenting a system-wide crisis. Our objectives in asking Congress for a financial rescue package were to, first, stabilize a financial system on the verge of collapse and then to get lending going again to support American consumers and businesses. Over the next few weeks, conditions worsened significantly. Confidence in the banking system continued to diminish. Industrial company access to all aspects of the bond market was dramatically curtailed. Small- and middle-sized companies with no direct connection to the financial sector were losing access to the normal credit needed to meet payrolls, pay suppliers, and buy inventory. During that same period, the FDIC acted to mitigate the failure of Washington Mutual and made clear that it would intervene to prevent Wachovia's failure. Turmoil had developed in the European markets. In a 2-day period at the end of September, the governments of Ireland, the U.K., Germany, Belgium, France, and Iceland intervened to prevent the failure of one or more financial institutions in their countries. By the time legislation had cleared Congress, the global market crisis was so broad and severe that powerful steps were necessary to quickly stabilize our financial system. Our response, in coordination with the Federal Reserve, the FDIC, and other banking regulators was a program to purchase equity in banks across the country. We have committed $250 billion to this effort. This action, in combination with the FDIC's guarantee of certain debt issued by financial institutions and the Fed's commercial paper program helped us to immediately stabilize the financial system. The Capital Purchase Program for banks and thrifts has already dispersed $148 billion, and we are processing many more applications. Yesterday, Treasury announced the terms for participation for nonpublicly traded banks, another important source of credit in our economy. We have designed these terms to help provide community development financial institutions and minority depository institutions with capital for lending to low-income and minority populations. These institutions have committed to use this capital for businesses and projects that serve their communities. In addition, we are developing a matching program for possible future use by banks or nonbank financial institutions. Capital strength enables banks to take losses as they write down or sell troubled assets. Stronger capitalization is also essential to increasing lending, which although difficult to achieve during times like this, is essential to economic recovery. We expect banks to increase their lending over time as a result of these efforts and as confidence is restored. This lending won't materialize as fast as any of us would like. But it will happen much, much faster having used the TARP to stabilize our system. As we continue significant work on our mortgage asset purchase plan, it became clear just how much damage the crisis had done to our economy. Third quarter GDP growth showed negative three-tenths of a percent. The unemployment rate rose to a level not seen in 15 years. Home price status showed that home prices in 10 major cities had fallen 18 percent over the previous year, demonstrating that the housing correction had not abated. The slowing of European economies has been even more dramatic. We assessed the potential use of remaining TARP funding against the backdrop of current economic and market conditions. It is clear that an effective mortgage asset purchase program would require a massive commitment of TARP funds. In September, before economic conditions worsened, $700 billion in troubled asset purchases would have had a significant impact. But half of that sum in a worse economy simply isn't enough firepower. We have therefore determined that the prudent course at this time is to conserve the remaining funds available from the TARP, providing flexibility for this and the next Administration. Other priorities that need to be addressed include actions to restore consumer credit. Treasury has been working on a program with the Federal Reserve to improve securitization in the credit marketplace. While this would involve investing only a relatively modest share of TARP funds in the Federal Reserve liquidity facility, it could have substantial positive benefits for consumer lending. Finally, Mr. Chairman, Treasury remains committed to continuing to work to reduce avoidable foreclosures. Congress and the Administration have made substantial progress on that front through HUD programs, the FDIC's IndyMac approach, our support and leadership of the HOPE NOW Alliance, and our work with the GSEs, including an important announcement they made last week establishing new servicer guidelines that will set a new standard for the entire industry. Our actions to stabilize and strengthen Fannie Mae and Freddie Mac have also helped mitigate the housing correction by increasing access to lower-cost mortgage lending. As some on the committee know, I have reservations about spending TARP resources to directly subsidize foreclosure mitigation because this is different than the original investment intent. We continue to look at good proposals and are dedicated to implementing those that protect the taxpayer and work well. Mr. Chairman, the actions of the Treasury, the Fed, and the FDIC have stabilized our financial system. The authorities in the TARP have been used to strengthen our financial system and to prevent the harm to our economy and financial system from the failure of a systemically important institution. As facts and conditions in the market and economy have changed, we have adjusted our strategy to most effectively address the urgent crisis and to preserve the flexibility of the President-elect and the new Secretary of the Treasury to address future challenges in the economy and capital markets. Thank you again for your efforts and for the opportunity to appear today. I would like to just make one last comment in response to a question that Congressman Bachus asked because it is one I hear a lot, the distinction between the financial markets and the economy. So when we have talked about the crisis and the financial markets and being unprecedented and having to go back to the Great Depression to see anything of this magnitude and be presented with this amount of difficulty, we are talking about the financial markets. Now, when the financial markets have problems, they hurt the economy. So the reason that it was very important to get in quickly and stabilize it was to mitigate damage to the economy. When we were here before you, we saw what was happening to the economy. We talked about it. We took the steps. The economy has continued to get worse. The American people look at the worsening economy. And as your chairman said to me yesterday, in politics, you don't get much credit for what might have happened and didn't happen. What the American people see is what is happening to the economy. But again, our purpose in coming to you was to take-- " CHRG-111hhrg55809--58 Mr. Royce," Let me ask you another question. Some economists are arguing that the Fed not only lost control, but its policy actions have unintentionally become procyclical--encouraging financial excesses instead of countering the extremes. And this gets to the point that has been argued by many economists. In fact, Friedrich Hayek won the Nobel Prize in 1974 for arguing that artificially low interest rates lead to the misallocation of capital and the bubbles which then lead to bursts. Looking back, do you agree that the negative real interest rate set by central banks from 2002 to 2006 had a dramatic impact on the boom and the subsequent bust, especially when you take into consideration what was already an inflating housing bubble with the drastic steps taken by the Federal Government to encourage less creditworthy borrowers to get into loans they could not afford? Do you think those combinations could have had an impact on that boom-bust? " fcic_final_report_full--5 Much attention over the past two years has been focused on the decisions by the federal government to provide massive financial assistance to stabilize the financial system and rescue large financial institutions that were deemed too systemically im- portant to fail. Those decisions—and the deep emotions surrounding them—will be debated long into the future. But our mission was to ask and answer this central ques- tion: how did it come to pass that in  our nation was forced to choose between two stark and painful alternatives —either risk the total collapse of our financial system and economy or inject trillions of taxpayer dollars into the financial system and an array of companies, as millions of Americans still lost their jobs, their savings, and their homes? In this report, we detail the events of the crisis. But a simple summary, as we see it, is useful at the outset. While the vulnerabilities that created the potential for cri- sis were years in the making, it was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages— that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of . Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world. When the bubble burst, hun- dreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them. This happened not just in the United States but around the world. The losses were magnified by derivatives such as synthetic securities. The crisis reached seismic proportions in September  with the failure of Lehman Brothers and the impending collapse of the insurance giant American Interna- tional Group (AIG). Panic fanned by a lack of transparency of the balance sheets of ma- jor financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession. The financial system we examined bears little resemblance to that of our parents’ generation. The changes in the past three decades alone have been remarkable. The financial markets have become increasingly globalized. Technology has transformed the efficiency, speed, and complexity of financial instruments and transactions. There is broader access to and lower costs of financing than ever before. And the financial sector itself has become a much more dominant force in our economy. CHRG-111hhrg48867--32 Mr. Wallison," Thank you, Mr. Chairman, and Ranking Member Bachus, for this opportunity to testify about a systemic risk regulator. There are two questions here, it seems to me. First, will a systemic regulator perform any useful function? And second, should a government agency be authorized to regulate so-called systemically significant financial institutions? I am going to start with the second question because I believe it is by far the most important. Giving a government agency the power to designate companies as systemically significant and to regulate their capital and activities is a very troubling idea. It has the potential to destroy competition in every market where a systemically significant company is designated. I say this as a person who has spent 10 years warning that Fannie Mae and Freddie Mac would have disastrous effects on the U.S. economy and that ultimately the taxpayers of this country would have to bail them out. Because they were seen as backed by the government, Fannie and Freddie were relieved of market discipline and able to take risks that other companies could not take. For the same reason, they also had access to lower cost financing than any of their competitors. These benefits enabled them to drive out competition and grow to enormous size. Ultimately, however, the risks they took caused their collapse and will cause enormous losses for U.S. taxpayers. When Fannie and Freddie were taken over by the government, they held or guaranteed $1.6 trillion in subprime and Alt-A mortgages. These loans are defaulting at unprecedented rates, and I believe will ultimately cost U.S. taxpayers $400 billion. There is very little difference between a company that has been designated as systemically significant and a GSE like Fannie or Freddie. By definition a systemically significant firm will not be allowed to fail because its failure could have systemic effects. As a result it will be seen as less risky for creditors and counterparties and will be able to raise money at lower rates than its competitors. This advantage, as we saw with Fannie and Freddie, will allow it to dominate its market, which is a nightmare for every smaller company in every industry where a systemically significant company is allowed to operate. Some will contend that in light of the failures among huge financial firms in recent months, we need regulation to prevent such things in the future, but this is obviously wrong. Regulation does not prevent risk-taking or loss. Witness the banking industry, the most heavily regulated sector in our economy. Many banks have become insolvent and many others have been or will be rescued by the taxpayers. It is also argued that since we already have rescued a lot of financial institutions, moral hazard has been created, so now we should regulate all financial institutions as if they will be rescued in the next crisis. But there is a lot of difference between de jure and de facto, especially when we are dealing with an unprecedented situation. Anyone looking at the Fed's cooperation with the Treasury today would say that the Fed de facto is no longer independent. But after the crisis is over, we would expect that the Fed's independence will be reestablished. That is the difference between de jure and de facto. Extending regulation beyond banking by picking certain firms and calling them systemically significant would, in my view, be a monumental mistake. We will simply be creating an unlimited number of Fannies and Freddies that will haunt our economy in the future. Let me now turn to the question of systemic regulation in general. Why choose certain companies as systemically significant? The theory seems to be that the failure of big companies caused this financial crisis or without regulation might cause another in the future. But is the U.S. banking system in trouble today because of the failure of one or more large companies? Of course not. It is in trouble because of pervasive losses on trillions of dollars of bad mortgages. So will regulation of systemically significant companies prevent a recurrence of a financial crisis in the future? Not on the evidence before us. An external shock that causes asset prices to crash or investors to lose confidence in the future will have the same effect whether we regulate systemically significant companies or not. And regulation, as with banks, will not even prevent the failure of systemically significant companies; it will only set them up for bailouts when inevitably they suffer losses in their risk taking. Finally, the Federal Reserve would be by far the worst choice for systemic regulator. As a lender of last resort, it has the power to bail out the companies it is supervising, without the approval of Congress or anyone else. Its regulatory responsibilities will conflict with its central banking role, and its involvement with the politics of regulation will raise doubts about its independence from the political branches. We will achieve nothing by setting up a systemic regulator. If we do it at the cost of destroying faith in the dollar and competition in the financial services market, we will have done serious and unnecessary harm to the American economy. Thank you, Mr. Chairman. [The prepared statement of Mr. Wallison can be found on page 159 of the appendix.] " CHRG-111shrg52619--182 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JOHN C. DUGANQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. As was discussed in Senior Deputy Comptroller Long's March 18th testimony before the Subcommittee on Securities, Insurance, and Investment, looking back on the events of the past two years, there are clearly things we may have done differently or sooner, but I do not believe our supervisory record indicates that there was a ``lack of action'' by the OCC. For example, we began alerting national banks to our concerns about increasingly liberal underwriting practices in certain loan products as early as 2003. Over the next few years, we progressively increased our scrutiny and responses, especially with regard to credit cards, residential mortgages, and commercial real estate loans even though the underlying ``fundamentals'' for these products and market segments were still robust. Throughout this period, our examiners were diligent in identifying risks and directing banks to take corrective action. Nonetheless, we and the industry initially underestimated the magnitude and severity of the disruptions that we have subsequently seen in the market and the rapidity at which these disruptions spilled over into the overall economy. In this regard, we concur with the GAO that regulators and large, complex banking institutions need to develop better stress test mechanisms that evaluate risks across the entire firm and that identify interconnected risks and potential tail events. We also agree that more transparency and capital is needed for certain off-balance sheet conduits and products that can amplify a bank's risk exposure. While changes to our regulatory system are warranted--especially in the area of systemic risk--I do not believe that fundamental changes are required to the structure for conducting banking supervision.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. A key issue for bankers and supervisors is determining when the accumulation of risks either within an individual firm or across the system has become too high, such that corrective or mitigating actions are needed. Knowing when and how to strike this balance is one of the most difficult jobs that supervisors face. Taking action too quickly can constrain economic growth and impede access to credit by credit-worthy borrowers. Waiting too long can result in an overhang of risk becoming embedded into banks that can lead to failure and, in the marketplace, that can lead to the types of dislocations we have seen over the past year. This need to balance supervisory actions, I believe, is fundamental to bank supervision and is not an issue that can be addressed through regulatory restructure--the same issue will face whatever entity or agency is ultimately charged with supervision. There are, however, actions that I believe we can and should take to help dampen some of the effects of business and economic cycles. First, as previously noted, I believe we need to insist that large institutions establish more rigorous and comprehensive stress tests that can identify risks that may be accumulating across various business and product lines. As we have seen, some senior bank managers thought they had avoided exposure to subprime residential mortgages by deliberately choosing not to originate such loans in the bank, only to find out after the fact that their investment banks affiliates had purchased subprime loans elsewhere. For smaller, community banks, we need to develop better screening mechanisms that we can use to help identify banks that are building up concentrations in a particular product line and where mitigating actions may be necessary. We have been doing just that for our smaller banks that may have significant commercial real estate exposures. We also need to ensure that banks have the ability to strengthen their loan loss reserves at an appropriate time in the credit cycle, as their potential future loans losses are increasing. A more forward-looking ``life of the loan'' or ``expected loss'' concept would allow provisions to incorporate losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime. Such a revision would help to dampen the decidedly pro-cyclical effect that the current rules are having today. This is an issue that I am actively engaged in through my role as Chairman of the Financial Stability Board's Working Group on Provisioning. Similarly, the Basel Committee on Bank Supervision recently announced an initiative to introduce standards that would promote the build up of capital buffers that can be drawn upon in periods of stress. Such a measure could also potentially serve as a buffer or governor to the build up of risk concentrations. There are additional measures we could consider, such as establishing absolute limits on the concentration a bank could have to a particular industry or market segment, similar to the loan limits we currently have for loans to an individual borrower. The benefits of such actions would need to be carefully weighed against the potential costs this may impose. For example, such a regime could result in a de facto regulatory allocation of credit away from various industries or markets. Such limits could also have a disproportionate affect on smaller, community banks whose portfolios by their very nature, tend to be concentrated in their local communities and, often, particular market segments such as commercial real estate.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3. As alluded to in Governor Tarullo and Chairman Bair's testimonies, most of the prominent failures that have occurred and contributed to the current market disruption primarily involved systemically important firms that were not affiliated with an insured bank and were thus not overseen by the Federal Reserve or subject to the provisions of the Bank Holding Company Act. Although portions of these firms may have been subject to some form of oversight, they generally were not subject to the type or scope of consolidated supervision applied to banks and bank holding companies. Nonetheless, large national banking companies clearly have not been immune to the problems we have seen over the past eighteen months and several have needed active supervisory intervention or the assistance of the capital and funding programs instituted by the U.S. Treasury, Federal Reserve, and FDIC. As I noted in my previous answer, prior to the recent market disruptions our examiners had been identifying risks and risk management practices that needed corrective action and were working with bank management teams to ensure that such actions were being implemented. We were also directing our large banks to shore up their capital levels and during the eight month period from October 2007 through early June 2008, the largest national banking companies increased their capital and debt levels through public and private offerings by over $100 billion. I firmly believe that our actions that resulted in banks strengthening their underwriting standards, increasing their capital and reserves, and shoring up their liquidity were instrumental to the resilience that the national banking system as whole has shown during this period of unprecedented disruption in bank funding markets and significant credit losses. Indeed several of the largest national banks have served as a source of strength to the financial system by acquiring significant problem thrift institutions (i.e., Countrywide and Washington Mutual) and broker-dealer operations (i.e., Bear Stearns and Merrill Lynch). In addition, we worked to successfully resolve via acquisition by other national banks, two large national banks--National City and Wachovia--that faced severe funding pressures in the latter part of 2008. While both of these banks had adequate capital levels, they were unable to roll over their short term liabilities in the marketplace at a time when market perception and sentiment for many banking companies were under siege. Due to these funding pressures, both banks had to be taken over by companies with stronger capital and funding bases. As the breadth and depth of credit problems accelerated in late 2008, two other large banking companies, Citigroup and Bank of America, required additional financial assistance through Treasury's Asset Guarantee and Targeted Investment programs to help stabilize their financial condition. As part of the broader Supervisory Capital Assessment Program that the OCC, Federal Reserve, and FDIC recently conducted on the largest recipients of funds under the Treasury's Troubled Assets Relief Program, we are closely monitoring the adequacy of these firms' capital levels to withstand further adverse economic conditions and will be requiring them to submit capital plans to ensure that they have sufficient capital to weather such conditions. In almost all cases, our large national banking organizations are on track to meet any identified capital needs and have been able to raise private capital through the marketplace, a sign that investor confidence may be returning to these institutions. While the vast majority of national banks remain sound, many national banks will continue to face substantial credit losses as credit problems work through the banking system. In addition, until the capital and securitization markets are more fully restored, larger banks will continue to face potential liquidity pressures and funding constraints. As I have stated in previous testimonies, we do expect that the number of problem banks and bank failures will continue to increase for some time given current economic conditions. In problem bank situations, our efforts focus on developing a specific plan that takes into consideration the ability and willingness of management and the board to correct deficiencies in a timely manner and return the bank to a safe and sound condition. In most instances our efforts, coupled with the commitment of bank management, result in a successful rehabilitation of the bank. There will be cases, however, where the situation is of such significance that we will require the sale, merger, or liquidation of the bank, if possible. Where that is not possible, we will appoint the FDIC as receiver.Q.4. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.4. The failure of certain hedge funds, while not by themselves systemically important (in contrast to the failure of Long Term Capital Management in 1998), led to a reduction in market liquidity as leveraged investors accelerated efforts to reduce exposures by selling assets. Given significant uncertainty over asset values, reflecting sharply reduced market liquidity, this unwinding of leveraged positions has put additional strains on the financial system and contributed to lack of investor confidence in the markets.Q.5. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.5. At the outset, it is important to be clear that bank examiners do not have authority over the nonbank companies in a holding company. These nonbank firms were the source of many of the issues confronting large banking firms. With respect to banks, as noted above, we were identifying issues and taking actions to address problems that we were seeing in loan underwriting standards and other areas. At individual banks, we were directing banks to strengthen risk management and corporate governance practices and, at some institutions, were effecting changes in key managerial positions. Nonetheless, in retrospect, it is clear that we should have been more aggressive in addressing some of the practices and risks that were building up across the banking system during this period. For example, it is clear that we and many bank managers put too much reliance on the various credit enhancements used to support certain collateralized debt obligations and not enough emphasis on the quality of, and correlations across, the underlying assets supporting those obligations. Similarly, we were not sufficiently attuned to the systemic risk implications of the significant migration by large banks to an ``originate-to-distribute model'' for commercial and leveraged loan products. Under this model, banks originated a significant volume of loans with the express purpose of packaging and selling them to institutional investors who generally were willing to accept more liberal underwriting standards than the banks themselves would accept, in return for marginally higher yields. In the fall of 2007, when the risk appetite of investors changed dramatically (and at times for reasons not directly related to the exposures they held), banks were left with significant pipelines of loans that they needed to fund, thus exacerbating their funding and capital pressures. As has been well-documented, similar pressures were leading to relaxation of underwriting standards within the residential mortgage loan markets. While the preponderance of the subprime and ``Alt-A'' loans that have been most problematic were originated outside of the national banking system, the subsequent downward spiral in housing prices that these practices triggered have clearly affected all financial institutions, including national banks. ------ CHRG-111shrg49488--16 Mr. Clark," Thank you, Mr. Chairman and Ranking Member Collins, for inviting me, and thank you to the other Members. I am obviously not here as a regulatory expert, but we have a wonderful panel.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Clark appears in the Appendix on page 326.--------------------------------------------------------------------------- I am going to speak much more as a CEO who operates under the regulatory regimes. We are a little unusual in the sense that we operate on both sides of the border in Canada and the United States. We have over 1,000 branches in the United States from Maine to Florida, and we are a bank in the United States that is continuing to lend, and lend aggressively. So we have double-digit lending growth, and we are one of the few AAA-rated banks left in the world. We exited the structured products area in 2005, the source of most of the problems. I thought I would comment on a couple of things, and one was the actual management of the crisis from the beginning of August 2007 until now, and I think what certainly distinguished the Canadian system, which may not be duplicable in larger countries, is that the six banks plus the Bank of Canada, the Office of the Superintendent of Financial Institutions (OSFI), and the Department of Finance essentially worked almost continuously together and have a shared objective. There was a very strong feeling among us that if any one of our banks ran into trouble, we would all run into trouble. So there was no attempt by one bank to, in a sense, game the system, and there was also fairly quickly a view that we should try to have a private sector solution to this problem, not a public sector solution; and to the extent we involved the public sector, it should be a profitable involvement on behalf of the taxpayers, not a subsidy, and we were able to successfully do that. In terms of the structure of the industry, I think it is well known that there are some important differences. All the major dealers are owned by the Canadian banks, and we did, in fact, absorb $18 billion (CAD) of write-offs by these dealers. TD Bank did not have any significant write-offs, but $18 billion (CAD) is a significant amount in the size of Canada, but they were able to absorb that because they were tied to large entities with very stable retail earnings. Second, the mortgage market is completely different in Canada. It is concentrated in the top banks, and we originate mortgages to hold them. And so we have resisted attempts--frankly, political attempts--to have us loosen standards because we are going to bear the risks of those loosened standards. So you did not get the development in Canada of what you did in the United States. Third, in terms of the capital requirements, our capital requirements have always been above world standards, with a particular emphasis on common equity. But it has also been reinforced by the insistence of our regulation that we have our own self-assessment of how much capital we need, and that in all cases, it caused Canadian banks to hold more than regulatory minimums, not at regulatory minimums. I think the other difference would be that our regime's binding constraint is risk-weighted assets, and that is a key feature why we hold our mortgages rather than sell them. Where you have total asset tests, you, in fact, encourage banks to sell low-risk assets, and where we have a total asset test is not the binding constraint. In terms of the nature of the regulatory regime, it is a principles regime, not a rule-based regime--it is rather light in terms of the actual number of people employed in the regulatory regime. There is a high focus on ensuring that management and the board know and understand the risks that the institution is taking and that, in fact, they are building the infrastructure to monitor and manage that risk. The way I put it internally in my organization is I am actually on the side of the regulator, not on the side of the bank. We have the same interest in ensuring that the bank does not run into trouble, and do you have less of this conflict situation because I see the regulator as helping me manage the bank. I think another important element that Canada moved to in terms of compensation some time ago was to have low cash bonuses. So in my case, 70 percent of my pay would be in the form of equity which I hold. I am required to hold my economic interests in the bank for 2 years after I retire, so I cannot cut and run. And all my executives, whether in the wholesale side of the bank or the retail side of the bank, are paid on the whole bank's performance, including its ability to deliver great customer satisfaction. We also have separation of the chairman from the CEO, and all board and committee meetings have meetings without management present to ensure that independence. Clearly, the issue, I think, you are addressing is the issue of systemic risk, and I think it is the toughest issue to deal with here. I think I would have to be in the camp to say all the systemic risk issues were well known and well talked about. It is not as if there was this mystery out there that the U.S. mortgage system was, in fact, going way up the risk curve and doing what most bankers would have regarded as crazy lending. It is not as if there was not meeting after meeting among bankers around the world about the risks that are inherent in structured products. And I would say the under-saving feature of the U.S. economy was a well-known fact. And so I think you do have to sit back and say, well, if these risks were well known, why were there no, in a sense, forces against that? I can comment on our own experience. As I indicated, we did actually exit these products. We exited them because they were hard to understand. They embedded tail risk and added a lot of complexity to the organization. We also refused to, in fact, distribute the asset-backed paper program that blew up in Canada on the basis that if I would not sell it to my mother-in-law, I should not sell it to my clients. But the real issue is that in doing that, that was a very unpopular thing to do. It was unpopular within my bank. It was unpopular among my investors. It is very hard to run against these tides, and so I think when you are talking about systemic risk, you have to recognize that there is this odd confluence of political, economic, and profit force actually always propelling it. It is like a lot of the literature, what creates boom. You have the same thing behind any forces of systemic risk. So what is my conclusion as a practicer in the field? Well, I do not think there is one answer because, as I have said, banks have failed under most regulatory regimes. But I do think a strong regulator is important, and you certainly should not allow regulatory shopping. I think that is obviously a very bad thing. And while rules are important, I actually think principles do matter. It was clear throughout the industry that people were in the process of using regulatory capital arbitrage, and if you sat there from a principle point of view, I think you might have stopped it. Leadership matters enormously. I think boards should be held accountable to ensure that they actually have a CEO with the right value system. His job is to preserve the institution. And I think it is clear to say while all regulatory regimes may have known about systemic risk, they did not focus on systemic risk. And I think we are lacking mechanisms where, if you did come upon a view that existed, how would you, in fact, coordinate action to bring it to an end? I do think going forward, though, there is also a risk that we could overreact, and one of the things I would plead is that many elements of the regulatory reforms could drive institutions to take more risk rather than less risk. And I think you have to be careful in your rules to make sure that low-risk strategies, such as the TD Bank one, are not, in fact, negatively impacted by some of the rule changes. Thank you very much. " CHRG-111hhrg55814--381 Mr. Menzies," Chairman Frank, Ranking Member Bachus, and members of the committee, it's an honor to be with you again. And I'm especially proud to be the chairman of the Independent Community Bankers of America. We represent 5,000 community bank members throughout the Nation. ICBA appreciates the opportunity to comment on the joint discussion draft that has just been released. Based on our early review, we believe the draft is a substantial improvement over earlier proposals, and we commend you, Mr. Chairman, and your committee for these efforts. Just a year ago, due to the failure of our Nation's largest institutions to adequately manage their highly risky activities, key elements of the Nation's financial system nearly collapsed. Even though our system of locally-owned and controlled community banks were not in similar danger, the resulting recession and credit crunch have now impacted the financial cornerstone of our local economies, community banks. Accordingly, we recommend that Congress move quickly on this legislation. We strongly support the provisions of the discussion draft that designate the Federal Reserve as the systemic risk regulator, and that appear to give it sufficient authority to carry out its responsibilities. We also support the enhanced authority of the Financial Services Oversight Council over the Federal Reserve's decisions. While the Federal Reserve has the expertise and experience to deal effectively with these matters, they are so critical that other agencies must be involved as well. ICBA is especially pleased that the discussion draft provides the Federal Reserve the authority to require a systemically risky holding company to sell assets or terminate activities if they pose a threat to the company's safety and soundness or the Nation's financial stability. This authority gets to the heart of many of the problems that led to the Nation's financial meltdown. Some institutions have become so large that they cannot be effectively managed or regulated, and must simply be downsized. ICBA recommends that the legislation direct the Federal Reserve to intensely study each identified financial holding company to determine if it should be subject to this new authority. The draft legislation appears to give the FDIC ample authority to responsibly resolve systemically risky holding companies. The bill gives the Treasury Secretary the sole authority to appoint the FDIC as receiver for a failed holding company. This vests a politically appointed official with tremendous power over the Nation's economy. We recommend that the legislation specifically empower the FDIC, as an independent agency, to recommend to the Secretary that he or she exercise his authority. Downsizing and resolving systemically risky institutions are key to eliminating ``too-big-to-fail'' from the financial system. Another important part of the solution of the ``too-big-to-fail'' problem is contained in the Bank Accountability and Risk Assessment Act introduced by Representative Gutierrez. This bill would make the funding of deposit insurance more risk-based and equitable. We urge the committee to incorporate this measure into broader financial reform. ICBA recommends that funding for the resolution process for systemically risky holding companies be provided by the largest institutions in advance, rather than after the fact. We believe that a pre-funded resolution process has many advantages. It avoids the initial call on taxpayer funds that would be likely if an institution were to fail unexpectedly, which of course is what happens. It places the cost on institutions that may later fail rather than only on institutions that haven't failed, providing an important equitable balance. And prefunding avoids procyclical effects, tapping the industry for modest, predictable contributions when the times are good. We strongly support the revisions in the discussion draft that block the creation of additional industrial loan companies that may be owned by commercial firms. This is the last loophole that would allow the mixing of banking and commerce. Even though the OTC would be merged into the OCC, ICBA is particularly pleased that the discussion draft retains the thrift charter; the vast majority of Federal thrifts have served their communities well. In that vein, we appreciate continued support of the chairman and the Administration for the current regulatory system as it applies to community banks. It provides valuable checks and balances that would be lost to a single regulatory scheme. I want to convey our appreciation for your efforts and thank you for the opportunity to testify today. [The prepared statement of Mr. Menzies can be found on page 166 of the appendix. ] " CHRG-111shrg52619--167 PREPARED STATEMENT OF SHEILA C. BAIR Chairman, Federal Deposit Insurance Corporation March 19, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the need to modernize and reform our financial regulatory system. The events that have unfolded over the past two years have been extraordinary. A series of economic shocks have produced the most challenging financial crisis since the Great Depression. The widespread economic damage has called into question the fundamental assumptions regarding financial institutions and their supervision that have directed our regulatory efforts for decades. The unprecedented size and complexity of many of today's financial institutions raise serious issues regarding whether they can be properly managed and effectively supervised through existing mechanisms and techniques. In addition, the significant growth of unsupervised financial activities outside the traditional banking system has hampered effective regulation. Our current system has clearly failed in many instances to manage risk properly and to provide stability. U.S. regulators have broad powers to supervise financial institutions and markets and to limit many of the activities that undermined our financial system, but there are significant gaps, most notably regarding very large insurance companies and private equity funds. However, we must also acknowledge that many of the systemically significant entities that have needed federal assistance were already subject to extensive federal supervision. For various reasons, these powers were not used effectively and, as a consequence, supervision was not sufficiently proactive. Insufficient attention was paid to the adequacy of complex institutions' risk management capabilities. Too much reliance was placed on mathematical models to drive risk management decisions. Notwithstanding the lessons from Enron, off-balance sheet-vehicles were permitted beyond the reach of prudential regulation, including holding company capital requirements. Perhaps most importantly, failure to ensure that financial products were appropriate and sustainable for consumers has caused significant problems not only for those consumers but for the safety and soundness of financial institutions. Moreover, some parts of the current financial system, for example, over the counter derivatives, are by statute, mostly excluded from federal regulation. In the face of the current crisis, regulatory gaps argue for some kind of comprehensive regulation or oversight of all systemically important financial firms. But, the failure to utilize existing authorities by regulators casts doubt on whether simply entrusting power in a single systemic risk regulator will sufficiently address the underlying causes of our past supervisory failures. We need to recognize that simply creating a new systemic risk regulator is a not a panacea. The most important challenge is to find ways to impose greater market discipline on systemically important institutions. The solution must involve, first and foremost, a legal mechanism for the orderly resolution of these institutions similar to that which exists for FDIC insured banks. In short, we need an end to too big to fail. It is time to examine the more fundamental issue of whether there are economic benefits to institutions whose failure can result in systemic issues for the economy. Because of their concentration of economic power and interconnections through the financial system, the management and supervision of institutions of this size and complexity has proven to be problematic. Taxpayers have a right to question how extensive their exposure should be to such entities. The problems of supervising large, complex financial institutions are compounded by the absence of procedures and structures to effectively resolve them in an orderly fashion when they end up in severe financial trouble. Unlike the clearly defined and proven statutory powers that exist for resolving insured depository institutions, the current bankruptcy framework available to resolve large complex nonbank financial entities and financial holding companies was not designed to protect the stability of the financial system. This is important because, in the current crisis, bank holding companies and large nonbank entities have come to depend on the banks within the organizations as a source of strength. Where previously the holding company served as a source of strength to the insured institution, these entities now often rely on a subsidiary depository institution for funding and liquidity, but carry on many systemically important activities outside of the bank that are managed at a holding company level or nonbank affiliate level. While the depository institution could be resolved under existing authorities, the resolution would cause the holding company to fail and its activities would be unwound through the normal corporate bankruptcy process. Without a system that provides for the orderly resolution of activities outside of the depository institution, the failure of a systemically important holding company or nonbank financial entity will create additional instability as claims outside the depository institution become completely illiquid under the current system. In the case of a bank holding company, the FDIC has the authority to take control of only the failing banking subsidiary, protecting the insured depositors. However, many of the essential services in other portions of the holding company are left outside of the FDIC's control, making it difficult to operate the bank and impossible to continue funding the organization's activities that are outside the bank. In such a situation, where the holding company structure includes many bank and nonbank subsidiaries, taking control of just the bank is not a practical solution. If a bank holding company or nonbank financial holding company is forced into or chooses to enter bankruptcy for any reason, the following is likely to occur. In a Chapter 11 bankruptcy, there is an automatic stay on most creditor claims, with the exception of specified financial contracts (futures and options contracts and certain types of derivatives) that are subject to termination and netting provisions, creating illiquidity for the affected creditors. The consequences of a large financial firm filing for bankruptcy protection are aptly demonstrated by the Lehman Brothers experience. As a result, neither taking control of the banking subsidiary or a bankruptcy filing of the parent organization is currently a viable means of resolving a large, systemically important financial institution, such as a bank holding company. This has forced the government to improvise actions to address individual situations, making it difficult to address systemic problems in a coordinated manner and raising serious issues of fairness. My testimony will examine some steps that can be taken to reduce systemic vulnerabilities by strengthening supervision and regulation and improving financial market transparency. I will focus on some specific changes that should be undertaken to limit the potential for excessive risk in the system, including identifying systemically important institutions, creating incentives to reduce the size of systemically important firms and ensuring that all portions of the financial system are under some baseline standards to constrain excessive risk taking and protect consumers. I will explain why an independent special failure resolution authority is needed for financial firms that pose systemic risk and describe the essential features of such an authority. I also will suggest improvements to consumer protection that would improve regulators' ability to stem fraud and abusive practices. Next, I will discuss other areas that require legislative changes to reduce systemic risk--the over-the-counter (OTC) derivatives market and the money market mutual fund industry. And, finally, I will address the need for regulatory reforms related to the originate-to-distribute model, executive compensation in banks, fair-value accounting, credit rating agencies and counter-cyclical capital policies.Addressing Systemic Risk Many have suggested that the creation of a systemic risk regulator is necessary to address key flaws in the current supervisory regime. According to the proposals, this new regulator would be tasked with monitoring large or rapidly increasing exposures--such as to sub-prime mortgages--across firms and markets, rather than only at the level of individual firms or sectors; and analyzing possible spillovers among financial firms or between firms and markets, such as the mutual exposures of highly interconnected firms. Additionally, the proposals call for such a regulator to have the authority to obtain information and examine banks and key financial market participants, including nonbank financial institutions that may not be currently subject to regulation. Finally, the systemic risk regulator would be responsible for setting standards for capital, liquidity, and risk management practices for the financial sector. Changes in our regulatory and supervisory approach are clearly warranted, but Congress should proceed carefully and deliberately in creating a new systemic risk regulator. Many of the economic challenges we are facing continue and new aspects of interconnected problems continue to be revealed. It will require great care to address evolving issues in the midst of the economic storm and to avoid unintended consequences. In addition, changes that build on existing supervisory structures and authorities--that fill regulatory voids and improve cooperation--can be implemented more quickly and more effectively. While I fully support the goal of having an informed, forward looking, proactive and analytically capable regulatory community, looking back, if we are honest in our assessment, it is clear that U.S. regulators already had many broad powers to supervise financial institutions and markets and to limit many of the activities that undermined our financial system. For various reasons, these powers were not used effectively and as a consequence supervision was not sufficiently proactive. There are many examples of situations in which existing powers could have been used to prevent the financial system imbalances that led to the current financial crisis. For instance, supervisory authorities have had the authority under the Home Ownership and Equity Protection Act to regulate the mortgage industry since 1994. Comprehensive new regulations intended to limit the worst practices in the mortgage industry were not issued until well into the onset of the current crisis. Failure to address lax lending standards among nonbank mortgage companies created market pressure on banks to also relax their standards. Bank regulators were late in addressing this phenomenon. In other important examples, federal regulatory agencies have had consolidated supervisory authority over institutions that pose a systemic risk to the financial system; yet they did not to exercise their authorities in a manner that would have enabled them to anticipate the risk concentrations in the bank holding companies, investment bank holding companies and thrift holding companies they supervise. Special purpose financial intermediaries--such as structured investment vehicles (SIVs)--played an important role in funding and aggregating the credit risks that are at the core of the current crisis. These intermediaries were formed outside the banking organizations so banks could recognize asset sales and take the assets off the balance sheet, or remotely originate assets to keep off the balance sheet and thereby avoid minimum regulatory capital and leverage ratio constraints. Because they were not on the bank's balance sheet and to the extent that they were managed outside of the bank by the parent holding company, SIVs escaped scrutiny from the bank regulatory agencies. With hindsight, all of the regulatory agencies will focus and find ways to better exercise their regulatory powers. Even though the entities and authorities that have been proposed for a systemic regulator largely existed, the regulatory community did not appreciate the magnitude and scope of the potential risks that were building in the system. Having a systemic risk regulator that would look more broadly at issues on a macro-prudential basis would be of incremental benefit, but the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively. The lack of regulatory foresight was not specific to the United States. As a recent report on financial supervision in the European Union noted, financial supervisors frequently did not have, and in some cases did not insist on obtaining--or received too late--all of the relevant information on the global magnitude of the excess leveraging that was accumulating in the financial system. \1\ Further, they did not fully understand or evaluate the size of the risks, or share their information properly with their counterparts in other countries. The report concluded that insufficient supervisory and regulatory resources combined with an inadequate mix of skills as well as different systems of national supervision made the situation worse. In interpreting this report, it is important to recall that virtually every European central bank is required to assess and report economic and financial system conditions and anticipate emerging financial-sector risks.--------------------------------------------------------------------------- \1\ European Union, Report of the High-level Group on Financial Supervision in the EU, J. de Larosiere, Chairman, Brussels, 25 February 2009.--------------------------------------------------------------------------- With these examples in mind, we should recognize that while establishing a systemic risk regulator is important, it is far from clear that it will prevent a future systemic crisis.Limiting Risk by Limiting Size and Complexity Before considering the various proposals to create a systemic risk regulator, Congress should examine a more fundamental question of whether there should be limitations on the size and complexity of institutions whose failure would be systemically significant. Over the past two decades, a number of arguments have been advanced about why financial organizations should be allowed to become larger and more complex. These reasons include being able to take advantage of economies of scale and scope, diversifying risk across a broad range of markets and products, and gaining access to global capital markets. It was alleged that the increased size and complexity of these organizations could be effectively managed using new innovations in quantitative risk management techniques. Not only did institutions claim that they could manage these new risks, they also argued that often the combination of diversification and advanced risk management practices would allow them to operate with markedly lower capital buffers than were necessary in smaller, less-sophisticated institutions. Indeed many of these concepts were inherent in the Basel II Advanced Approaches, resulting in reduced capital requirements. In hindsight, it is now clear that the international regulatory community relied too heavily on diversification and risk management when setting minimum regulatory capital requirements for large complex financial institutions. Notwithstanding expectations and industry projections for gains in financial efficiencies, economies of scale seem to be reached at levels far below the size of today's largest financial institutions. Also, efforts designed to realize economies of scope have not lived up to their promise. In some instances, the complex institutional combinations permitted by the Gramm-Leach-Bliley (GLB) legislation were unwound because they failed to realize anticipated economies of scope. The latest studies of economies produced by increased scale and scope find that most banks could improve their cost efficiency more by concentrating their efforts on reducing operational inefficiencies. There also are limits to the ability to diversify risk using securitization, structured finance and derivatives. No one disputes that there are benefits to diversification for smaller and less-complex institutions, but as institutions become larger and more complex, the ability to diversify risk is diminished. When a financial system includes a small number of very large complex organizations, the system cannot be well-diversified. As institutions grow in size and importance, they not only take on a risk profile that mirrors the risk of the market and general economic conditions, but they also concentrate risk as they become the only important counterparties to many transactions that facilitate financial intermediation in the economy. The fallacy of the diversification argument becomes apparent in the midst of financial crisis when these large complex financial organizations--because they are so interconnected--reveal themselves as a source of risk in the system.Managing the Transition to a Safer System If large complex organizations concentrate risk and do not provide market efficiencies, it may be better to address systemic risk by creating incentives to encourage a financial industry structure that is characterized by smaller and therefore less systemically important financial firms, for instance, by imposing increasing financial obligations that mirror the heightened risk posed by large entities.Identifying Systemically Important Firms To be able to implement and target the desired changes, it becomes important to identify characteristics of a systemically important firm. A recent report by the Group of Thirty highlights the difficulties that are associated with a fixed common definition of what comprises a systemically important firm. What constitutes systemic importance is likely to vary across national boundaries and change over time. Generally, it would include any firm that constitutes a significant share of their market or the broader financial system. Ultimately, identification of what is systemic will have to be decided within the structure created for systemic risk regulation, but at a minimum, should rely on triggers based on size and counterparty concentrations.Increasing Financial Obligations To Reflect Increasing Risk To date, many large financial firms have been given access to vast amounts of public funds. Obviously, changes are needed to prevent this situation from reoccurring and to ensure that firms are not rewarded for becoming, in essence, too big to fail. Rather, they should be required to offset the potential costs to society. In contrast to the capital standards implied in the Basel II Accord, systemically important firms should face additional capital charges based on both size and complexity. In addition, they should be subject to higher Prompt Corrective Action (PCA) limits under U.S. laws. Regulators should judge the capital adequacy of these firms, taking into account off-balance-sheet assets and conduits as if these risks were on balance sheet.Next Steps Currently, not all parts of the financial system are subject to federal regulation. Insurance company regulation is conducted at the state level. There is, therefore, no federal regulatory authority specifically designed to provide comprehensive prudential supervision for large insurance companies. Hedge funds and private equity firms are typically designed to operate outside the regulatory structures that would otherwise constrain their leverage and activities. This is of concern not only for the safety and soundness of these unregulated firms, but for regulated firms as well. Some of banking organizations' riskier strategies, such as the creation of SIVs, may have been driven by a desire to replicate the financial leverage available to less regulated entities. Some of these firms by virtue of their gross balance sheet size or by their dominance in particular markets can pose systemic risks on their own accord. Many others are major participants in markets and business activities that may contribute to a systemic collapse. This loophole in the regulatory net cannot continue. It is important that all systemically important financial firms, including hedge funds, insurance companies, investment banks, or bank or thrift holding companies, be subject to prudential supervision, including across the board constraints on the use of financial leverage.New Resolution Procedures There is clearly a need for a special resolution regime, outside the bankruptcy process, for financial firms that pose a systemic risk, just as there is for commercial banks and thrifts. As noted above, beyond the necessity of capital regulation and prudential supervision, having a mechanism for the orderly resolution of institutions that pose a systemic risk to the financial system is critical. Creating a resolution regime that could apply to any financial institution that becomes a source of systemic risk should be an urgent priority. The differences in outcomes from the handling of Bear Stearns and Lehman Brothers demonstrate that authorities have no real alternative but to avoid the bankruptcy process. When the public interest is at stake, as in the case of systemically important entities, the resolution process should support an orderly unwinding of the institution in a way that protects the broader economic and taxpayer interests, not just private financial interests. In creating a new resolution regime, we must clearly define roles and responsibilities and guard against creating new conflicts of interest. In the case of banks, Congress gave the FDIC backup supervisory authority and the power to self-appoint as receiver, recognizing there might be conflicts between a primary regulators' prudential responsibilities and its willingness to recognize when an institution it supervises needs to be closed. Thus, the new resolution authority should be independent of the new systemic risk regulator. This new authority should also be designed to limit subsidies to private investors (moral hazard). If financial assistance outside of the resolution process is granted to systemically important firms, the process should be open, transparent and subject to a system of checks and balances that are similar to the systemic-risk exception to the least-cost test that applies to insured financial institutions. No single government entity should be able to unilaterally trigger a resolution strategy outside the defined parameters of the established resolution process. Clear guidelines for this process are needed and must be adhered to in order to gain investor confidence and protect public and private interests. First, there should be a clearly defined priority structure for settling claims, depending on the type of firm. Any resolution should be subject to a cost test to minimize any public loss and impose losses according to the established claims priority. Second, it must allow continuation of any systemically significant operations. The rules that govern the process, and set priorities for the imposition of losses on shareholders and creditors should be clearly articulated and closely adhered to so that the markets can understand the resolution process with predicable outcomes. The FDIC's authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets offers a good model. A temporary bridge bank allows the government to prevent a disorderly collapse by preserving systemically significant functions. It enables losses to be imposed on market players who should appropriately bear the risk. It also creates the possibility of multiple bidders for the bank and its assets, which can reduce losses to the receivership. The FDIC has the authority to terminate contracts upon an insured depository institution's failure, including contracts with senior management whose services are no longer required. Through its repudiation powers, as well as enforcement powers, termination of such management contracts can often be accomplished at little cost to the FDIC. Moreover, when the FDIC establishes a bridge institution, it is able to contract with individuals to serve in senior management positions at the bridge institution subject to the oversight of the FDIC. The new resolution authority should be granted similar statutory authority in the resolution of financial institutions. Congress should recognize that creating a new separate authority to administer systemic resolutions may not be economic or efficient. It is unlikely that the separate resolution authority would be used frequently enough to justify maintaining an expert and motivated workforce as there could be decades between systemic events. While many details of a special resolution authority for systemically important financial firms would have to be worked out, a new systemic resolution regime should be funded by fees or assessments charged to systemically important firms. In addition, consistent with the FDIC's powers with regard to insured institutions, the resolution authority should have backup supervisory authority over those firms which it may have to resolve.Consumer Protection There can no longer be any doubt about the link between protecting consumers from abusive products and practices and the safety and soundness of the financial system. Products and practices that strip individual and family wealth undermine the foundation of the economy. As the current crisis demonstrates, increasingly complex financial products combined with frequently opaque marketing and disclosure practices result in problems not just for consumers, but for institutions and investors as well. To protect consumers from potentially harmful financial products, a case has been made for a new independent financial product safety commission. Certainly, more must be done to protect consumers. We could support the establishment of a new entity to establish consistent consumer protection standards for banks and nonbanks. However, we believe that such a body should include the perspective of bank regulators as well as nonbank enforcement officials such as the FTC. However, as Congress considers the options, we recommend that any new plan ensure that consumer protection activities are aligned and integrated with other bank supervisory information, resources, and expertise, and that enforcement of consumer protection rules for banks be left to bank regulators. The current bank regulation and supervision structure allows the banking agencies to take a comprehensive view of financial institutions from both a consumer protection and safety-and-soundness perspective. Banking agencies' assessments of risks to consumers are closely linked with and informed by a broader understanding of other risks in financial institutions. Conversely, assessments of other risks, including safety and soundness, benefit from knowledge of basic principles, trends, and emerging issues related to consumer protection. Separating consumer protection regulation and supervision into different organizations would reduce information that is necessary for both entities to effectively perform their functions. Separating consumer protection from safety and soundness would result in similar problems. Our experience suggests that the development of policy must be closely coordinated and reflect a broad understanding of institutions' management, operations, policies, and practices--and the bank supervisory process as a whole. Placing consumer protection policy-setting activities in a separate organization, apart from existing expertise and examination infrastructure, could ultimately result in less effective protections for consumers. One of the fundamental principles of the FDIC's mission is to serve as an independent agency focused on maintaining consumer confidence in the banking system. The FDIC plays a unique role as deposit insurer, federal supervisor of state nonmember banks and savings institutions, and receiver for failed depository institutions. These functions contribute to the overall stability of and consumer confidence in the banking industry. With this mission in mind, if given additional rulemaking authority, the FDIC is prepared to take on an expanded role in providing consumers with stronger protections that address products posing unacceptable risks to consumers and eliminate gaps in oversight. Under the Federal Trade Commission (FTC) Act, only the Federal Reserve Board (FRB) has authority to issue regulations applicable to banks regarding unfair or deceptive acts or practices, and the Office of Thrift Supervision (OTS) and the National Credit Union Administration (NCUA) have sole authority with regard to the institutions they supervise. The FTC has authority to issue regulations that define and ban unfair or deceptive acts or practices with respect to entities other than banks, savings and loan institutions, and federal credit unions. However, the FTC Act does not give the FDIC authority to write rules that apply to the approximately 5,000 entities it supervises--the bulk of state banks--nor to the OCC for their 1,700 national banks. Section 5 of the FTC Act prohibits ``unfair or deceptive acts or practices in or affecting commerce.'' It applies to all persons engaged in commerce, whether banks or nonbanks, including mortgage lenders and credit card issuers. While the ``deceptive'' and ``unfair'' standards are independent of one another, the prohibition against these practices applies to all types of consumer lending, including mortgages and credit cards, and to every stage and activity, including product development, marketing, servicing, collections, and the termination of the customer relationship. In order to further strengthen the use of the FTC Act's rulemaking provisions, the FDIC has recommended that Congress consider granting Section 5 rulemaking authority to all federal banking regulators. By limiting FTC rulemaking authority to the FRB, OTS and NCUA, current law excludes participation by the primary federal supervisors of about 7,000 banks. The FDIC's perspective--as deposit insurer and as supervisor for the largest number of banks, many of whom are small community banks--would provide valuable input and expertise to the rulemaking process. The same is true for the OCC, as supervisor of some of the nation's largest banks. As a practical matter, these rulemakings would be done on an interagency basis and would benefit from the input of all interested parties. In the alternative, if Congress is inclined to establish an independent financial product commission, it should leverage the current regulatory authorities that have the resources, experience, and legislative power to enforce regulations related to institutions under their supervision, so it would not be necessary to create an entirely new enforcement infrastructure. In fact, in creating a financial products safety commission, it would be beneficial to include the FDIC and principals from other financial regulatory agencies on the commission's board. Such a commission should be required to submit periodic reports to Congress on the effectiveness of the consumer protection activities of the commission and the bank regulators. Whether or not Congress creates a new commission, it is essential that there be uniform standards for financial products whether they are offered by banks or nonbanks. These standards must apply across all jurisdictions and issuers, otherwise gaps create competitive pressures to reduce standards, as we saw with mortgage lending standards. Clear standards also permit consistent enforcement that protects consumers and the broader financial system. Finally, in the on-going process to improve consumer protections, it is time to examine curtailing federal preemption of state consumer protection laws. Federal preemption of state laws was seen as a way to improve efficiencies for financial firms who argued that it lowered costs for consumers. While that may have been true in the short run, it has now become clear that abrogating sound state laws, particularly regarding consumer protection, created an opportunity for regulatory arbitrage that frankly resulted in a ``race-to-the-bottom'' mentality. Creating a ``floor'' for consumer protection, based on either appropriate state or federal law, rather than the current system that establishes a ceiling on protections would significantly improve consumer protection. Perhaps reviewing the existing web of state and federal laws related to consumer protections and choosing the most appropriate for the ``floor'' could be one of the initial priorities for a financial products safety commission.Changing the OTC Market and Protecting of Money Market Mutual Funds Two areas that require legislative changes to reduce systemic risk are the OTC derivatives market and the money market mutual fund industry.Credit Derivatives Markets and Systemic Risk Beyond issues of size and resolution schemes for systemically important institutions, recent events highlight the need to revisit the regulation and oversight of credit derivative markets. Credit derivatives provide investors with instruments and markets that can be used to create tremendous leverage and risk concentration without any means for monitoring the trail of exposure created by these instruments. An individual firm or a security from a sub-prime, asset-backed or other mortgage-backed pool of loans may have only $50 million in outstanding par value and yet, the over-the-counter markets for credit default swaps (CDS) may create hundreds of millions of dollars in individual CDS contracts that reference that same debt. At the same time, this debt may be referenced in CDS Index contracts that are created by OTC dealers which creates additional exposure. If the referenced firm or security defaults, its bond holders will likely lose some fraction of the $50 million par value, but CDS holders face losses that are many times that amount. Events have shown that the CDS markets are a source of systemic risk. The market for CDS was originally set up as an inter-bank market to exchange credit risk without selling the underlying loans, but it has since expanded massively to include hedge funds, insurance companies, municipalities, public pension funds and other financial institutions. The CDS market has expanded to include OTC index products that are so actively traded that they spawned a Chicago Board of Trade futures market contract. CDS markets are an important tool for hedging credit risk, but they also create leverage and can multiply underlying credit risk losses. Because there are relatively few CDS dealers, absent adequate risk management practices and safeguards, CDS markets can also create counterparty risk concentrations that are opaque to regulators and financial institutions. Our views on the need for regulatory reform of the CDS and related OTC derivatives markets are aligned with the recommendations made in the recent framework proposed by the Group of Thirty. OTC contracts should be encouraged to migrate to trade on a nationally regulated exchange with centralized clearing and settlement systems, similar in character to those of the futures and equity option exchange markets. The regulation of the contracts that remain OTC-traded should be subject to supervision by a national regulator with jurisdiction to promulgate rules and standards regarding sound risk management practices, including those needed to manage counterparty credit risk and collateral requirements, uniform close-out practices, trade confirmation and reporting standards, and other regulatory and public reporting standards that will need to be established to improve market transparency. For example, OTC dealers may be required to report selected trade information in a Trade Reporting and Compliance Engine (TRACE)-style system, which would be made publicly available. OTC dealers and exchanges should also be required to report information on large exposures and risk concentrations to a regulatory authority. This could be modeled in much the same way as futures exchanges regularly report qualifying exposures to the Commodities Futures Trading Commission. The reporting system would need to provide information on concentrations in both short and long positions.Money Market Mutual Funds Money market mutual funds (MMMFs) have been shown to be a source of systemic risk in this crisis. Two similar models of reform have been suggested. One would place MMMFs under systemic risk regulation, which would provide permanent access to the discount window and establish a fee-based insurance fund to prevent losses to investors. The other approach, offered by the Group of 30, would segment the industry into MMMFs that offer bank-like services and assurances in maintaining a stable net asset value (NAV) at par from MMMFs that that have no explicit or implicit assurances that investors can withdraw funds on demand at par. Those that operate like banks would be required to reorganize as special-purpose banks, coming under all bank regulations and depositor-like protections. But, this last approach will only be viable if there are restrictions on the size of at-risk MMMFs so that they do not evolve into too-big-to-fail institutions.Regulatory Issues Several issues can be addressed through the regulatory process including, the originate-to-distribute business model, executive compensation in banks, fair-value accounting, credit rating agency reform and counter-cyclical capital policies.The Originate-To-Distribute Business Model One of the most important factors driving this financial crisis has been the decline in value, liquidity and underlying collateral performance of a wide swath of previously highly rated asset backed securities. In 2008, over 221,000 rated tranches of private-label asset-backed securitizations were downgraded. This has resulted in a widespread loss of confidence in agency credit ratings for securitized assets, and bank and investor write-downs on their holdings of these assets. Many of these previously highly rated securities were never traded in secondary markets, and were subject to little or no public disclosure about the characteristics and ongoing performance of underlying collateral. Financial incentives for short-term revenue recognition appear to have driven the creation of large volumes of highly rated securitization product, with insufficient attention to due diligence, and insufficient recognition of the risks being transferred to investors. Moreover, some aspects of our regulatory framework may have encouraged banks and other institutional investors in the belief that a highly rated security is, per se, of minimal risk. Today, in a variety of policy-making groups around the world, there is consideration of ways to correct the incentives that led to the failure of the originate-to-distribute model. One area of focus relates to disclosure. For example, rated securitization tranches could be subject to a requirement for disclosure, in a readily accessible format on the ratings-agency Web sites, of detailed loan-level characteristics and regular performance reports. Over the long term, liquidity and confidence might be improved if secondary market prices and volumes of asset backed securities were reported on some type of system analogous to the Financial Industry Regulatory Authority's Trade Reporting and Compliance Engine that now captures such data on corporate bonds. Again over the longer term, a more sustainable originate-to-distribute model might result if originators were required to retain ``skin-in-the-game'' by holding some form of explicit exposure to the assets sold. This idea has been endorsed by the Group of 30 and is being actively explored by the European Commission. Some in the United States have noted that there are implementation challenges of this idea, such as whether we can or should prevent issuers from hedging their exposure to their retained interests. Acknowledging these issues and correcting the problems in the originate-to-distribute model is very important, and some form of ``skin-in-the-game'' requirement that goes beyond the past practices of the industry should continue to be explored.Executive Compensation In Banks An important area for reform includes the broad area of correcting or offsetting financial incentives for short-term revenue recognition. There has been much discussion of how to ensure financial firms' compensation systems do not excessively reward a short-term focus at the expense of longer term risks. I would note that in the Federal Deposit Insurance Act, Congress gave the banking agencies the explicit authority to define and regulate safe-and-sound compensation practices for insured banks and thrifts. Such regulation would be a potentially powerful tool but one that should be used judiciously to avoid unintended consequences.Fair-Value Accounting Another broad area where inappropriate financial incentives may need to be addressed is in regard to the recognition of potentially volatile noncash income or expense items. For example, many problematic exposures may have been driven in part by the ability to recognize mark-to-model gains on OTC derivatives or other illiquid financial instruments. To the extent such incentives drove some institutions to hold concentrations of illiquid and volatile exposures, they should be a concern for the safety-and-soundness of individual institutions. Moreover, such practices can make the system as a whole more subject to boom and bust. Regulators should consider taking steps to limit such practices in the future, perhaps by explicit quantitative limits on the extent such gains could be included in regulatory capital or by incrementally higher regulatory capital requirements when exposures exceed specified concentration limits. For the immediate present, we are faced with a situation where an institution confronted with even a single dollar of credit loss on its available-for-sale and held-to-maturity securities, must write down the security to fair value, which includes not only recognizing the credit loss, but also the liquidity discount. We have expressed our support for the idea that FASB should consider allowing institutions facing an other-than-temporary impairment (OTTI) loss to recognize the credit loss in earnings but not the liquidity discount. We are pleased that the Financial Accounting Standards Board this week has issued a proposal that would move in this direction.Credit Rating Agency Reform The FDIC generally agrees with the Group of 30 recommendation that regulatory policies with regard to Nationally Recognized Securities Rating Organizations (NRSROs) and the use their ratings should be reformed. Regulated entities should do an independent evaluation of credit risk products in which they are investing. NRSROs should evaluate the risk of potential losses from the full range of potential risk factors, including liquidity and price volatility. Regulators should examine the incentives imbedded in the current business models of NRSROs. For example, an important strand of work within the Basel Committee on Banking Supervision that I have supported for some time relates to the creation of operational standards for the use of ratings-based capital requirements. We need to be sure that in the future, our capital requirements do not incent banks to rely blindly on favorable agency credit ratings. Preconditions for the use of ratings-based capital requirements should ensure investors and regulators have ready access to the loan level data underlying the securities, and that an appropriate level of due diligence has been performed.Counter-Cyclical Capital Policies At present, regulatory capital standards do not explicitly consider the stage of the economic cycle in which financial institutions are operating. As institutions seek to improve returns on equity, there is often an incentive to reduce capital and increase leverage when economic conditions are favorable and earnings are strong. However, when a downturn inevitably occurs and losses arising from credit and market risk exposures increase, these institutions' capital ratios may fall to levels that no longer appropriately support their risk profiles. Therefore, it is important for regulators to institute counter-cyclical capital policies. For example, financial institutions could be required to limit dividends in profitable times to build capital above regulatory minimums or build some type of regulatory capital buffer to cover estimated through-the-cycle credit losses in excess of those reflected in their loan loss allowances under current accounting standards. Through the Basel Committee on Banking Supervision, we are working to strengthen capital to raise its resilience to future episodes of economic and financial stress. Furthermore, we strongly encourage the accounting standard-setters to revise the existing accounting model for loan losses to better reflect the economics of lending activity and enable lenders to recognize credit impairment earlier in the credit cycle.Conclusion The current financial crisis demonstrates the need for changes in the supervision and resolution of financial institutions, especially those that are systemically important to the financial system. The choices facing Congress in this task are complex, made more so by the fact that we are trying to address problems while the whirlwind of economic problems continues to engulf us. While the need for some reforms is obvious, such as a legal framework for resolving systemically important institutions, others are less clear and we would encourage a thoughtful, deliberative approach. The FDIC stands ready to work with Congress to ensure that the appropriate steps are taken to strengthen our supervision and regulation of all financial institutions--especially those that pose a systemic risk to the financial system. I would be pleased to answer any questions from the Committee. ______ CHRG-110hhrg46591--227 Mr. Yingling," Thank you for the opportunity to present the views of the ABA on regulatory reform. Clearly, changes are needed. The recent turmoil needs to be addressed through better supervision and regulation in parts of our financial services industry. The biggest failures of the current system have not been in the regulated banking system, but in the unregulated or weakly regulated sectors. Indeed, while the system for regulating banks has been strained in recent months, it has shown resilience. In spite of the difficulties of this weak economy, I want to assure you that the vast majority of banks continue to be strongly capitalized, and are opening their doors every day to meet the credit and savings needs of their customers. As the chairman has noted many times, it has been the unregulated and less regulated firms that have created problems. Given this, there has been a logical move to begin applying more bank-like regulation to the less regulated parts of the financial system. For example, when certain securities firms were granted access to the discount window, they were subjected to bank-like leverage and capital requirements. The marketplace has also pointed toward the banking model. The biggest example, of course, is the fact that Goldman Sachs and Morgan Stanley have moved to the Federal Reserve for holding company regulation. Ironically, while both the regulatory model and the business model moved toward traditional banking, bankers themselves are extremely worried that the regulatory and accounting policies could make traditional banking unworkable. Time after time, bankers have seen regulatory changes aimed at others result in massive new regulations for banks. Now, thousands of banks of all sizes are afraid that their already crushing regulatory burdens will increase dramatically by regulations aimed at less-regulated companies. We appreciate the sensitivity of this committee and the leadership of this committee toward this issue of regulatory burden. As you contemplate changes in regulation to address critical gaps, ABA urges you to ask this simple question: How will this change impact those thousands of banks that are making the loans needed to get our economy moving again? There are gaps in the current regulatory structure. First, although the Federal Reserve generally looks over the entire economy, it does not have explicit authority to look for problems and take action to address them. A systemic oversight regulator is clearly needed. The second type of gap relates to holes in the regulatory scheme where entities escape effective regulation. It is now apparent to everyone that the lack of regulation of independent mortgage brokers was a critical gap, with costly consequences. There are also gaps with respect to credit derivatives, hedge funds, and others. Finally, I wish to emphasize the critical importance of accounting policy. It is now clear that accounting standards are not only measurements designed for accurate reporting; they also have a profound impact on the financial system. So profound that they must now be part of any systemic risk calculation. Today, accounting standards are made with little accountability to anyone outside the Financial Accounting Standards Board. No systemic regulator can do its job if it cannot have input into accounting standards, standards that have the potential to undermine any action from a systemic regulator. The Congress cannot address regulatory reform in a comprehensive fashion if it does not include accounting policymaking. ABA therefore calls on Congress to establish an accounting oversight board, chaired by the chairman of the systemic regulator. The SEC Chairman could also sit on this board. The board could still delegate basic accounting standards-making to a private sector body, but the oversight process would be more formal, transparent, and robust. I believe this approach would accomplish the goal that the chairman mentioned a few minutes ago in his comments about separating mark to market from the consequences of mark to market. And I appreciate your recent letter, Congressman Bachus, on this subject. That is a good goal. But I don't think that that goal can be accomplished if you have the current regulatory situation on accounting. Clearly, it is time to make changes in the financial regulatory structure. We look forward to working with Congress to address needed changes in a timely fashion, while maintaining the critical role of our Nation's banks. Thank you. [The prepared statement of Mr. Yingling can be found on page 177 of the appendix.] " CHRG-111shrg61651--134 PREPARED STATEMENT OF SIMON JOHNSON Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; and Senior Fellow, Peterson Institute for International Economics; and Cofounder of BaselineScenario.com February 4, 2010A. General Principles \1\--------------------------------------------------------------------------- \1\ This testimony draws on joint work with James Kwak, including ``13 Bankers'' (forthcoming, March 2010) and ``The Quiet Coup'' (The Atlantic, April, 2009), and Peter Boone, particularly ``The Next Financial Crisis: It's Coming and We Just Made It Worse'' (The New Republic, September 8, 2009). Underlined text indicates links to supplementary material; to see this, please access an electronic version of this document, e.g., at http://BaselineScenario.com, where we also provide daily updates and detailed policy assessments for the global economy.--------------------------------------------------------------------------- 1) The broad principles behind the so-called ``Volcker Rules'' are sound. As articulated by President Obama at his press conference on January 21, the priority should be to limit the size of our largest banks and to reduce substantially the risks that can be taken by any financial entity that is backed, implicitly or explicitly, by the Federal Government. 2) Perceptions that certain financial institutions were ``too big to fail'' played a role in encouraging reckless risk-taking in the run-up to the financial crisis that broke in September 2008. Once the crisis broke, the Government took dramatic and unprecedented steps to save individual banks and nonbanks that were large relative to the financial system; at the same time, relatively small banks, hedge funds, and private equity and other investment funds were either intervened by the FDIC (for banks with guaranteed deposits) or just allowed to go out of business (including through bankruptcy). 3) Looking forward, we face a major and undeniable problem with the ``too big to fail'' institutions that became more powerful (in economic and political terms) as a result of the 2008-09 crisis and now dominate our financial system. Implementing the principles behind the Volcker Rules should be a top priority. 4) As a result of the crisis and various Government rescue efforts, the largest 6 banks in our economy now have total assets in excess of 63 percent of GDP (based on the latest available data; details of the calculation and related information are available in ``13 Bankers''). This is a significant increase from even 2006, when the same banks' assets were around 55 percent of GDP, and a complete transformation compared with the situation in the U.S. just 15 years ago--when the 6 largest banks had combined assets of only around 17 percent of GDP. 5) The credit markets are convinced that the biggest banks in the United States are so important to the real economy that, if any individual bank got into trouble, it would be rescued in such a way that creditors would be fully protected. As a result, the implied probability of default on debt issued by these mega-banks is very low--as reflected, for example, in their current credit default swap spreads. 6) The consequent low cost of credit for mega-banks--significantly below what is paid by smaller banks that can fail (i.e., banks that can realistically be taken over through a FDIC intervention)--constitutes a form of unfair subsidy that enables the biggest banks to become even larger. Without a size cap on individual bank size, we will move toward the highly dangerous situation that prevails in some parts of Western Europe--where individual banks hold assets worth more (at least on paper, during a boom) than their home country's GDP. 7) Just to take one example, the Royal Bank of Scotland (RBS) had assets--at their peak--worth roughly 125 percent of U.K. GDP. The mismanagement and effective collapse of RBS poses severe risks to the U.K. economy, and the rescue will cost the taxpayer dearly. Iceland is widely ridiculed for allowing banks to build up assets (and liabilities) worth between 11 and 13 times GDP, but the biggest four banks in the U.K. had bank assets worth over 3 times GDP (and total bank assets were substantially higher, by some estimates as much as 6 times GDP)--and the two largest banks in Switzerland held assets that were worth over 8 times GDP. When there is an implicit Government subsidy to bank size and growing global opportunities to export (subsidized) financial services, market forces do not limit how large banks and nonbank financial institutions can become relative to the domestic economy. In fact, as financial globalization continues, we should expect the largest U.S. banks--left unchecked--to become even bigger in dollar terms and relative to the size of our economy. 8) At the same time, under the current interpretation of our financial rules, a bank such as Goldman Sachs now has full access to the Fed's discount window (as a bank holding company)--yet also retains the ability to make risky investments of all kinds anywhere in the world (as it did when it was an investment bank, before September 2008). In a very real sense, the U.S. Government is now backing the world's largest speculative investment funds--without any effective oversight mechanisms. 9) Under the framework now in place, we are set up for another round of the boom-bailout-bust cycle that the head of financial stability at the Bank of England now terms a ``doom loop.'' The likely consequences range from terrible, in terms of pushing up our net Government debt by another 40 percentage points of GDP (or more), as we struggle again to prevent recession from becoming depression, to catastrophic--if we fail to prevent a Second Great Depression. 10) In this context, reining in the size of our largest banks is not only an appealing proposition, it is also compelling. There is no evidence for economies of scale in banking over $100 billion of total assets (measured in today's dollars). As a result, the growth of our largest banks since the early 1990s has been entirely without social benefits. At the same time, the crisis of 2008-09 manifestly demonstrates the very real social costs: the revised data will likely show more than 8 million net jobs lost since December 2007--due to more than a decade of reckless risk-taking involving large financial institutions. 11) The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 specified a size cap for banks: No single bank may hold more than 10 percent of total retail deposits. This cap was not related to antitrust concerns as 10 percent of a national market is too low to imply pricing power. Rather this was a sensible macroprudential preventive measure--don't put all your eggs in one basket. Unfortunately, since 1994 two limitations of Riegle-Neal have become clear, (1) the growth of big banks was not fueled by retail deposits but rather by various forms of ``wholesale'' financing, and (2) the cap was not enforced by lax regulators, so that Bank of America, JPMorgan Chase, and Wells Fargo all received waivers in recent years. 12) While the U.S. financial system has a long tradition of functioning well with a relatively large number of banks and other intermediaries, in recent years it has become transformed into a highly concentrated system for key products. The big four have half of the market for mortgages and two-thirds of the market for credit cards. Five banks have over 95 percent of the market for over-the-counter derivatives. Three U.S. banks have over 40 percent of the global market for stock underwriting. This degree of market power is dangerous in many ways. 13) These large banks are widely perceived--including by their own management, their creditors, and Government officials--as too big to fail. The executives who run these banks obviously have an obligation to make money for their shareholders. The best way to do this is to take risks that pay off when times are good and that result in bailouts--creating huge costs for taxpayers and all citizens--when times are bad. \2\--------------------------------------------------------------------------- \2\ For more analytical analysis and relevant data on this point, see ``Banking on the State'', by Andrew Haldane and Piergiorgio Alessandri, BIS Review 139/2009.--------------------------------------------------------------------------- 14) This incentive system distorts market outcomes, encourages reckless risk-taking, and will lead to serious trouble. While reducing bank size is not a panacea and should be combined with other key measures that are not yet on the table--including a big increase in capital requirements--finding ways to effectively reduce and then limit the size of our largest banks is a necessary condition for a safer financial system.B. Assessment of Bank Size 1) The counterargument is that big banks provide benefits to the economy that cannot be provided by smaller banks. There are also claims that the global competitiveness of U.S. corporations requires American banks be at least as big as the banks in any other country. Another argument is that large financial institutions enjoy significant economies of scale and scope that make them more efficient, helping the economy as a whole. Finally, it is argued global banks are necessary to provide liquidity to far-flung capital markets, making them more efficient and benefiting companies that raise money in those markets. 2) There is weak or no hard empirical evidence supporting any of these claims. 3) Multinational corporations do have large, global financing needs, but there are currently no banks that can supply those needs alone; instead, corporations rely on syndicates of banks for major offerings of equity or debt. And even if there were a bank large enough to meet all of a large corporation's financial needs, it would not make sense for any nonfinancial corporation to restrict itself to a single source of financial services. It is much preferable to select banks based on their expertise in particular markets or geographies. 4) In addition, U.S. corporations already benefit from competition between U.S. and foreign banks, which can provide identical financial products; there is no reason to believe that the global competitiveness of our nonfinancial sector depends on our having the world's largest banks. 5) There is also very little evidence that large banks gain economies of scale beyond a low size threshold. a. Economies of scale vanish at some point below $10 billion in assets. \3\--------------------------------------------------------------------------- \3\ Dean Amel, Colleen Barnes, Fabio Panetta, and Carmelo Salleo, ``Consolidation and Efficiency in the Financial Sector: A Review of the International Evidence'', Journal of Banking and Finance 28 (2004): 2493-2519. See also Stephen A. Rhoades, ``A Summary of Merger Performance Studies in Banking, 1980-93, and an Assessment of the`'Operating Performance' and 'Event Study' Methodologies'', Federal Reserve Board Staff Studies 167, summarized in Federal Reserve Bulletin July 1994, complete paper available at http://www.federalreserve.gov/Pubs/staffstudies/1990-99/ss167.pdf: ``In general, despite substantial diversity among the nineteen operating performance studies, the findings point strongly to a lack of improvement in efficiency or profitability as a result of bank mergers, and these findings are robust both within and across studies and over time.'' See also Allen N. Berger and David B. Humphrey, ``Bank Scale Economies, Mergers, Concentration, and Efficiency: The U.S. Experience'', Wharton Financial Institutions Center Working Paper 94-24, 1994, available at http://fic.wharton.upenn.edu/fic/papers/94/9425.pdf.--------------------------------------------------------------------------- b. The 2007 Geneva Report on ``International Financial Stability'', coauthored by former Federal Reserve vice chair Roger Ferguson, found that the unprecedented consolidation in the financial sector over the previous decade had led to no significant efficiency gains, no economies of scale beyond a low threshold, and no evident economies of scope. \4\--------------------------------------------------------------------------- \4\ Roger W. Ferguson, Jr., Philipp Hartmann, Fabio Panetta, and Richard Portes, International Financial Stability (London: Centre for Economic Policy Research, 2007), 93-94.--------------------------------------------------------------------------- c. Since large banks exhibit constant returns to scale (they are no more or less efficient as they grow larger), and we know that large banks enjoy a subsidy due to being too big to fail, ``offsetting diseconomies must exist in the operation of large institutions''--that is, without the ``too big to fail'' subsidy, large banks would actually be less efficient than midsize banks. \5\--------------------------------------------------------------------------- \5\ Edward J. Kane, ``Extracting Nontransparent Safety Net Subsidies by Strategically Expanding and Contracting a Financial Institution's Accounting Balance Sheet'', Journal of Financial Services Research 36 (2009): 161-168.--------------------------------------------------------------------------- d. There is evidence for increased productivity in U.S. banking over time, but this is due to improved use of information technology--not increasing size or scope. \6\--------------------------------------------------------------------------- \6\ Kevin J. Stiroh, ``Information Technology and the U.S. Productivity Revival: What Do the Industry Data Say?'' American Economic Review 92 (2002): 1559-1576.--------------------------------------------------------------------------- 6) Large banks do dominate customized (over-the-counter) derivatives. But this is primarily because of the implicit taxpayer subsidy they receive--again, because they are regarded as too big to fail, their cost of funds is lower and this gives them an unfair advantage in the marketplace. There is no sense in which this market share is the outcome of free and fair competition. 7) The fact that ``end-users'' of derivatives share in the implicit Government subsidy should not encourage the continuation of ``too big to fail'' arrangements. This is a huge and dangerous form of support for private interests at the expense of the taxpayer and--because of the apparent downside risks--of everyone who can lose a job or see their wealth evaporate in the face of an economic collapse. 8) There are no proven social benefits to having banks larger than $100 billion in total assets. Vague claims regarding the social value of big banks are not backed up by data or reliable estimates. This should be weighed against the very obvious costs of having banks that are too big to fail.C. Actions Needed 1) While the general principles behind the Volcker Rules make sense and there is no case for keeping our largest banks anywhere near their current size, the specific proposals outlined so far by the Administration are less persuasive. 2) Capping the size of our largest banks at their current level today does not make much sense. It is highly unlikely that, after 30 years of excessive financial deregulation, the worst crisis since the Great Depression, and an extremely generous bailout that we found ourselves with the ``right'' size for big banks. 3) Furthermore, limiting the size of individual banks relative to total nominal liabilities of the financial system does not make sense, as this would not be ``bubble proof''. For example, if housing prices were to increase ten-fold, the nominal assets and liabilities of the financial system would presumably also increase markedly relative to GDP. When the bubble bursts, it is the size of individual banks relative to GDP that is the more robust indicator of the damage caused when that bank fails--hence the degree to which it will be regarded as too big to fail. 4) Also, splitting proprietary trading from integrated investment-commercial banks would do little to reduce their overall size. The ``too big to fail'' banks would find ways to take similar sized risks, in the sense that their upside during a boom would still be big and the downside in a bust would have dramatic negative effects on the economy--and force the Government into some sort of rescue to prevent further damage. 5) The most straightforward and appealing application of the Volcker Principles is: Do not allow financial institutions to be too big to fail; put a size cap on existing large banks relative to GDP, forcing these entities to find sensible ways to break themselves up over a period of 3 years. 6) CIT Group was not too big to fail in summer 2009; it then had around $80 billion in total assets. Goldman Sachs was too big to fail in fall 2008, with assets over $1 trillion. If Goldman Sachs were to break itself up into 10 or more independent companies, this would substantially increase the likelihood that one or more could fail without damaging the financial system. It would also greatly improve the incentives of Goldman management, from a social perspective, encouraging them to be much more careful. 7) Addressing bank size is not a panacea. In addition, capital requirements need to be strengthened dramatically, back to the 20-25 percent level that was common before 1913, i.e., before the creation of the Federal Reserve, when the Government effectively had no ability to bail out major banks. Capital needs to be risk-weighted, but in a broad manner that is not amenable to gaming (i.e., quite different from Basel II and related approaches). 8) Such strengthening and simplifying of capital requirements would go substantially beyond what the Obama administration has proposed and what regulators around the world currently have in mind. In November 2009, Morgan Stanley analysts predicted that new regulations would result in Tier 1 capital ratios of 7-11 percent for large banks--i.e., below the amount of capital that Lehman had immediately before it failed. \7\--------------------------------------------------------------------------- \7\ Research Report, Morgan Stanley, ``Banking--Large and Midcap Banks: Bid for Growth Caps Capital Ask'', November 17, 2009.--------------------------------------------------------------------------- 9) The capital requirements for derivative positions also need to be simplified and strengthened substantially. For this purpose derivative holdings need to be converted according to the ``maximum loss'' principle, i.e., banks should calculate their total exposure as they would for a plain vanilla nonderivative position; they should then hold the same amount of capital as they would for this nonderivative equivalent. For example, if a bank sells protection on a bond as a derivative transaction, the maximum loss is the face value of the bond so insured. The capital requirement should be the same as when the bank simply holds that bond. 10) A strengthened and streamlined bankruptcy procedure for nonbank financial institutions makes sense. This will help wind up smaller entities more efficiently. 11) But improving the functioning of bankruptcy does not make ``too big to fail'' go away. When they are on the brink of failing, ``too big to fail'' banks are ``saved'' from an ordinary bankruptcy procedure because creditors and counterparties would be cut off from their money for months, which is exactly what causes broader economic damage. You can threaten all financial institutions with bankruptcy, but that threat is not credible for the biggest banks and nonbanks in our economy today. And if the Government did decide to make an example of a big bank and push it into bankruptcy, the result would likely be the kind of chaos--and bailouts--that followed the failure of Lehman in September 2008. 12) A resolution authority as sought by the Obama administration could help under some circumstances but is far from a magic bullet in the global world of modern finance. Some of the most severe complications of the Lehman bankruptcy occurred not in the United States, but in other countries, each of which has its own laws for dealing with a failing financial institution. These laws are often mutually inconsistent and no progress is likely toward an integrated global framework for dealing with failing cross-border banks. When a bank with assets in different countries fails, it is in each country's immediate interest to have the strictest rules on freezing assets to pay off domestic creditors (and, in some jurisdictions, to protect local workers). No other G-20 country, for example, is likely to cede to the United States the right to run a resolution process for banking activities that are located outside the U.S. 13) More broadly, solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraints on regulation and the political power of today's large banks. The idea that we can simply regulate huge banks more effectively assumes that regulators will have the incentive to do so, despite everything we know about regulatory capture and political constraints on regulation. It assumes that regulators will be able to identify the excess risks that banks are taking, overcome the banks' arguments that they have appropriate safety mechanisms in place, resist political pressure (from the Administration and Congress) to leave the banks alone for the sake of the economy, and impose controversial corrective measures that will be too complicated to defend in public. And, of course, it assumes that important regulatory agencies will not fall into the hands of people like Alan Greenspan, who believed that Government regulation was rendered largely unnecessary by the free market. 14) The ``rely on better regulation'' approach also assumes that political officials, up to and including the president, will have the backbone to crack down on large banks in the heat of a crisis, while the banks and the Administration's political opponents make accusations about socialism and the abuse of power. FDIC interventions (i.e., taking over and closing down banks) currently do not face this challenge because the banks involved are small and have little political power; the same cannot be said of JPMorgan Chase or Goldman Sachs. 15) There are no perfect solutions to the problem we now face: a handful of banks and other financial institutions that are too big to fail. The Volcker Principles are sound--we should reduce the size of our largest banks and ensure that banks with implicit (and explicit) Government subsidies are not allowed to engage in risky undercapitalized activities. 16) However, the proposed details in the Volcker Rules do not go far enough. We should put a hard size cap, as a percent of GDP, on our largest banks. A fair heuristic would be to return our biggest banks to where they were, relative to GDP, in the early 1990s--the financial system, while never perfect, functioned fine at that time and our banks were internationally competitive, and there is no evidence that our nonfinancial companies were constrained by lack of external funding. (More details on this proposal are available in ``13 Bankers''.) 17) Much stronger capital requirements will reduce the chance that any individual financial institution fails. But financial failure is a characteristic of modern market economies that cannot be legislated out of existence. When banks and nonbank financial institutions fail, there is far less damage and much less danger if they are small. ______ FinancialCrisisReport--329 The following two case studies examine how two investment banks active in the U.S. mortgage market constructed, marketed, and sold RMBS and CDO securities; how their activities magnified risk in the mortgage market; and how conflicts of interest negatively impacted investors and contributed to the financial crisis. The Deutsche Bank case history provides an insider’s view of what one senior CDO trader described as Wall Street’s “CDO machine.” It reveals the trader’s negative view of the mortgage market in general, the poor quality RMBS assets placed in a CDO that Deutsche Bank marketed to clients, and the fees that made it difficult for investment banks like Deutsche Bank to stop selling CDOs. The Goldman Sachs case history shows how one investment bank was able to profit from the collapse of the mortgage market, and ignored substantial conflicts of interest to profit at the expense of its clients in the sale of RMBS and CDO securities. CHRG-111hhrg52406--11 The Chairman," Next, the gentlewoman from California, Ms. Waters, for 2 minutes. Ms. Waters. Thank you very much, Mr. Chairman, for holding this hearing. Judging from the proliferation of all kind of exotic products such as the no-doc loans, option ARMs, and other subprime mortgages and payday loans, our current regulatory framework inadequately protects consumers. One of the issues is jurisdiction. There are several types of consumer financial products which because they are offered by nonbanks fall into what may be classified as the shadow banking industry. These products and institutions escape Federal regulation yet often lead to Federal problems such as our current economic and foreclosure crisis. A prime example of this is mortgage servicing. Mortgage servicing is an important part of the housing market and consumers often have more contact with their mortgage servicers than they do with their mortgage broker, real estate agent, or bank combined. However, lately many services have been unable to properly assist consumers for all kinds of reasons. There are liability issues and basic lack of capacity. There is currently no Federal agency with specific jurisdiction over the mortgage servicing industry, and therefore no mechanism for anyone to address this pressing issue. Keeping this in mind, an agency that merely examines up-front disclosure will not offer adequate protection to consumers who enter into transactions for financial products only to find that those products lack proper servicing and support. I am of the firm belief that if we are to truly protect consumers, we must go beyond the mere questions of disclosure in plain language and also investigate whether interactions between consumers and financial services providers are efficient and sound. That is why any Consumer Financial Protection Agency must have broad authority to examine both products and practices. Thank you, Mr. Chairman. I yield back the balance of my time. " CHRG-111shrg54675--85 PREPARED STATEMENT OF ARTHUR C. JOHNSON Chairman and Chief Executive Officer, United Bank of Michigan, Grand Rapids, Michigan, On Behalf of the American Bankers Association July 8, 2009 Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, my name is Arthur C. Johnson. I am Chairman and Chief Executive Officer of United Bank of Michigan, headquartered in Grand Rapids, Michigan. I serve as Chairman-Elect of the American Bankers Association (ABA), and I chair the ABA Community Bank Solutions Task Force, a committee dedicated to finding ways to address problems most acutely affecting community banking during this economic downturn. I am pleased to be here today representing ABA. ABA brings together banks of all sizes and charters into one association. ABA works to enhance the competitiveness of the Nation's banking industry and strengthen America's economy and communities. Its members--the majority of which are banks with less than $125 million in assets--represent over 95 percent of the industry's $13.5 trillion in assets and employ over 2 million men and women. We are pleased to share the banking industry's perspective on the current economic situation in rural America and the effects the recession is having on rural community banks. We strongly believe that community banks are one of the most important resources supporting the economic health of rural communities. Not surprisingly, the banks that serve our Nation's small towns also tend to be small community banks. Less well known is that over 3,500 banks--41 percent of the banking industry--have fewer than 30 employees. This is not the first recession faced by banks; they have been in their communities for decades and intend to be there for many decades to come. My bank, United Bank of Michigan, was chartered in 1903. We have survived the Great Depression and all the other ups and downs for over a century. We are not alone, however. In fact, there are 2,556 other banks--31 percent of the banking industry--that have been in business for more than a century; 62 percent (5,090) of banks have been in existence for more than half a century. These numbers tell a dramatic story about the staying power of community banks and their commitment to the communities they serve. My bank's focus, and those of my fellow bankers throughout the country, is on developing and maintaining long-term relationships with customers. We cannot be successful without such a philosophy and without treating our customers fairly. In spite of the severe recession, community banks located in rural communities have expanded lending. In fact, during 2008--the first year of the recession--loans from banks headquartered outside of metropolitan statistical areas \1\ increased by $17 billion, or 7 percent. Loan growth last year was also reflected in a smaller subset of community banks: farm banks. Lending for these banks expanded by $4.7 billion, or 9.2 percent, in 2008.--------------------------------------------------------------------------- \1\ Metropolitan statistical areas are defined as areas that have at least one town over 50,000 inhabitants.--------------------------------------------------------------------------- Considerable challenges remain, of course and these trends are not likely to be sustained. While many areas of our country have benefited from strong exports which have helped agricultural exports in particular, other rural areas of the country have not been as lucky. The downturn has continued to impose hardships on small businesses and manufacturers. In my home State of Michigan, we are facing our eighth consecutive year of job losses. The necessary--but painful--restructuring of the auto industry will likely cause this job erosion to continue for some time, leading to a long recovery in these areas. Other rural areas with a manufacturing employment base are also suffering similar problems. In this environment, it is only natural for businesses and individuals to be more cautious. Individuals are saving more and borrowing less. Businesses are reevaluating their credit needs and, as a result, loan demand is also declining. Banks, too, are being prudent in underwriting, and our regulators demand it. Accordingly, it is unlikely that loan volumes will increase this year, and in fact, the total loans in rural areas declined slightly in the first quarter. With the economic downturn, credit quality has suffered and losses have increased for banks. Fortunately, community banks entered this recession with strong capital levels. As this Committee is aware, however, it is extremely difficult to raise new capital in this financial climate. Without access to capital, maintaining the flow of credit in rural communities will be increasingly difficult. We believe there are actions the government can take to assist viable community banks to weather the current downturn. The success of many local economies--and, by extension, the success of the broader national economy--depends in large part on the success of these banks. Comparatively small steps taken by the government now can make a huge difference to these banks, their customers, and their communities--keeping capital and resources focused where they are needed most. Importantly, the amount of capital required to provide an additional cushion for all community banks--which had nothing to do with the current crisis--is tiny compared to the $182 billion provided to AIG. In fact, it takes only about $500 million in new capital today to bring all banks under $10 billion in assets above the well-capitalized levels for Tier 1 capital. Even under a baseline stress test, the additional capital needed is less than $3 billion for all these smaller banks to be well-capitalized. Without new capital, banks under $10 billion in assets would have to shed nearly $9 billion in loans to achieve the same capital-to-assets ratio. Simply put, capital availability means credit availability. A small investment in community banks is likely to save billions of dollars of loans in local communities. Before discussing these points in more detail, I did want to thank Members of the Subcommittee for their tireless support of S. 896, the Helping Families Save Their Homes Act of 2009, legislation that expanded the insurance limits for deposits to $250,000 for 4 years and expanded FDIC's line of credit with the Treasury from $30 billion to $100 billion. Expanding the deposit insurance limit provided additional protection to small businesses, retirees, and other bank depositors that need to protect their payrolls or life-savings. Expanding the FDIC's line of credit helped to reduce banks' expenses, thus preserving resources in communities across this Nation. Without this expanded line, the FDIC would have imposed a special assessment on the banking industry totaling more than $15 billion dollars. By enacting this expanded line of credit, the FDIC has an additional cushion to rely upon--particularly for working capital purposes necessary to resolve bank failures quickly and to ensure that depositors have immediate access to their money. This increase in borrowing authority enabled the FDIC to make good on its promise to cut the special assessment in half. The original special assessment would have devastated the earnings of banks, particularly community banks, just at the time funds are needed most in their communities. Of course, the industry still bears a considerable financial burden from both the regular quarterly premiums and the final special assessment. The vast majority of banks that will bear this cost are well capitalized and had nothing to do with the subprime mortgages that led to our financial and economic problems. Yet these banks bear much of the costs of cleaning up the problems created. We will continue to work with you to find ways to reduce the costs imposed on healthy banks and to build a strong base to support new lending as our economy emerges from this recession. In my statement, I would like to focus on the following points: Banks in rural communities continue to lend in this difficult economic environment, but the broadening economic problems will make this more difficult in the future. New and expanded programs directed at community banks can help rural America cope with the current downturn, including broadening capital programs to enable participation by a broader cross section of viable but struggling banks. Moreover, regulators should ensure that their regulatory and supervisory responses are commensurate to the risks they are seeing in banks, and that they avoid inappropriate, procyclical responses that make bad situations worse. ABA believes that it is critical for this Subcommittee and Congress to focus on creating a systemic regulator, providing a strong mechanism for resolving troubled systemically important firms and filling gaps in the regulation of the shadow banking industry. Such significant legislation would address the principal causes of the financial crisis and constitute major reform. We believe there is a broad consensus in the need to address these issues. I will address each of these points in turn.I. Banks in rural communities continue to lend in this difficult economic environment, but the broadening economic problems will make this more difficult in the future. Rural America has been bolstered in recent years by an agriculture sector that experienced one of the longest periods of financial prosperity in history. In 2007 and 2008, American farmers and ranchers in the aggregate enjoyed some of their most profitable years ever. The balance sheet for U.S. agriculture at the end of 2008 (according to USDA) was the strongest it has ever been, with a debt to asset ratio of less than 10 percent. USDA projects that, at year end 2009, farm and ranch net worth will be $2.171 trillion. This unprecedented high net worth is due in part to a robust increase in farm asset values (mainly farm real estate)--values which have not suffered the dramatic fluctuation as in some sectors during this time of crisis--but the high net worth is equally due to solid earned net worth as farmers used their excess cash profits to retire debt. However, while the past 10 years may be looked back upon by historians as an era of farm prosperity, not all sectors of the farm economy are doing well in 2009. Pressured by increases in the price of grain, the livestock sector is under considerable financial pressure. Dairy prices have dropped to below break-even levels for many producers, as demand has declined and dairy production continues to increase. The cattle feeding business has lost money for over 24 months. Poultry producers have been hurt by lower prices and by the collapse of the largest poultry integrator in the country in 2008. The hog industry, which was poised to recover from low prices in 2008, has been badly hurt by misguided fears of the H1N1 virus and the subsequent closure of some key export markets. Fortunately, rural America was well positioned at the beginning of 2009 to face the trying times they have encountered as a result of the economic crisis and other world events. In this environment, we sometimes hear that banks are not lending money. This is simply not true. As the charts on the next page show, bank lending in rural America has risen steadily over the last half-dozen years, and even during the first year of the recession, bank lending in rural areas has increased. As noted above, maintaining an expanding volume of credit will be a considerable challenge this year as the economy continues to weaken. While overall banks have continued to lend throughout this recession, that does not mean much to an individual borrower having difficulty obtaining financing. In many of these individual cases, however, upon further investigation, it appears that the primary reason for not receiving funding was either that the borrower's financial condition was vulnerable (perhaps weakened by local economic conditions), or the borrower expected to borrow money at prerecession terms when the risk of lending was considerably lower and funds available for lending were more accessible. Of course, every loan application is unique and must be evaluated that way. One thing that has clearly appened is that banks are looking carefully at the risk of a loan and reevaluating the proper pricing of that risk. This is a prudent business practice and one expected by our bank regulators. Against the backdrop of a very weak economy and in light of the troubles in the agricultural sector, it is only reasonable and prudent that all businesses--including banks and farms--exercise caution in taking on new financial obligations. In fact, farmers and ranchers have been very conscious of this financial cycle, and wisely used their excess cash profits to retire debt and to acquire new plant and equipment during the boom years. Both banks and their regulators are understandably more cautious in today's environment. Bankers are asking more questions of their borrowers, and regulators are asking more questions of the banks they examine. This means that some higher-risk projects that might have been funded when the economy was stronger may not find funding today.II. New and expanded programs directed at community banks can help rural America cope with the current downturn. The vast majority of community banks had absolutely nothing to do with the current crisis, yet as their communities have suffered, so have they. In spite of the strong agricultural economy which has helped to shield many parts of this Nation from the recession, the economic decline--and its global impact--will surely be felt over the course of the next several years. There has never been a more important time to put in place solutions that will help all community banks as they manage through this downturn. The many programs that have been initiated to calm the markets and provide capital for lending have helped to stabilize financial markets. As an example, the announcement of the Capital Purchase Program on October 14 caused risk spreads to decline from their pinnacle of 457 basis points on October 10 to 249 basis points on October 22, a drop of 45 percent. Clearly, the program to inject capital in healthy banks had a dramatic and immediate impact, and the trends begun then continue to narrow margins even further--back nearly to precrisis spreads. (See the charts on the following page.) However, the focus of the CPP and other stimulus programs has been on the largest banks and was only slowly made available to smaller banks. The changing nature of this program and the restrictive selection process has meant that banks that could have benefited from the program were unable to do so. As a result, to maintain reasonable capital levels, these banks have been forced to limit, or even reduce, their lending. As I emphasized at the outset, the amount of capital required to provide an additional cushion for all community banks is small. To reiterate, it takes only about $500 million in new capital today to bring all banks under $10 billion in assets above the well-capitalized levels for Tier 1 capital. Even under a baseline stress test to assess future needs, the additional capital needed is less than $3 billion for all banks to be well-capitalized. Without new capital, banks under $10 billion in assets would have to shed nearly $9 billion in loans to achieve the same capital-to-assets ratio. Thus, a small injection of capital goes a long way to keeping credit flowing in rural communities. Given the continued weakness in this economy and the challenges we will face in the next 18 months, it is a critical time to focus on strategies for helping community banks. ABA recommends that new programs be developed--and existing programs be expanded--to help banks in rural America. Several key changes that are needed include: Broadening capital programs to enable participation by a broader cross section of banks. Revising the risk-based capital rules to more accurately reflect the risks presented by these investments. Avoiding appraising banks into insolvency by using inappropriately conservative asset valuations and underwriting standards.Broaden capital programs to enable participation by a broader cross section of banks The Capital Purchase Program (CPP) has been implemented in a way that ignores community banks that are viable but that are experiencing significant--yet temporary--problems. The Capital Assistance Program has not yet been implemented for community banks, but reportedly will apply the same eligibility criteria that have been used with the CPP. The Legacy Loans Program has the potential to help, but the FDIC recently announced a delay in implementing the Legacy Loans Program that calls into serious question its viability outside the possible use in failed bank situations. The Legacy Securities Program is still struggling to get off the ground as well. Program after program either has failed to meet the needs of viable community banks or has languished. ABA believes that this problem can be solved through several modifications: 1. Permit banks with up to $1 billion in total assets to participate in the expanded CPP. 2. Publish the eligibility criteria for participating in the CPP and CAP. 3. Provide funding to viable banks that have significant--yet manageable--issues. 4. Revive the Legacy Loans Program and implement the Legacy Securities programs in a way that expands the universe of eligible assets to include trust preferred securities, ``real estate owned,'' and other real estate-related loans. The programs also should be implemented in a way that avoids effectively shutting small banks out (for example, minimum sizes on asset pools that no community bank could meet). The comparatively small sums of money that would be invested in these struggling but viable banks would pay big returns for the communities they serve.Revise the risk-based capital rules to more accurately reflect the risks presented by banks' investments Congress should use its oversight powers to assure that the regulators have rules and regulations that accurately reflect the risks that banks face. For example, banks' investment in mortgage backed securities and collateralized debt obligations are being severely downgraded by ratings agencies, largely due to liquidity issues (not credit or repayment risk). When the investments are downgraded below investment grade, an inappropriately conservative capital charge applies that can cause a risk weighting to go from 100 percent to 1,250 percent, regardless of the performance of the security and regardless of the amount of subordinate positions that will absorb loss before a given bank's position. Mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) are securities whose performance depends on multiple obligors; the default by one borrower is not likely to impact the performance of other borrowers whose debt has been bundled in the security. Despite this--because ratings are based primarily on the probability of loss of the first dollar--any loss in an MBS or CDO adversely affects the rating of the security. This, in turn, can trigger higher capital requirements for banks, regardless of the likelihood that a holder of an interest in the security may be repaid at 100 cents on the dollar. Moreover, the current application of the Uniform Agreement on the Classification of Assets and Appraisal of Securities causes the entire face amount of a debt security with some degree of impairment to be classified, rather than requiring classification only of the portion of the security that reflects potential loss to the banking organization. ABA believes that two changes will help this situation considerably: 1. Revise the risk-based capital rules to more accurately reflect the risks presented by these investments. 2. Classify only that portion of the security that represents the credit risk-related expected loss on the exposures underlying the security, adjusted for any credit enhancements and further adjusted for recoveries and expected loss severity. An additional problem related to bank capital is that the risk weighting of debt issued by Fannie Mae and Freddie Mac is too high. Prior to those institutions being placed into conservatorship, the debt was risk-weighted at 20 percent. Given the stated intent of the United States government to support these GSEs, a lower risk weight is appropriate and would help offset to a small degree the adverse impact that the conservatorships had on those banks that invested in Fannie and Freddie stock. The risk weight of GSE debt should be reduced to below 20 percent. The agencies proposed to lower the risk weight of Fannie and Freddie debt to 10 percent, but this rulemaking has been pending since October of last year. A third issue related to capital concerns is the extent to which a bank's allowance for loan and lease losses (ALLL) is included in the bank's capital. The agencies' capital rules permit a bank's ALLL to count as Tier 2 capital, but only up to 1.25 percent of a bank's risk-weighted assets. This fails to adequately recognize the loss-absorbing abilities of the entire allowance and creates a disincentive to banks reserving more. Both the ALLL and ``core'' capital are available to absorb losses. The Comptroller of the Currency recently acknowledged this, stating, ``loan loss reserves are a front line of defense for absorbing credit losses before capital must do so. . . . Given their primary, capital-like loss-absorbing function, loan loss reserves should get greater recognition in regulatory capital rules, a result that would help remove disincentives for banks to hold higher levels of reserves.'' \2\--------------------------------------------------------------------------- \2\ Remarks by John C. Dugan, Comptroller of the Currency, Before the Institute for International Bankers, March 2, 2009.--------------------------------------------------------------------------- These changes suggested in response to these three issues would result in a more accurate reflection of the health of institutions. ABA fully supports the system of risk-based regulation and supervision, but when the rules no longer reflect risk, the system breaks down. Our suggestions are intended to address instances where a bank's risk of loss is not fairly reflected in the rules. In the case of downgraded debt securities, the rules can, in extreme cases, threaten the viability of institutions that are directed to raise significant additional capital in a short period of time. It is bad policy to require a bank to raise capital to address the appearance of a shortfall but not the reality of one. When a rule requires more capital than the actual risk to the bank would suggest, the rule should be changed.Avoid appraising banks into insolvency by using inappropriately conservative asset valuations and underwriting standards In my role as Chairman-Elect and as chairman of the ABA Community Bank Solutions Task Force, I have heard numerous stories from bankers about issues that are coming up in exams. Banks are being told to write down the value of assets based on the sales prices of assets being dumped on the market at distressed prices. Appraisals of property that are based on comparable sales are particularly problematic when the sales do not involve a willing buyer and a willing seller. Valuations by a banker acting reasonably and in good faith are likely to be more accurate than appraisals in those situations. ABA frequently hears that examiners either are not using FASB-compliant valuation methods or are using ``personal formulas'' to downgrade or reevaluate portfolio values, even when stated values are supported by timely appraisals. We also hear that examiners are applying new, unpublished, and seemingly arbitrary ``rules of thumb'' for how much a bank must put in its allowance for loan and lease losses (ALLL). For example, in some cases examiners require 25 percent of every substandard asset; 75 percent of nonperforming assets; etc. ABA believes there are several steps that the regulators should be taking to remedy this situation and we urge this Subcommittee to use its oversight authority to encourage them: 1. Issue written guidance affirming that banks should not use distressed sales values when analyzing ``comparables.'' Guidance should address proper appraisal documentation, particularly where foreclosures or auction sales comprise a majority of the comparable transactions. Moreover, this guidance should state that banks may rely, in appropriate situations, on bank management's judgment about the value of a property. 2. Allow institutions that have rented properties at market rates to exclude them from ``nonperforming loans.'' 3. Apply clear and consistent standards to the maintenance of the ALLL that reflect a realistic assessment of the assets' likely performance. These changes are necessary to confront the natural inclination of examiners to be conservative in order to avoid the inevitable second-guessing that would arise if a bank were to fail on their watch. We are not suggesting that examiners use forbearance or otherwise relax their examination standards; rather, we are suggesting that the examiners not be harder on banks than circumstances warrant. The regulators can make things worse in their efforts to make things better. Insisting upon punitive, procyclical steps at a time when a bank is working through issues can push an otherwise viable bank over the edge. There are many more actions that could be taken to help banks throughout this period. ABA would be happy to discuss this further with the Committee.III. Creating a systemic risk regulator, providing a mechanism for resolving troubled systemically important institutions, and filling gaps in the regulation of the shadow banking industry should be the focus of Congressional action. One of the most critical needs today is a regulator with explicit systemic risk responsibility. ABA strongly supports having such a regulator. There are many aspects to consider related to the authority of this regulator, including the ability to mitigate risk-taking from systemically important institutions, authority over how accounting rules are developed and applied, and the protections needed to maintain the integrity of the payments system. ABA believes that systemic risk oversight should utilize existing regulatory structures to the maximum extent possible and involve a limited number of market participants, both bank and nonbank. Safety and soundness implications, financial risk, consumer protection, and other relevant issues need to be considered together by the regulator of each institution. To be effective, the systemic risk regulator must have some authority over the development and implementation of accounting rules. No systemic risk regulator can do its job if it cannot have some input into accounting standards--standards that have the potential to undermine any action taken by a systemic regulator. Thus, a new system for the establishment of accounting rules--one that considers the real-world effects of accounting rules--needs to be created in recognition of the critical importance of accounting rules to systemic risk and economic activity. Moreover, there must be a mechanism for the orderly resolution of systemically important nonbank firms. Our regulatory bodies should never again be in the position of making up a solution on the fly to a Bear Stearns or AIG, of not being able to solve a Lehman Brothers. The inability to deal with those situations in a predetermined way greatly exacerbated the crisis. A critical issue in this regard is ``too-big-to-fail.'' Whatever is done on the systemic regulator and on a resolution system will set the parameters of ``too-big-to-fail.'' In an ideal world, no institution would be ``too-big-to-fail,'' and that is ABA's goal; but we all know how difficult that is to accomplish, particularly with the events of the last few months. This ``too-big-to-fail'' concept has profound moral hazard implications and competitive effects that are very important to address. We note Chairman Bernanke's statement: ``Improved resolution procedures . . . would help reduce the ``too-big-to-fail'' problem by narrowing the range of circumstances that might be expected to prompt government action. . . . '' \3\--------------------------------------------------------------------------- \3\ Ben Bernanke, speech to the Council on Foreign Relations, Washington, DC, March 10, 2009.--------------------------------------------------------------------------- Finally, a major cause of our current problems is the regulatory gaps that allowed some entities to completely escape effective regulation. It is now apparent to everyone that a critical gap occurred with respect to the lack of regulation of independent mortgage brokers. Questions are also being raised with respect to credit derivatives, hedge funds, and others. As these gaps are being addressed, Congress should be careful not to impose new, unnecessary regulations on the traditional banking sector, which was not the source of the crisis and continues to provide credit. Thousands of banks of all sizes, in communities across the country, are scared to death that their already-crushing regulatory burdens will be increased dramatically by regulations aimed primarily at their less-regulated or unregulated competitors. Even worse, the new regulations will be lightly applied to nonbanks while they will be rigorously applied--down to the last comma--to banks.Conclusion I want to thank you, Mr. Chairman, for the opportunity to present the views of the ABA on the challenges ahead for rural communities and the banks that serve them. These are difficult times and the challenges are significant. In the face of a severe recession, however, bankers are working hard every day to assure that the credit needs of our communities are met. As you contemplate major changes in regulation--and change is needed--ABA would urge you to ask this simple question: how will this change impact those thousands of banks that make the loans needed to get our economy moving again? Addressing these issues will provide the most constructive avenue to assure that rural communities throughout this Nation will continue to have access to credit by local financial institutions. We look forward to working with Congress to address needed changes in a timely fashion, while maintaining the critical role of our Nation's banks. CHRG-109shrg26643--77 Chairman Bernanke," Mr. Chairman, let me just assure you that the Federal Reserve does not want to see a significant reduction in capital in the U.S. banking system. We are prudential supervisors. We have a very strong interest in maintaining a safe and sound banking system and a stable financial system. We are planning a very slow phase-in process, one that will involve considerable consultation, will involve a variety of safeguards such as floors that will be phased out over a period of time. Moreover, there are a number of other safeguards such as the leverage ratio and Pillar II which allows the supervisors to evaluate the overall safety and soundness of the bank and look at such things as compliance risk or interest rate or liquidity risk. We are very much on the same page as you are, Mr. Chairman. We think Basel II is very important because it will allow banks' capital holdings to be sensitive to the risks that they take, and it will be consistent with modern risk management techniques, so we think it is important to move forward with Basel II. But we do not see this, we certainly do not want this, to be a source of a significant reduction in aggregate capital in the U.S. banking system. " FinancialCrisisInquiry--16 The past two years have been unlike anything I’ve seen in my 40 years in financial service. Unprecedented illiquidity and turmoil on Wall Street saw the fall of two leading franchises and the consolidation of others. We saw credit markets seize, the competitive landscape remade, and vast governmental intervention in the financial sector. And the consequences have obviously spread far beyond Wall Street. Millions in America today are struggling to find work. They’ve lost homes. They watched their retirements evaporate their savings. I believe the financial crisis exposed fundamental flaws in our financial system. There is no doubt that we as an industry made mistakes. In retrospect it’s clear that many firms were too highly leveraged. They took on too much risk, and they didn’t have sufficient resources to manage those risks effectively in a rapidly changing environment. The financial crisis also made clear that regulators simply didn’t have the visibility, tools or authority to protect the stability of the financial system as a whole. Let me briefly walk you through what happened from Morgan Stanley’s viewpoint and our response to the crisis. As the commission knows, the entire financial service history was hit by a series of macro shocks that began with the steep decline in U.S. real estate prices in 2007. Morgan Stanley, like many of its peers, experienced significant losses related to the decline in the value of securities and collateralized debt obligations backed by residential mortgage loans. This was a powerful wake-up call for this firm, and we moved quickly and aggressively to adapt our business to the rapidly changing environment. We cut leverage. We strengthened risk management. We raised private capital and dramatically reduced our balance sheet. We increased total average liquidity by 46 percent, and we entered the fall of ‘08 with $170 billion in cash on our balance sheet. Thanks to these prudent steps, we were in a better position than some of our peers to weather the worst financial storm, but we did not do everything right. When Lehman Brothers collapsed in early September of ‘08, it sparked a severe crisis of confidence across global financial markets. Like many of our peers, we experienced a classic run on the bank as the entire investment banking business model came under siege. Morgan Stanley and other financial institutions experienced huge swings and spreads on the credit-default swaps tied to our debt and sharp drops in our share price. This led clearing banks to request that firms post additional collateral causing further depletion of cash resources. FOMC20080805meeting--27 25,CHAIRMAN BERNANKE.," Thank you. I guess I would comment that there is an asymmetry here, which is the possibility of systemic risk. There are situations in which failures--major collapses of certain markets--can have discontinuous and large effects on the economy. We have seen that in many contexts across a large number of countries. These stresses do reflect the working out of equilibriums given fundamental losses, which we can't do very much or anything about. But they do create machinery that is less flexible and less able to respond to new shocks, and that raises systemic risk. That is the risk that we want to try to minimize, even as we allow the markets to work their way through and to price the changes we have seen. " CHRG-110hhrg46596--384 Mr. Kashkari," Congresswoman, thank you for the comment. I will say three things. First, remember, when we started in this hearing, the overall objective of our actions has been to stabilize the financial system and to prevent a collapse, number one. Number two, we are working with the regulators to design the right measurements to look at loan levels, to see if increasing in lending is taking place relative to those who did not take the capital over time, to judge the merits of the Capital Purchase Program by themselves. And third, Mr. Chairman, if you will indulge me for just 30 seconds, to get some sense of the severity of this crisis, think about this: Bear Stearns; Washington Mutual; IndyMac; Fannie Mae; Freddie Mac; AIG; Wachovia; Lehman Brothers--all major U.S. financial institutions that have collapsed in the last 9 or 10 months. This is not a joke. " CHRG-111shrg53822--84 PREPARED STATEMENT OF SHEILA C. BAIR Chairman, Federal Deposit Insurance Corporation May 6, 2009 Chairman Dodd, Ranking Member Shelby and members of the Committee, I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on the need to address the issue of systemic risk and the existence of financial firms that are deemed ``too big to fail.'' It has been a difficult 18 months since the financial crisis began, but despite some long weekends and tense moments, government and industry have worked together to take extraordinary measures to maintain the stability of our financial system. The FDIC has been working with other federal agencies, Congress, and the White House to protect insured depositors and preserve the stability of our banking system. We have sought input from the public and the financial industry about our programs and how to structure them to produce the best results to turn this crisis around. There are indications that progress is being made in the availability of credit and the profitability of financial institutions. As we move beyond the liquidity crisis of last year, we must examine how we can improve our financial system for the future. The financial crisis has taught us that many financial organizations have grown in both size and complexity to the point that, should one of them become distressed, it may pose systemic risk to the broader financial system. The managers, directors and supervisors of these firms ultimately placed too much reliance in risk management systems that proved flawed in their operations and assumptions. Meanwhile, the markets have funded these organizations at rates that implied they were simply ``too big to fail.'' In addition, the difficulty in supervising these firms was compounded by the lack of an effective mechanism to resolve them when they became troubled in a way that controlled the potential damage their failure could bring to the broader financial system. In a properly functioning market economy there will be winners and losers, and some firms will become insolvent and should fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the market's incentive to monitor the actions of similarly situated firms. Unfortunately, the actions taken during the past crisis have reinforced the idea that some financial organizations are ``too big to fail.'' The most important challenge now is to find ways to impose greater market discipline on systemically important financial organizations. My testimony will examine whether large institutions posing systemic risk are necessary for the efficient functioning of our financial system--that is, whether they promote or hinder competition and innovation among financial firms. I also will focus on some specific changes that should be undertaken to limit the potential for excessive risk in the system, including identifying systemically important institutions, creating incentives to reduce the size of systemically important firms and ensuring that all portions of the financial system are under some baseline standards to constrain excessive risk taking. In addition, I will explain why an independent, special failure resolution authority is needed for financial firms that pose systemic risk and describe the essential features of such an authority. Finally, independent of the systemic risk issue, I will discuss the benefits of providing the FDIC with a statutory structure under which we would have authority to resolve a non-systemic failing or failed bank or thrift holding company, and how this authority would improve the ability to effect a least cost resolution for the depository institution or institutions it controls.Do We Need Financial Firms That Are Too Big to Fail? Before policymakers can address the issue of ``too big to fail,'' it is important to analyze the fundamental issue of whether there are economic benefits to having institutions that are so large and complex that their failure can result in systemic issues for the economy. Because of their concentration of economic power and interconnections through the financial system, the management and supervision of institutions that are large and complex has proven to be problematic. Unless there are clear benefits to the financial system that offset the risks created by systemically important institutions, taxpayers have a right to question how extensive their exposure should be to such entities. Over the past two decades, a number of arguments have been advanced about why financial organizations should be allowed to become larger and more complex. These reasons include being able to take advantage of economies of scale and scope, diversifying risk across a broad range of markets and products, and gaining access to global capital markets. It was alleged that the increased size and complexity of these organizations could be effectively managed using new innovations in quantitative risk management techniques. Not only did institutions claim that they could manage these new risks, they also argued that often the combination of diversification and advanced risk management practices would allow them to operate with markedly lower capital buffers than were necessary in smaller, less-sophisticated institutions. Indeed many of these concepts were inherent in the Basel II Advanced Approaches, resulting in reduced capital requirements. In hindsight, it is now clear that the international regulatory community over-estimated the risk mitigation benefits of diversification and risk management when they set minimum regulatory capital requirements for large, complex financial institutions. Notwithstanding expectations and industry projections for gains in financial efficiency, the academic evidence suggests that benefits from economies of scale are exhausted at levels far below the size of today's largest financial institutions. Also, efforts designed to realize economies of scope have not lived up to their promise. In some instances, the complex institutional combinations permitted by the Gramm-Leach-Bliley (GLB) Act were unwound because they failed to realize anticipated economies of scope. Studies that assess the benefits produced by increased scale and scope find that most banks could improve their cost efficiency more by concentrating their efforts on improving core operational efficiency. There also are practical limits on an institution's ability to diversify risk using securitization, structured financial products and derivatives. Over-reliance on financial engineering and model-based hedging strategies increases an institution's exposure to operational, model and counterparty risks. Clearly, there are benefits to diversification for smaller and less complex institutions, but the ability to diversify risk is diminished as market concentration rises and institutions become larger and more complex. When a financial system includes a small number of very large, complex organizations, the system cannot be well-diversified. As institutions grow in size and importance, they not only take on a risk profile that mirrors the risk of the market and general economic conditions, but they also concentrate risk as they become the only important counterparties to many transactions that facilitate financial intermediation in the economy. These flaws in the diversification argument become apparent in the midst of financial crisis when large, complex financial organizations--because they are so interconnected--reveal themselves as a source of risk to the system.Creating a Safer Financial System A strong case can be made for creating incentives that reduce the size and complexity of financial institutions as being bigger is not necessarily better. A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over a long period of time will always make the right decisions at the right time. Reliance solely on the supervision of these institutions is not enough. We also need a ``fail-safe'' system where if any one large institution fails, the system carries on without breaking down. Financial firms that pose systemic risks should be subject to regulatory and economic incentives that require these institutions to hold larger capital and liquidity buffers to mirror the heightened risk they pose to the financial system. In addition, restrictions on leverage and the imposition of risk-based premiums on institutions and their activities would act as disincentives to growth and complexity that raise systemic concerns. In contrast to the standards implied in the Basel II Accord, systemically important firms should face additional capital charges based on both their size and complexity. To address pro-cyclicality, the capital standards should provide for higher capital buffers that increase during expansions and are drawn down during contractions. In addition, these firms should be subject to higher Prompt Corrective Action (PCA) limits under U.S. laws. Regulators also should take into account off-balance-sheet assets and conduits as if these risks were on-balance-sheet. One existing example of statutory limitations placed on institutions is the 10 percent nationwide cap on domestic deposits imposed in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. While this regulatory limitation has been somewhat effective in preventing concentration in the U.S. system, the Riegle-Neal constraints have some significant limitations. First, these limits only apply to interstate bank mergers. Also, deposits in savings and loan institutions generally are not counted against legal limits. In addition, the law restricts only domestic deposit concentration and is silent on asset concentration, risk concentration or product concentration. The four largest banking organizations have slightly less than 35 percent of the domestic deposit market, but have over 45 percent of total industry assets.\1\ As we have seen, even with these deposit limits, banking organizations have become so large and interconnected that the failure of even one can threaten the financial system.--------------------------------------------------------------------------- \1\ FDIC, Call Report data, 4th Quarter 2008.--------------------------------------------------------------------------- In addition to establishing disincentives to unchecked growth and increased complexity of institutions, two additional fundamental approaches could reduce the likelihood that an institution will be ``too big to fail.'' One action is to create or designate a supervisory framework for regulating systemic risk. Another critical aspect to ending ``too big to fail'' is to establish a comprehensive resolution authority for systemically significant financial companies that makes the failure of any systemically important institution both credible and feasible. A realistic resolution regime would send a message that no institution is really too big to ultimately fail.Regulating Systemic Risk Our current system has clearly failed in many instances to manage risk properly and to provide stability. While U.S. regulators have broad powers to supervise financial institutions and markets and to limit many of the activities that undermined our financial system, there are significant gaps that led to the current crisis. First, there were gaps in the regulation of specific financial institutions that posed significant systemic risk--most notably very large insurance companies, private equity and hedge funds, and differences in regulatory leverage standards for commercial and investment banks. Second, there were gaps in the oversight of certain types of risk that cut across many different financial institutions. A prime example of this was the credit default swap (CDS) market which was used to both hedge and leverage risk in the structured mortgage finance market. Both of these aspects of oversight and regulation need to be addressed. A distinction should be drawn between the direct supervision of systemically-significant financial firms and the macro-prudential oversight of developing risks that may pose systemic risks to the U.S. financial system. The former appropriately calls for a single regulator for the largest, most systemically-significant firms, including large bank holding companies. The macro-prudential oversight of system-wide risks requires the integration of insights from a number of different regulatory perspectives--banks, securities firms, holding companies, and perhaps others. Only through these differing perspectives can there be a holistic view of developing risks to our system. As a result, for this latter role, the FDIC would suggest creation of a systemic risk council (SRC) to provide analytical support, develop needed prudential policies, and have the power to mitigate developing risks.Systemic Risk Regulator With regard to the regulation of systemically important entities, a systemic risk regulator (SRR) should be responsible for monitoring and regulating their activities. Centralizing the responsibility for supervising institutions that are deemed to be systemically important would bring clarity and focus to the efforts needed to identify and mitigate the buildup of risk at individual institutions. The SRR could focus on the adequacy of complex institutions' risk measurement and management capabilities, including the mathematical models that drive risk management decisions. With a few additions to their existing holding company authority, the Federal Reserve would seem well positioned for this important role. While the creation of a SRR would be a significant improvement over the current system, risks that resulted in the current crisis grew across the financial system and supervisors were slow to identify them and limited in our ability to address these issues. This underscores the weakness of monitoring systemic risk through the lens of individual financial institutions, and argues for the need to assess emerging risks using a system-wide perspective.Systemic Risk Council One way to organize a system-wide regulatory monitoring effort is through the creation of a systemic risk council (SRC) to address issues that pose risks to the broader financial system. Based on the key roles that they currently play in determining and addressing systemic risk, positions on this council should be held by the U.S. Treasury, the FDIC, the Federal Reserve Board and the Securities and Exchange Commission. It may be appropriate to add other prudential supervisors as well. The SRC would be responsible for identifying institutions, practices, and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, completing analyses and making recommendations on potential systemic risks, setting capital and other standards and ensuring that the key supervisors with responsibility for direct supervision apply those standards. The standards would be designed to provide incentives to reduce or eliminate potential systemic risks created by the size or complexity of individual entities, concentrations of risk or market practices, and other interconnections between entities and markets. The SRC could take a more macro perspective and have the authority to overrule or force actions on behalf of other regulatory entities. In order to monitor risk in the financial system, the SRC should also have the authority to demand better information from systemically important entities and to ensure that information is shared more readily. The creation of a comprehensive systemic risk regulatory regime will not be a panacea. Regulation can only accomplish so much. Once the government formally establishes a systemic risk regulatory regime, market participants may assume that the likelihood of systemic events will be diminished. Market participants may incorrectly discount the possibility of sector-wide disturbances and avoid expending private resources to safeguard their capital positions. They also may arrive at distorted valuations in part because they assume (correctly or incorrectly) that the regulatory regime will reduce the probability of sector-wide losses or other extreme events. To truly address the risks posed by systemically important institutions, it will be necessary to utilize mechanisms that once again impose market discipline on these institutions and their activities. For this reason, improvements in the supervision of systemically important entities must be coupled with disincentives for growth and complexity, as well as a credible and efficient structure that permits the resolution of these entities if they fail while protecting taxpayers from exposure.Resolution Authority The most important challenge in addressing the issue of ``too big to fail'' is to find ways to impose greater market discipline on systemically important institutions. The solution must involve, first and foremost, a legal mechanism for the orderly resolution of these institutions similar to that which exists for FDIC insured banks. The purpose of the resolution authority should not be to prop up a failed entity indefinitely, but to permit the swift and orderly dissolution of the entity and the absorption of its assets by the private sector as quickly as possible. Creating a resolution regime that applies to any financial institution that becomes a source of systemic risk should be an urgent priority. The ad-hoc response to the current banking crisis was inevitable because no playbook existed for taking over an entire complex financial organization. There were important differences in the subsequent outcomes of the Bear Stearns and Lehman Brothers cases, and these difference are due, in part, to issues that arise when large complex financial institutions are subjected to the bankruptcy process. Bankruptcy is a very messy process for financial organizations and, as was demonstrated in the Lehman Brothers case, markets can react badly. Following the Lehman Brothers filing, the commercial paper market stopped functioning and the resulting decrease in liquidity threatened other financial institutions. One explanation for the freeze in markets was that the Lehman failure shocked investors because, following Bear Stearns, they had assumed Lehman was too big too fail and its creditors would garner government support. In addition, many feel that the bankruptcy process itself had a destabilizing effect on markets and investor confidence. While the underlying causes of the market disruption that followed the Lehman failure will likely be debated for years to come, both explanations point to the need for a new resolutions scheme for systemically important non-bank financial institutions which will provide clear, consistent rules for all systemically important financial institutions, as well as a mechanism to maintain key systemic functions during an orderly wind down of those institutions. Under the first explanation, investors found it incredible that the government would allow Lehman, or firms similar to Lehman, to declare bankruptcy. Because the protracted proceedings of a Chapter 11 bankruptcy were not viewed as credible prior to the bankruptcy filing, investors were willing to make ``moral hazard'' investments in the high-yielding commercial paper of large systemic institutions. Had a credible resolution mechanism been in place prior to the Lehman bankruptcy, investors would not have made these bets, and markets would not have reacted so negatively to the shock of a bankruptcy filing. Under the second explanation, the legal features of a bankruptcy filing itself triggered asset fire sales and destroyed the liquidity of a large share of claims against Lehman. In this explanation, the liquidity and asset fire sale shock from the Lehman bankruptcy caused a market-wide liquidity shortage. Under both explanations, we are left with the same conclusion--that we need to develop a new credible and efficient means for resolving a distressed large complex non-bank institution. When the public interest is at stake, as in the case of systemically important entities, the resolution process should support an orderly unwinding of the institution in a way that protects the broader economic and taxpayer interests, not just private financial interests, and imposes losses on stakeholders in the institution. Unlike the clearly defined and proven statutory powers that exist for resolving insured depository institutions, the current bankruptcy framework available to resolve large, complex non-bank financial entities and financial holding companies was not designed to protect the stability of the financial system. This is important because, in the current crisis, bank holding companies and large non-bank entities have come to depend on the banks within their organizations as a source of strength. Where previously the holding company may have served as a source of strength to the insured institution, these entities now often rely on a subsidiary depository institution for funding and liquidity, but carry on many systemically important activities outside of the bank that are managed at a holding company level or non-bank affiliate level. In the case of a bank holding company, whether systemically significant or not, the FDIC has the authority to take control of only the failing bank subsidiary, thereby protecting the insured depositors. However, in some cases, many of the essential services for the bank's operations lie in other portions of the holding company and are left outside of the FDIC's control, making it difficult to operate and resolve the bank. When the bank fails, the holding company and its subsidiaries typically find themselves too operationally and financially unbalanced to continue to fund ongoing commitments. In such a situation, where the holding company structure includes many bank and non-bank subsidiaries, taking control of just the bank is not a practical solution. While the depository institution could be resolved under existing authorities, the resolution would likely cause the holding company to fail and its activities would then be unwound through the normal corporate bankruptcy process. Putting the holding company through the normal corporate bankruptcy process may create additional instability as claims outside the depository institution become completely illiquid under the current system. Without a system that provides for the orderly resolution of activities outside of the depository institution, the failure of a large, complex financial institution includes the risk that it will become a systemically important event. If a bank-holding company or non-bank financial holding company is forced into, or chooses to enter, bankruptcy for any reason, the following is likely to occur. In a Chapter 11 bankruptcy, there is an automatic stay on most creditor claims--with the exception of specified financial contracts (futures and options contracts and certain types of derivatives) that are subject to immediate termination and netting provisions. The automatic stay renders illiquid the entire balance of outstanding creditor claims. There are no alternative funding mechanisms, other than debtor-in-possession financing, available to remedy this problem. On the other hand, the bankrupt's financial market contracts are subject to immediate termination--and cannot be transferred to another existing institution or a temporary institution, such as a bridge bank. In bankruptcy, without a bridge bank or similar type of option, there is really no practical way to provide continuity for the holding company's or its subsidiaries' operations. Those operations are based principally on financial agreements dependent on market confidence and require continuity through a bridge bank mechanism to allow the type of quick, flexible action needed. The automatic stay and the uncertainties inherent in the judicially-based bankruptcy proceedings further impair the ability to maintain these key functions. As a result, the current bankruptcy resolution options available--taking control of the banking subsidiary or a bankruptcy filing of the parent organization--make the effective resolution of a large, systemically important financial institution, such as a bank holding company, virtually impossible. This has forced the government to improvise actions to address individual situations, making it difficult to address systemic problems in a coordinated manner and raising serious issues of fairness.Addressing Risks Posed By the Derivatives Markets One of the major risks demonstrated in the current crisis is the tremendous expansion in the size, concentration, and complexity of the derivatives markets. While these markets perform important risk mitigation functions, financial firms that rely on market funding can see it dry up overnight. If the market decides the firm is weakening, other market participants can demand more and more collateral to protect their claims. At some point, the firm cannot meet these additional demands and it collapses. In bankruptcy, current law allows market participants to terminate and net out derivatives and sell any pledged collateral to pay off the resulting net claim. During periods of market instability--such as during the fall of 2008--the exercise of these netting and collateral rights can increase systemic risks. At such times, the resulting fire sale of collateral can depress prices, freeze market liquidity as investors pull back, and create risks of collapse for many other firms. In effect, financial firms are more prone to sudden market runs because of the cycle of increasing collateral demands before a firm fails and collateral dumping after it fails. Their counterparties have every interest to demand more collateral and sell it as quickly as possible before market prices decline. This can become a self-fulfilling prophecy--and mimics the depositor runs of the past. One way to reduce these risks while retaining market discipline is to make derivative counterparties keep some ``skin in the game'' throughout the cycle. The policy argument for such an approach is even stronger if the firm's failure would expose the taxpayer or a resolution fund to losses. One approach to addressing these risks would be to haircut up to 20 percent of the secured claim for companies with derivatives claims against the failed firm if the taxpayer or a resolution fund is expected to suffer losses. This would ensure that market participants always have an interest in monitoring the financial health of their counterparties. It also would limit the sudden demand for more collateral because the protection could be capped and also help to protect the taxpayer and the resolution fund from losses.Powers The new resolution entity should be independent of the institutional regulator. In creating a new resolution regime, we must clearly define roles and responsibilities and guard against creating new conflicts of interest. No single entity should be able to make the determination to resolve a systemically important institution. The resolution entity should be able to initiate action, but the final decision should involve other affected regulators. For example, the current statute requires that decisions to exercise the systemic risk authorities for banks must have the concurrence of several parties. Yet, Congress also gave the FDIC backup supervisory authority, recognizing there might be conflicts between a primary regulator's prudential responsibilities and its willingness to recognize when an institution it supervises needs to be closed. Once the decision to resolve a systemically important institution is made, the resolution entity must have the flexibility to implement this decision in the way that protects the public interest and limits costs. This new resolution authority should also be designed to limit subsidies to private investors by assisting a troubled institution. If financial assistance outside of the resolution process is granted to systemically important firms, the process should be open, transparent and subject to a system of checks and balances that are similar to the systemic-risk exception to the least-cost test that applies to insured depository institutions. No single government entity should be able to unilaterally trigger a resolution strategy outside the defined parameters of the established resolution process. Clear guidelines for this process are needed and must be adhered to in order to gain investor confidence and protect public and private interests. First, there should be a clearly defined priority structure for settling claims, depending on the type of firm. Any resolution should be subject to a cost test to minimize any public loss and impose losses according to the established claims priority. Second, the process must allow continuation of any systemically significant operations. Third, the rules that govern the process, and set priorities for the imposition of losses on shareholders and creditors should be clearly articulated and closely adhered to so that the markets can understand the resolution process with predicable outcomes. The FDIC's authority to act as receiver and to establish a bridge bank to maintain key functions and sell assets offers a good model. A temporary bridge bank allows the government to prevent a disorderly collapse by preserving systemically significant functions. The FDIC has the power to transfer needed contracts to the bridge bank, including the financial market contracts, known as QFCs, which can be crucial to stemming contagion. It enables losses to be imposed on market players who should appropriately bear the risk. It also creates the possibility of multiple bidders for the bank and its assets, which can reduce losses to the receivership. The FDIC has the authority to terminate contracts upon an insured depository institution's failure, including contracts with senior management whose services are no longer required. Through its repudiation powers, as well as enforcement powers, termination of such management contracts can often be accomplished at little cost to the FDIC. Moreover, when the FDIC establishes a bridge institution, it is able to contract with individuals to serve in senior management positions at the bridge institution subject to the oversight of the FDIC. The new resolution entity should be granted similar statutory authority as in the current resolution of financial institutions. These additional powers would enable the resolution authority to employ what many have referred to as a ``good bank-bad bank'' model in resolving failed systemically significant institutions. Under this scenario, the resolution authority would take over the troubled firm, imposing losses on stockholders and unsecured creditors. Viable portions of the firm would be placed in the good bank, using a structure similar to the FDIC's bridge bank authority. The nonviable or troubled portions of the firms would remain behind in a bad bank and would be unwound or sold over time. Even in the case of creditor claims transferred to the bad bank, these claims could be made partially liquid very quickly using a system of ``haircuts'' tied to FDIC estimates of potential losses on the disposition of assets.Who Should Resolve Systemically Significant Entities? As the only government entity regularly involved in the resolution of financial institutions, the FDIC can testify to what a difficult and contentious business it is. Resolution work involves making hard choices between competing interests with very few good options. It can be delicate work and requires special expertise. In deciding whether to create a new government entity to resolve systemically important institutions, Congress should recognize that it would be difficult to maintain an expert and motivated workforce when there could be decades between systemic events. The FDIC experienced a similar challenge in the period before the recent crisis when very few banks failed during the years prior to the current crisis. While no existing government agency, including the FDIC, has experience with resolving systemically important entities, probably no agency other than the FDIC currently has the kinds of skill sets necessary to perform resolution activities of this nature. In determining how to resolve systemically important institutions, Congress should only designate one entity to perform this role. Assigning resolution responsibilities to multiple regulators creates the potential for inconsistent resolution results and arbitrage. While the resolution entity should draw from the expertise and consult closely with other primary regulators, spreading the responsibility beyond a single entity would create inefficiencies in the resolution process. In addition, establishing multiple resolution entities would create significant practical difficulties in the effective administration of an industry funded resolution fund designed to protect taxpayers.Funding Obviously, many details of a special resolution authority for systemically significant financial firms would have to be worked out. To be truly credible, a new systemic resolution regime should be funded by fees or assessments charged to systemically important firms. Fees imposed on these firms could be imposed either before failures, to pre-fund a resolution fund, or fees could be assessed after a systemic resolution. The FDIC would recommend pre-funding the special resolution authority. One approach to doing this would be to establish assessments on systemically significant financial companies that would be placed in a ``Financial Companies Resolution Fund'' (FCRF). A FCRF would not be funded to provide a guarantee to the creditors of systemically important institutions, but rather to cover the administrative costs of the resolution and the costs of any debtor-in-possession lending that would be necessary to ensure an orderly unwinding of a financial company's affairs. Any administrative costs and/or debtor-in-possession lending that could not be recovered from the estate of the resolved firm would be covered by the FCRF. The FDIC's experience strongly suggests that there are significant benefits to an industry funded resolution fund. First, and foremost, such a fund reduces taxpayer exposure for the failure of systemically important institutions. The ability to draw on the accumulated reserves of the fund also ensures adequate resources and the credibility of the resolution structure. The taxpayer confidence in the Deposit Insurance Fund (DIF) with regard to the resolution of banks is a direct result of the respect engendered by its funding structure and conservative management. The FCRF would be funded by financial companies whose size, complexity or interconnections potentially could pose a systemic risk to the financial system at some point in time (perhaps the beginning of each year). Those systemically important firms that have an insured depository subsidiary or other financial entity whose claimants are insured through a federal or state guarantee fund could receive a credit for the amount of their assessment to cover those institutions. It is anticipated that the number of companies covered by the FCRF would be fluid, changing periodically depending upon the activities of the company and the market's ability to develop mechanisms to ameliorate systemic risk. Theoretically, as companies fall below the threshold for being potentially systemically important, they would no longer be assessed for coverage by the FCRF. Similarly, as companies undertake activities or provide products/services that make them potentially more systemically important, they would fall under the purview of the FCRF and be subject to assessment. Assessing institutions based on the risk they pose to the financial systems serves two important purposes. A strong resolution fund ensures that resolving systemically important institutions is a credible option which enhances market discipline. At the same time, risk-based assessments are an important tool to affect the behavior of these institutions. Assessments could be imposed on a sliding scale based on the increasing level of systemic risk posed by an entity's size or complexity.Resolution of Non-Systemic Holding Companies Separate and apart from establishing a resolution structure to handle systemically important institutions, the ability to resolve non-systemic bank failures would be greatly enhanced if Congress provided the FDIC the authority to resolve bank and thrift holding companies affiliated with a failed institution. The corporate structure of bank and thrift holding companies, with their insured depositories and other subsidiaries, has become increasingly complex and inter-reliant. The insured depository is likely to be dependent on affiliates that are subsidiaries of its holding company for critical services, such as loan and deposit processing, loan servicing, auditing, risk management and wealth management. Moreover, in many cases the non-bank affiliates themselves are dependent on the bank for their continued viability. It is not unusual for many business lines of these corporate enterprises to be conducted in both insured and non-insured affiliates without regard to the confines of a particular entity. Examples of such multi-entity operations often include retail and mortgage banking and capital markets. Atop this network of corporate relationships, the holding company exercises critical control of its subsidiaries and their mutually dependent business activities. The bank may be so dependent on its holding company that it literally cannot operate without holding company cooperation. The most egregious example of this problem emerged with the failure of NextBank in northern California in 2002. When the bank was closed, the FDIC ascertained that virtually the entire infrastructure of the bank was controlled by the holding company. All of the bank personnel were holding company employees and all of the premises used by the bank were owned by the holding company. Moreover, NextBank was heavily involved in credit card securitizations and the holding company threatened to file for bankruptcy, a strategy that would have significantly impaired the value of the bank and the securitizations. To avert this adverse impact on the DIF, the FDIC was forced to expend significant funds to avoid the bankruptcy filing. As long as the threats exists that a bank or thrift holding company can file for bankruptcy, as well as affect the business relationships between its bank and other subsidiaries, the FDIC faces great difficulty in effectuating a resolution strategy that preserves the franchise value of the failed bank and so protects the DIF. Bankruptcy proceedings, involving the parent or affiliate of a bank, are time-consuming, unwieldy, and expensive. The FDIC as receiver or conservator occupies a position no better than any other creditor and so lacks the ability to protect the receivership estate and the DIF. The threat of bankruptcy by the BHC or its affiliates is such that the Corporation may be forced to expend considerable sums propping up the holding company or entering into disadvantageous transactions with the holding company or its subsidiaries in order to proceed with a bank's resolution. The difficulties are particularly egregious where the Corporation has established a bridge bank to preserve franchise value, protect creditors (including uninsured depositors), and facilitate disposition of the failed institution's assets and liabilities. By giving the FDIC authority to resolve a failing or failed bank's holding company, Congress would provide the FDIC with a vital tool to deal with the increasingly complicated and highly symbiotic business structures in which banks operate in order to develop an efficient and economical resolution. The purpose of the authority to resolve non-systemic holding companies would be to achieve the least cost resolution of a failed insured depository institution. It would be used to reduce costs to the DIF through a more orderly and comprehensive resolution of the entire financial entity. If the current bifurcated resolution structure involving resolution of the insured institution by the FDIC and bankruptcy for the holding company would produce the least costly resolution, the FDIC should retain the ability to use that structure as well. Enhanced authorities that allow the FDIC to efficiently resolve failed depository institutions that are part of a complex holding company structure will provide immediate efficiencies in bank resolutions result in reduced losses to the DIF and not require any additional funding.Conclusion The current financial crisis demonstrates the need for changes in the supervision and resolution of financial institutions, especially changes relative to large, complex organizations that are systemically important to the financial system. The choices facing Congress in this task are complex, made more so by the fact that we are trying to address problems while dealing with one of the greatest economic challenges we've seen in decades. While the need for some reforms is obvious, such as a legal framework for resolving systemically important institutions, others are less clear and we would encourage a thoughtful, deliberative approach. The FDIC stands ready to work with Congress to ensure that the appropriate steps are taken to strengthen our supervision and regulation of all financial institutions--especially those that pose a systemic risk to the financial system. I would be pleased to answer any questions from the Committee. ______ CHRG-111shrg51395--274 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DAMON A. SILVERSQ.1. Do you all agree with Federal Reserve Board Chairman Bernanke's remarks today about the four key elements that should guide regulatory reform? First, we must address the problem of financial institutions that are deemed too big--or perhaps too interconnected--to fail. Second, we must strengthen what I will call the financial infrastructure--the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets--to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality--that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing.A.1. I would cover some of the same ground that Chairman Bernanke did in a different way. I think regulatory reform must: 1. LProtect the public by creating an independent consumer protection agency for financial services, which would, among other duties, ensure mortgage markets are properly regulated 2. LReregulate the shadow markets-in particular, derivatives, hedge funds, private equity funds, and off-balance sheet vehicles, so that it is no longer possible for market actors to choose to conduct activities like bond insurance or money management either in a regulated or an unregulated manner. As President Obama said in 2008 at Cooper Union, financial activity should be regulated for its content, not its form. 3. LProvide for systemic risk regulation by a fully public entity, including the creation of a resolution mechanism applicable to any financial firm that would be the potential subject of government support. The Federal Reserve System under its current governance structure, which includes significant bank involvement at the Reserve Banks, is too self-regulatory to be a proper systemic risk regulator. Either the Federal Reserve System needs to be fully public, or the systemic risk regulatory function needs to reside elsewhere, perhaps in a committee that would include the Fed Chairman in its leadership. The issue of procyclicality is complex. I think anticyclicality in capital requirements may be a good idea. I have become very skeptical of the changes that have been made to GAAP that have had the effect, in my opinion, of making financial institutions' balance sheets and income statements less transparent and reliable. See the August, 2009, report of the Congressional Oversight Panel. Most importantly, moves that appear to be anticyclical may be procyclical, by allowing banks not to write down assets that are in fact impaired, these measures may be a disincentive, for example, for banks to restructure mortgages in ways that allow homeowners to stay in their homes.Q.2. Would a merger or rationalization of the roles of the SEC and CFTC be a valuable reform, and how should that be accomplished?A.2. A merger of the SEC and the CFTC would be a valuable reform. Alternatively, jurisdiction over financial futures and derivatives could be transferred from the CFTC to the SEC so that there is no possibility of regulatory arbitrage between securities on the one hand and financial futures and derivatives on the other. Recent efforts by both agencies to harmonize their approaches to financial regulation, while productive, have highlighted the degree to which they are regulating the same market, and the extent of the continuing threat of regulatory arbitrage created by having separate agencies. If there were to be a merger, it must be based on adopting the SEC's greater anti-fraud and market oversight powers. The worst idea that has surfaced in the entire regulatory reform debate, going back to 2006, was the proposal in the Paulson Treasury blueprint to use an SEC-CFTC merger to gut the investor protection and enforcement powers of the SEC. For more details on these issues, the Committee should review the transcript of the second day of the joint SEC-CFTC roundtable on coordination issues held on September 3, 2009. I have attached my written statement to that roundtable. [See, Joint Hearing Testimony, below.]Q.3. How is it that AIG was able to take such large positions that it became a threat to the entire financial system? Was it a failure of regulation, a failure of a product, a failure of risk management, or some combination?A.3. AIG took advantage of three regulatory loopholes that should be closed. Their London-based derivatives office was part of a thrift bank, regulated by the OTS, an agency which during the period in question advertised itself to potential ``customers'' as a compliant regulator. This ability to play regulators off against each other needs to end. Second, the Basel II capital standards for banks allowed banks with AAA ratings not to have to set capital aside to back up derivatives commitments. Third, thanks to the Commodities Futures Modernization Act, there was no ability of any agency to regulate derivatives as products, or to require capital to be set aside to back derivative positions. Within AIG, the large positions taken by the London affiliate represent a colossal managerial and governance failure. It is a managerial failure in that monitoring capital at risk and leverage is a central managerial function in a financial institution. It is a governance failure in that the scale of the London operation, and its apparent contribution to AIG's profits in the runup to the collapse, was such that the oversight of the operation should have been of some importance to the board. The question now is, what sort of accountability has there really been for these failures?Q.4. How should we update our rules and guidelines to address the potential failure of a systematically critical firm?A.4. We need to make the following changes to our financial regulatory system to address the need to protect the financial system against systemic risk: 1. LWe need to give the FDIC and a systemic risk regulator the power to resolve any financial institution, much as that power is now given to the FDIC to resolve insured depositary institutions, if that financial institution represents a systemic threat. 2. LCapital requirements and deposit insurance premiums need to increase as a percentage of assets as the size of the firm increases. The Obama Administration has proposed a two tier approach to this idea. More of a continuous curve would be better for a number of reasons--in particular it would not tie the hands of policy makers when a firm fails in the way a two tier system would. If we have a two tier system, the names of the firm in the top tier must be made public. These measures both operate as a deterrent to bigness, and compensate the government for the increased likelihood that we will have to rescue larger institutions. 3. LBank supervisory regulators need to pay much closer attention to executive compensation structures in financial institutions to ensure they are built around the proper time horizons and the proper orientation around risk. This is not just true for the CEO and other top executives--it is particularly relevant for key middle management employees in areas like trading desks and internal audit. Fire alarms should go off if internal audit is getting incentive pay based on stock price. 4. LWe need to close regulatory loopholes in the shadow markets so that all financial activity has adequate capital behind it and so regulators have adequate line of site into the entire market landscape. This means regulating derivatives, hedge funds, private equity and off-balance sheet vehicles based on the economic content of what they are doing, not based on what they are called. 5. LWe need to end regulatory arbitrage, among bank regulators; between the SEC and the CFTC, and to the extent possible, internationally by creating a global financial regulatory floor. 6. LWe need to adopt the recommendation of the Group of Thirty, chaired by Paul Volcker, to once again separate proprietary securities and derivatives trading from the management of insured deposits. AMERICAN FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL ORGANIZATIONS Joint Hearing of the CFTC and the SEC--Harmonization of Regulation September 3, 2009 Good morning Chairman Schapiro and Chairman Gensler. My name is Damon Silvers, I am an Associate General Counsel of the AFL-CIO, and I am the Deputy Chair of the Congressional Oversight Panel created under the Emergency Economic Stabilization Act of 2008 to oversee the TARP. My testimony reflects my views and the views of the AFL-CIO unless otherwise noted, and is not on behalf of the Panel, its staff or its chair, Elizabeth Warren. I should however note that a number of the points I am making in this testimony were also made in the Congressional Oversight Panel's Report on Financial Regulatory Reform's section on reregulating the shadow capital markets, and I commend that report to you. \1\--------------------------------------------------------------------------- \1\ Congressional Oversight Panel, Special Report on Regulatory Reform, at 22-24 (Jan. 29, 2009), available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- Thank you for the opportunity to share my views with you today on how to best harmonize regulation by the SEC and the CFTC. Before I begin, I would like to thank you both for bringing new life to securities and commodities regulation in this country. Your dedication to and enforcement of the laws that ensure fair dealing in the financial and commodities markets has never been more important than it is today. Derivatives are a classic shadow market. To say a financial instrument is a derivative says nothing about its economic content. Derivative contracts can be used to synthesize any sort of insurance contract, including most prominently credit insurance. Derivatives can synthesize debt or equity securities, indexes, futures and options. Thus the exclusion of derivatives from regulation by any federal agency in the Commodity Futures Modernization Act ensured that derivatives could be used to sidestep thoughtful necessary regulations in place throughout our financial system. \2\ The deregulation of derivatives was a key step in creating the Swiss cheese regulatory system we have today, a system that has proven to be vulnerable to shocks and threatening to the underpinnings of the real economy. The result--incalculable harm throughout the world, and harm in particular to working people and their benefit funds who were not invited to the party and in too many cases have turned out to be paying for the cleanup.--------------------------------------------------------------------------- \2\ Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763 (2000).--------------------------------------------------------------------------- There are three basic principles that the AFL-CIO believes are essential to the successful harmonization of SEC and CFTC regulation and enforcement, and to the restoration of effective regulation across our financial system: 1. Regulators must have broad, flexible jurisdiction over the derivatives markets that prevents regulatory arbitrage or the creation of new shadow markets under the guise of innovation. 2. So long as the SEC and the CFTC remain separate agencies, the SEC should have authority to regulate all financial markets activities, including derivatives that reference financial products. The CFTC should have authority to regulate physical commodities markets and all derivatives that reference such commodities. 3. Anti-fraud and market conduct rules for derivatives must be no less robust than the rules for the underlying assets the derivatives reference. The Administration's recently proposed Over-the-Counter Derivatives Markets Act of 2009 (``Proposed OTC Act'') will help to close many, but not all, of the loopholes that make it difficult for the SEC and the CFTC to police the derivatives markets. It will also make it even more important that the SEC and the CFTC work together to ensure that regulation is comprehensive and effective.Regulators Must Have Broad, Flexible Jurisdiction Over the Entire Derivatives Market Derivatives as a general matter should be traded on fully regulated, publicly transparent exchanges. The relevant regulatory agencies should ensure that the exchanges impose tough capital adequacy and margin requirements that reflect the risks inherent in contracts. Any entity that markets derivatives products must be required to register with the relevant federal regulators and be subject to business conduct rules, comprehensive recordkeeping requirements, and strict capital adequacy standards. The Proposed OTC Act addresses many of the AFL-CIO's concerns about the current lack of regulation in the derivatives markets. If enacted, the Proposed OTC Act would ensure that all derivatives and all dealers face increased transparency, capital adequacy, and business conduct requirements. \3\ It would also require heightened regulation and collateral and margin requirements for OTC derivatives.--------------------------------------------------------------------------- \3\ Available at http://www.financialstability.gov/docs/regulatoryreform/titleVII.pdf--------------------------------------------------------------------------- The Proposed OTC Act would also require the SEC and CFTC to develop joint rules to define the distinction between ``standardized'' and ``customized'' derivatives. \4\ This would make SEC/CFTC harmonization necessary to the establishment of effective derivatives regulation.--------------------------------------------------------------------------- \4\ Proposed OTC Act 713(a)(2) (proposing revisions to the Commodity Exchange Act, 7 U.S.C. 2(j)(3)(A)).--------------------------------------------------------------------------- The AFL-CIO believes that the definition of a customized contract should be very narrowly tailored. Derivatives should not be permitted to trade over-the-counter simply because the counterparties have made minor tweaks to a standard contract. If counter-parties are genuinely on opposite sides of some unique risk event that exchange-trading could not accommodate, then they should be required to show that that is the case through a unique contract. The presence or absence of significant arms-length bargaining will be indicative of whether such uniqueness is genuine, or artificial. In a recent letter to Senators Harkin and Chambliss, Chairman Gensler flagged several areas of the Proposed OTC Act that he believes should be improved. \5\ The AFL-CIO strongly supports Chairman Gensler's recommendation that Congress revise the Proposed OTC Act to eliminate exemptions for foreign exchange swaps and forwards. We also strongly agree with Chairman Gensler that mandatory clearing and exchange trading of standardized swaps must be universally applicable and there should not be an exemption for counterparties that are not swap dealers or ``major swap participants.''--------------------------------------------------------------------------- \5\ Letter from Gary Gensler, Chairman of the Commodity Futures Trading Commission, to The Honorable Tom Harkin and The Honorable Saxby Chambliss, August 17, 2009, page 4, available at http://tradeobservatory.org/library.cfm?refid=106665---------------------------------------------------------------------------The SEC Should Regulate Financial Markets and the CFTC Should Regulate Commodities Markets The SEC was created in 1934, due to Congress' realization that ``national emergencies . . . are precipitated, intensified, and prolonged by manipulation and sudden and unreasonable fluctuations of security prices and by excessive speculation on such exchanges and markets, and to meet such emergencies the Federal Government is put to such great expense as to burden the national credit.'' \6\ As a result of the impact instability in the financial markets had on the broader economy during the Great Depression, Congress gave the SEC broad authority to regulate financial markets activities and individuals that participate in the financial markets in a meaningful way. \7\--------------------------------------------------------------------------- \6\ 15 U.S.C. 78b. \7\ See generally The Securities Act of 1933 (15 USC 77a et seq.); The Securities Exchange Act of 1934 (15 USC 78a et seq.); The Investment Company Act of 1940 (15 USC 80a-1 et seq.); The Investment Advisers Act of 1940 (15 USC 80b-1 et seq.).--------------------------------------------------------------------------- As presently constituted, the CFTC has oversight not only for commodities such as agricultural products, metals, energy products, but also has come to regulate--through court and agency interpretation of the CEA--financial instruments, such as currency, futures on U.S. government debt, and security indexes. \8\--------------------------------------------------------------------------- \8\ 7 U.S.C. 1a(4) provides the CFTC with jurisdiction over agricultural products, metals, energy products, etc. See Commodity Futures Trading Com'n v. International Foreign Currency, Inc., 334 F.Supp.2d 305 (E.D.N.Y. 2004), Commodity Futures Trading Com'n v. American Bd. of Trade, Inc., 803 F.2d 1242 (2d Cir 1986) discussing the CFTC's authorities with regard to currency derivatives. Since 1975, the CFTC has determined that all futures based on short-term and long-term U.S. government debt qualifies as a commodity under the CEA. See CFTC History, available at http://www.cftc.gov/aboutthecftc/historyofthecftc/history--1970s.html. Other financial products regulated by the CFTC include security indexes, Mallen v. Merrill Lynch., 605 F.Supp. 1105 (N.D.Ga.1985).--------------------------------------------------------------------------- So long as two agencies continue to regulate the same or similar financial instruments, there will be opportunities for market participants to engage in regulatory arbitrage. As we have seen on the banking regulatory side and with respect to credit default swaps, such arbitrage can have devastating results. As long as the SEC and the CFTC are separate, the SEC should regulate all financial instruments including stocks, bonds, mutual funds, hedge funds, securities, securities-based swaps, securities indexes, and swaps that reference currencies, U.S. government debt, interest rates, etc. The CFTC should have authority to regulate all physical commodities and commodities-based derivatives. We recognize that the proposed Act does not in all cases follow the principles laid out above. To the extent financial derivatives remain under the jurisdiction of the CFTC, it is critical that the CFTC and the SEC seek the necessary statutory changes to bring the CFTC's power to police fraud and market manipulation in line with the SEC's powers. In this respect, we are heartened by the efforts by the CFTC under Chairman Gensler's leadership to address possible gaps in the Administration's proposed statutory language. A vigorous and coordinated approach to enforcement by both agencies can in some respects correct for flaws in jurisdictional design. They cannot correct for lack of jurisdiction or weak substantive standards of market conduct. In his letter to Senators Harkin and Chambliss, Chairman Gensler raised concerns about the Administration's proposal for the regulation of ``mixed swaps,'' or swaps whose value is based on a combination of assets including securities and commodities. Because the underlying asset will include those regulated by both the SEC and the CFTC, the Administration proposes that both agencies separately regulate these swaps in a form of ``dual regulation.'' Chairman Gensler expresses concern that such dual regulation will be unnecessarily confusing, and suggests instead that each mixed swap be assigned to one agency or the other, but not both. In that proposed system, the mixed swap would be ``primarily'' deriving its economic identity from either a security or a commodity. \9\ Under the Chairman's view, only one agency would regulate any given mixed swap, depending on whether the swap was ``primarily'' a security- or a commodity-based swap.--------------------------------------------------------------------------- \9\ Id.--------------------------------------------------------------------------- Chairman Gensler's proposal certainly has a great deal of appeal--it's simpler, and eliminates the concern that duplicative regulation becomes either unnecessarily burdensome, or worse, completely ineffective. One could imagine a situation where each agency defers to the other, leaving mixed swaps dealers with free reign to develop their market as they see fit. But a proposal that focuses on the boundary between an SEC mixed swap and a CFTC mixed swap will run into a clear problem. There are swaps that are not primarily either security- or commodity-based: in fact, by design, they are swaps that, at the time of contract, are exactly 50/50, where the economic value of the SEC-type asset is equivalent to the economic value of the CFTC based asset. 50/50 swaps aren't that unusual, and Chairman Gensler's approach does not address what to do in those instances. These kinds of boundary issues become inevitable when we decide not to merge the two agencies. In order to prevent these problems from becoming loopholes, a solution must either eliminate the boundary--e.g., the Administration's dual regulation proposal--or it must adequately police that boundary. One potential alternative would be to form a staff-level joint task force between the CFTC and the SEC to ensure that these 50/50 swaps--those that are neither obviously SEC-swaps nor CFTC-swaps--would be regulated comprehensively, and consistently, across the system.Anti-Fraud and Market Conduct Rules In considering enforcement issues for derivatives, it is critical to consider the appropriate level of regulation of the underlying assets from which these derivatives flow. Some of the strongest tools in the agencies' toolboxes are anti-fraud and market conduct enforcement. Derivatives must be held at a minimum to the same standards as the underlying assets. The Administration's Proposed OTC Derivatives Act makes important steps in this direction. However, there will be a continuing problem if the rules governing the underlying assets are too weak. Here the CFTC's current statutory framework is substantially weaker in terms of both investor protection and market oversight than the SEC. The Commodities Exchange Act (CEA) does not recognize insider trading as a violation of the law. This is a serious weakness in the context of mixed derivatives and both financial futures and derivatives based on financial futures. It also appears to be an obstacle to meaningful oversight of the commodities markets themselves in the light of allegations of market manipulation in the context of the recent oil price bubble. Similarly, the CEA has an intentionality standard for market manipulation, while the SEC operates under a statutory framework where the standard in general is recklessness. Intentionality as a standard for financial misconduct tends to require that the agency be able to read minds to enforce the law. Recklessness is the proper common standard.Rules Versus Principles The Treasury Department's White Paper on Financial Regulatory Reform suggests there should be a harmonization between the SEC's more rules-based approach to market regulation and the CFTC's more principles-based approach. \10\ Any effective system of financial regulation requires both rules and principles. A system of principles alone gives no real guidance to market actors and provides too much leeway that can be exploited by the politically well connected. A system of rules alone is always gameable.--------------------------------------------------------------------------- \10\ Financial Regulatory Reform: A New Foundation. Department of the Treasury (June 17, 2009). See also http://www.financialstability.gov/docs/regs/FinalReport_web.pdf--------------------------------------------------------------------------- Unfortunately, in the years prior to the financial crisis that began in 2007 the term ``principles based regulation'' became a code word for weak regulation. Perhaps the most dangerous manifestation of this effort was the Paulson Treasury Department's call in its financial reform blueprint for the weakening of the SEC's enforcement regime in the name of principles based regulation by requiring a merged SEC and CFTC to adopt the CEA's approach across the entire securities market. \11\--------------------------------------------------------------------------- \11\ http://www.treas.gov/press/releases/reports/Blueprint.pdf--------------------------------------------------------------------------- The SEC and the CFTC should build a strong uniform set of regulations for derivatives markets that blend principles and rules. These rules should not be built with the goal of facilitating speedy marketing of innovative financial products regardless of the risks to market participants or the system as a whole. In particular, the provisions of the Commodities Exchange Act that place the burden on the CFTC to show an exchange or clearing facilities operations are not in compliance with the Act's principles under a ``substantial evidence'' test are unacceptably weak, and if adopted in the area of derivatives would make effective policing of derivatives' exchanges and/or clearinghouses extremely difficult. It remains a mystery to us why ``innovation'' in finance is uncritically accepted as a good thing when so much of the innovation of the last decade turned out to be so destructive, and when so many commentators have pointed out that the ``innovations'' in question, like naked credit default swaps with no capital behind them, were well known to financial practitioners down through the ages and had been banned in our markets for good reason, in some cases during the New Deal and in some cases earlier. This approach is not a call for splitting the difference between strong and weak regulation. It is a call for building strong, consistent regulation that recognizes that the promotion of weak regulation under the guise of ``principles based regulation'' was a major contributor to the general failure of the financial regulatory system.Conclusion The last 2 years have shown us the destructive consequences of the present system--destructive not only to our overall economy, but also to the lives and livelihoods of the men, women, and families least positioned to weather these storms. We have seen firsthand how regulatory arbitrage in the financial markets create tremendous systemic risks that can threaten the stability of the global economy. Derivatives are a primary example of how jurisdictional battles among regulators can result in unregulated and unstable financial markets. We urge you to work together to create a system that will ensure that nothing falls through the cracks when the SEC and the CFTC are no longer under your collective leadership. CHRG-111hhrg53021Oth--147 Secretary Geithner," I think, Congressman, that is an excellent question. We could debate this for hours. But the lesson of the financial crisis here in the United States, and around the world, is that when you face a loss of confidence and a loss of demand of this magnitude, when you have a financial system on the edge of collapse, the only path to mitigate the damage is for the government to do what this Congress did and this government did, which was to try to make sure you were providing support for investment, for targeted tax cuts, to try to get demand going again. That is necessary but not sufficient. It also requires making sure you stabilize the financial system and help get credit flowing again. And that is the basic strategy that this country, fortunately, has adopted. " CHRG-111hhrg53021--147 Secretary Geithner," I think, Congressman, that is an excellent question. We could debate this for hours. But the lesson of the financial crisis here in the United States, and around the world, is that when you face a loss of confidence and a loss of demand of this magnitude, when you have a financial system on the edge of collapse, the only path to mitigate the damage is for the government to do what this Congress did and this government did, which was to try to make sure you were providing support for investment, for targeted tax cuts, to try to get demand going again. That is necessary but not sufficient. It also requires making sure you stabilize the financial system and help get credit flowing again. And that is the basic strategy that this country, fortunately, has adopted. " CHRG-111hhrg53245--11 INSTITUTION Ms. Rivlin. Thank you, Mr. Chairman. I am really glad you're holding this hearing to focus on the question of systemic risk and how do we avoid getting into this situation again; and, as you pointed out, I don't think anybody wants more bailouts ever if we can avoid it. I think that requires focusing on prevention. How do we fix the financial system so that we don't have these perfect storms of a huge bubble that makes our system very prone to collapse? And then if this does happen, how do we make it less likely that we would have to resort to bailing out institutions? So I think the task before this committee is first to repair the regulatory gaps and change the perverse incentives and reduce the chances that we will get another pervasive bubble. But, however, hard we try to do this, we have to recognize that there's no permanent fix. And I think one concept of systemic risk, what I call a macro system stabilizer that we need is an institution charged with looking continuously at the regulatory system at the markets and at perverse incentives that have crept into our system. Because whatever rules we adopt will become obsolete as financial innovation progresses, and market participants find around the rules. This macro system stabilizer, I think, should be constantly searching for gaps, weak links, perverse incentives, and so forth and should make views public and work with other regulators and Congress to mitigate the problem. Now, the Obama Administration makes a case for such an institution, for a regulator with a broad mandate to collect information from all financial institutions and identify emerging risk. It proposes putting this responsibility in a financial services oversight counsel, chaired by the Treasury with its own expert staff. That seems to me likely to be a cumbersome mechanism, and I would actually give this kind of responsibility to the Federal Reserve. I think the Fed should have the clear responsibility for spotting emerging risks, and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and the possible threats to it, similar to the report you heard from Mr. Bernanke this morning about the economy. It should consult regularly with the Treasury and other regulators, but it should have the lead responsibility for monitoring systemic risk. Spotting emerging risk would fit naturally with the Fed's efforts to monitor the state of the economy and the health of the financial sector in order to set and implement monetary policy. Having that explicit responsibility and more information on which to base it would enhance its effectiveness as a central bank. I would also suggest giving the Fed a new tool to control leverage across the financial system. While lower interest rates may have contributed to the bubble, monetary policy has multiple objectives, and the short-term interest rate is a poor tool for controlling bubbles. The Fed needs a stronger tool, a control of leverage more generally. But the second task is one you have emphasized in your title, how to make the system less vulnerable to cascading failures, domino effects, due to the presence of large interconnected financial firms whose failure could bring down other firms and markets. This view of what happened could lead to policies to restrain the growth of large interconnected financial firms or even break them up. " CHRG-111shrg55278--14 Mr. Tarullo," Thank you, Mr. Chairman, Senator Shelby, and Members of the Committee. My prepared statement sets forth in some detail the positions of the Federal Reserve on a number of the proposals that have been brought before you, so I thought I would use these introductory remarks to offer a few more general points. First, I think the title you have given this hearing captures the task well, ``Establishing a Framework for Systemic Risk Regulation.'' The task is not to enact one piece of legislation or to establish one overarching systemic risk regulator and then to move on. The shortcomings of our regulatory system were too widespread, the failure of risk management at financial firms too pervasive, and the absence of market discipline too apparent to believe that there was a single cause of, much less a single solution for, the financial crisis. We need a broad agenda of basic changes at our regulatory agencies and in financial firms, and a sustained effort to embed market discipline in financial markets. Second, the ``too-big-to-fail'' problem looms large on the agenda. Therein lies the importance of proposals to ensure that the systemically important institutions are subject to supervision, to promote capital and other kinds of rules that will apply more stringently because the systemic importance of an institution increases, and to establish a resolution mechanism that makes the prospect of losses for creditors real, even at the largest of financial institutions. But ``too-big-to-fail,'' for all its importance, was not the only problem left unaddressed for too long. The increasingly tightly wound connection between lending and capital markets, including the explosive growth of the shadow banking system, was not dealt with as leverage built up throughout the financial system. That is why there are also proposals before you pertaining to derivatives, money market funds, ratings agencies, mortgage products, procyclical regulations, and a host of other issues involving every financial regulator. Third, in keeping with my first point on a broad agenda for change, let me say a few words about the Federal Reserve. Even before my confirmation, I had begun conversations with many of you on the question of how to ensure that the shortcomings of the past would be rectified and the right institutional structure for rigorous and efficient regulation put in place, particularly in light of the need for a new emphasis on systemic risk. This colloquy has continued through the prior hearing your Committee conducted and in subsequent conversations that I have had with many of you. My colleagues and I have thought a good deal about this question and are moving forward with a series of changes to achieve these ends. For example, we are instituting closer coordination and supervision of the largest holding companies, with an emphasis on horizontal reviews that simultaneously examine multiple institutions. In addition, building on our experience with the SCAP process that drew so successfully upon the analytic and financial capacities of the nonsupervisory divisions of the Board, we will create a quantitative surveillance program that will use a variety of data sources to identify developing strains and imbalances affecting individual firms and large institutions as a group. This program will be distinct from the activities of the on-site examiners, so as to provide an independent perspective on the financial condition of the institutions. Fourth and finally, I would note that there are many possible ways to organize or to reorganize the financial regulatory structure. Many are plausible, but as experience around the world suggests, none is perfect. There will be disadvantages, as well as advantages, to even good ideas. One criterion, though, that I suggest you keep in mind as you consider various institutional alternatives is the basic principle of accountability. Collective bodies of regulators can serve many useful purposes: examining latent problems, coordinating a response to new problems, recommending new action to plug regulatory gaps, and scrutinizing proposals for significant regulatory initiatives from all participating agencies. When it comes to specific regulations or programs or implementation, though, collective bodies often diffuse responsibility and attenuate the lines of accountability, to which I know this Committee has paid so much attention. Achieving an effective mix of collective process and agency responsibility with an eye toward relevant institutional incentives will be critical to successful reform. Thank you very much, Mr. Chairman. I would be happy to answer any questions. " CHRG-110hhrg44903--17 Mr. Geithner," Thank you, Mr. Chairman, Ranking Member Bachus, and other members of the committee. I appreciate the opportunity to be here with you today. We are dealing with some very consequential issues, and I think as a country we are going to face some very important questions going forward. I am particularly pleased to be here with Chairman Cox from the SEC. We are working very, very closely together in navigating through the present challenges. And I want to express appreciation for his support and cooperation. The U.S. and the global financial systems are going through a very challenging period of adjustment, an exceptionally challenging period of adjustment. And this process is going to take some time. A lot of adjustment has already happened, but this process will necessarily take time. And the critical imperative of the policymakers today is to help ease that process of adjustment and cushion its impact on the broader economy, first stability and repair and then reform. Looking forward though, the United States will look to undertake substantial reforms to our financial system. There was a strong case for reform before this crisis. Our system was designed in a different era for a different set of challenges. But the case for reform, of course, is stronger today. Reform is important, of course, because a strong and resilient financial system is integral to the economic performance of any economy. My written testimony outlines some of the changes to the financial system that motivate the case for reform. These changes include, of course, a dramatic decline in the share of financial assets held by traditional banks; a corresponding increase in the share of financial assets held by nonbank financial institutions, funds, and complex financial structures; a gradual blurring of the line between banks and nonbanks, as well as between institutions and markets; extensive rapid innovation in derivatives that have made it easier to trade and hedge credit risk; and a dramatic growth in the extension of credit, particularly for less creditworthy borrowers. As a consequence of these changes and other changes to our financial system, a larger share of financial assets ended up in institutions and vehicles with substantial leverage, and in many cases, these assets were financed with short-term obligations. And just as banks are vulnerable to a sudden withdrawal of deposits, these nonbanks and funding vehicles are vulnerable to an erosion in market liquidity when confidence deteriorates. The large share of financial assets held in institutions without direct access to the Fed's traditional lending facilities complicated our ability as a central bank, the ability of our traditional policy instruments to help contain the damage to the financial system and their broader economy presented by this crisis. I want to outline a core set of principles, objectives that I believe should guide reform. I offer these from my perspective at the Federal Reserve Bank of New York. The critical imperative is to build a system that is a financial--that is more robust to shocks. This is not the only challenge facing reform. We face a broad set of changes in how to better protect consumers, how the mortgage market should evolve, the appropriate role of the GSEs and others, and how to think about market integrity and investor protection going forward. I want to focus on the systemic dimensions of reform and regulatory restructure. First on capital, the shock absorbers for financial institutions, the critical shock absorbers are about capital and reserves, about margin and collateral, about liquidity resources, and about the broad risk manageme