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 management and control regime. We need to ensure that, in periods of expansion, in periods of relative stability, financial institutions and the centralized infrastructure of the system hold adequate resources against the losses and liquidity pressures that can emerge in economic downturns. This is important both in the institutions and the infrastructure. And the best way I think that we know how to limit pro-cyclicality and severity of financial crises is to try to ensure that those cushions are designed in a way that provides adequate protection against extreme events. A few points on regulatory simplification and consolidation. It is very important, I believe, that central banks and supervisors and market regulators together move to adopt a more integrated approach to the design and enforcement of these capital standards and other prudential regulations that are critical to financial stability. We need a more consistent set of rules, more consistently applied, that substantially reduce the opportunities for arbitrage that exist in our current very segmented, fragmented system. Reducing moral hazard is critical. As we change the framework of regulation oversight, we need to do so in a way that strengthens market discipline over financial institutions and limits the moral hazard risk that is present in any regulated financial system. The liquidity tools of central banks and, to some extent, the emergency powers of other public authorities were created in the recognition of the fact of the basic reality that individual financial institutions cannot protect themselves fully from an abrupt evaporation in market liquidity or the ability to liquify their assets. Now the moral hazard that is associated with these lender-of-last-resort tools needs to be mitigated by strong supervisory authority over the consolidated financial entities that are critical to the financial system. On crisis management, the Congress gave the Federal Reserve very substantial tools, very substantial powers to mitigate the risk to the economy in any financial crisis. But I think, going forward, there are things we could put in place that would help strengthen the capacity of governments to respond to crises. As Secretary Paulson, Chairman Bernanke, and Chairman Cox have all recognized, we need a companion framework to what exists now in FDICIA for facilitating the orderly liquidation of financial institutions where failure may pose risks to the stability of the financial system or where the disorderly unwinding or the abrupt risk of default of an institution may pose risk to the stability of the financial system. Finally, we need a clearer structure of responsibility and authority over the payment systems. These payment systems, settlement systems, play a very important role in financial stability. And our current system is overseen by a patchwork of authorities with responsibilities diffused across several different agencies with significant gaps. It is very important to underscore that, as we move to adapt the U.S. framework, we have to work to bring a consensus among the major economies about complementary changes in the global framework. Moving forward will require a very complicated set of policy choices, including determining what level of conservatism should be built into future prudential regulations and capital requirements; what institutions should be subject to that framework of constraints or protections; which institutions should have access to central bank liquidity under what conditions; and many other questions. A few points, finally, about how to think about the role of the Federal Reserve in promoting financial stability. First, the Federal Reserve has a very important role today, working in cooperation with bank supervisors and the SEC in establishing the capital and other prudential safeguards that are applied on a consolidated basis to institutions that are critical to the proper functioning of markets. Second, the Federal Reserve, as the financial system's lender of last resort, should play an important role in the consolidated supervision of those institutions that have access to central bank liquidity and play a critical role in market functioning. The judgments we are required to make about liquidity and solvency of institutions in the system requires the knowledge that can only come from a direct, established, ongoing role in prudential supervision. Third, the Federal Reserve should be granted clear authority over systemically important payments or settlement systems. Fourth, the Federal Reserve Board should have an important consultative role in judgment about official intervention in crises where there is potential for systemic risk as is currently the case for bank resolutions under FDICIA. And finally, the Federal Reserve's approach to supervision and to market oversight will need to look beyond the stability just of individual banks to market developments more broadly, to the infrastructure that is critical to market functioning, and the role played by other leveraged financial institutions. I want to emphasize in conclusion that we are working very actively now today in close cooperation with the SEC and other bank supervisors and with our international counterparts to put in place steps now that offer the prospect of improving the capacity of the financial system to withstand stress. We are doing this in the derivative markets. We are doing it in secure funding markets, and we are doing it with respect to the centralized infrastructure. I very much look forward to working with you and your colleagues as we move ahead in working to build a more effective financial regulatory framework in this country. Thank you very much. [The prepared statement of Mr. Geithner can be found on page 55 of the appendix.] " FinancialCrisisInquiry--21 We have seen, in our view, four crises unfold: a mortgage crisis, a capital markets crisis, a global credit crisis, and a severe global recession. The mortgage crisis originated with the dramatic expansion in the availability of mortgage credit through subprime lending and aggressive mortgage terms even in prime products. This led to a greater debt burden for consumers. Lenders, prompted by lower interest rates, rapidly rising home prices, and large amounts of capital available, made credit available to borrowers who could not previously qualify for a mortgage or extended more credit to a borrower who could or perhaps should—would not be able to handle. The national policy to expand American homeownership was also popular and created tailwinds. No one involved in the housing system—lenders, rating agencies, investors, insurers, consumers, regulators, and policy makers, foresaw a dramatic and rapid depreciation of home prices. When the nation did experience this rapid depreciation in home prices, the first that had been experienced since the Great Depression, many of these loans became very unfavorable and the option of refinancing disappeared leading to defaults. The second crisis came in investment banks in the capital markets area. Investment banks not only had underwritten mortgages, but they had retained significant amounts of the risk by holding interest and providing backup liquidity for mortgage-related securities they had sold. Investment banks created products based on these mortgage assets. The risk of these assets spread. This happened when a monoline insurer guaranteed the mortgages or a structured investment vehicle brought the mortgage securities and having the money- market funds to purchase that commercial paper from those vehicles. Third, the stress of the financial crisis began to spread beyond the investment banks and mortgages to other fixed income products and to more market participants. This destabilized the financial institutions and non-financial institutions that had little to do with the U.S. or the mortgage market. This contagion was, in fact, global. Without government intervention to restore liquidity to capital markets, the risk of global economic collapse was very real. CHRG-111shrg57320--401 Mr. Bowman," Good afternoon, Chairman Levin. My name is John Bowman. I am a career Federal employee who became Acting Director of the Office of Thrift Supervision a little over 1 year ago during the height of the financial crisis after about 5 years as the agency's chief counsel. It is not a role that I sought, but I am honored to serve.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Bowman appears in the Appendix on page 181.--------------------------------------------------------------------------- My written testimony summarizes OTS' supervision of Washington Mutual, and the reasons why WaMu failed. It is important to note that this failure came at no cost to the Deposit Insurance Fund and at no cost to the American taxpayer unlike recent failures of other financial institutions and the near collapse of some of the Nation's largest banks which were deemed ``too big to fail'' and, therefore, provided government assistance. The demise of WaMu came early in the procession of more than 200 banks and thrifts that have closed during this crisis. Lifelines, such as the Treasury's TARP program and the FDIC's increase in deposit insurance coverage, came too late for WaMu. During the real estate boom before the crisis, WaMu and other financial firms made a critical error by widely underwriting home mortgages based more on the value of the collateral represented by the homes than on the borrower's documented ability to repay. As home prices continued to rise, these practices supported a widely praised initiative to increase homeownership in America. Yet, as we now know, homeownership reached unsustainable levels and became too much of a good thing. Like all of the players in the home mortgage market, bank managers at WaMu and elsewhere mistakenly believed that they were effectively averting risks by moving loans off their books and securitizing them. Similarly, homeowners perceived little risk in their adjustable-rate mortgages because they thought they could sell their homes at a profit before rate resets kicked in. Investors believed mortgage-backed securities carried little risk because credit rating agencies rated them highly. Those beliefs proved misplaced when the real estate market collapsed, the secondary market froze, and the risks turned out to be all too real. The fallout hit financial institutions large and small, with State and Federal charters, overseen by every banking industry regulator. Since WaMu's failure, the OTS has taken lessons to heart from our own internal review of failed thrifts and from the Treasury Inspector General's Material Loss Reviews, and we have made strides to address the resulting recommendations. We have instituted controls to better track problems identified in their examination reports and to take timely, effective action when necessary. We have established a Large Bank Unit to keep close watch over our largest regulated institutions, strengthened oversight of our OTS regions, enhanced supervisory consistency among regions, tightened scrutiny of problem banks, and set deadlines for taking enforcement actions after safety and soundness downgrades. In short, we have made meaningful changes. Although some thrifts helped to overinflate the housing bubble, traditional thrifts whose managers stuck to their conservative business practices of lending to people they knew and keeping loans on their books weathered this economic storm and continue to provide badly needed credit in their communities. Because consumer and community lending remains important for American families, I continue to believe in the thrift charter and the need for thrifts to have a separate regulator. With the changes we have instituted, I believe we have made the OTS significantly stronger for the future. Thank you again, Mr. Chairman. I am happy to answer your questions. Senator Levin. Thank you very much, Mr. Bowman. Throughout the last few years of WaMu's operation, the FDIC as the back-up regulator made repeated requests to participate in OTS exams and was continually rebuffed. We heard in the second panel how the FDIC sought to participate in OTS exams of Washington Mutual, was limited in terms of staff, forbidden to do file review. For periods of time, OTS blocked FDIC access to exam material. Mr. Bowman, are you familiar with that, and was that the right course of action? " CHRG-111hhrg46820--120 Chairwoman Velazquez," Mr. Merski, I would like to ask you a last question, since we are going to be dealing with the TARP reform on Financial Services where I serve. Although this recession started from the collapse of the mortgage lending, recent economic indicators have raised significant fears about witnesses in other types of financing, particularly commercial real estate and consumer credit. Do you believe that efforts such as the Treasury's capital purchase plan or the Fed's TALF will be adequate to help small banks weather the extended economic downturn if credit defaults continue to spread? " fcic_final_report_full--243 COMMISSION CONCLUSIONS ON CHAPTER 11 The Commission concludes that the collapse of the housing bubble began the chain of events that led to the financial crisis. High leverage, inadequate capital, and short-term funding made many finan- cial institutions extraordinarily vulnerable to the downturn in the market in . The investment banks had leverage ratios, by one measure, of up to  to . This means that for every  of assets, they held only  of capital. Fannie Mae and Freddie Mac (the GSEs) had even greater leverage—with a combined  to  ratio. Leverage or capital inadequacy at many institutions was even greater than re- ported when one takes into account “window dressing,” off-balance-sheet expo- sures such as those of Citigroup, and derivatives positions such as those of AIG. The GSEs contributed to, but were not a primary cause of, the financial crisis. Their  trillion mortgage exposure and market position were significant, and they were without question dramatic failures. They participated in the expansion of risky mortgage lending and declining mortgage standards, adding significant demand for less-than-prime loans. However, they followed, rather than led, the Wall Street firms. The delinquency rates on the loans that they purchased or guar- anteed were significantly lower than those purchased and securitized by other fi- nancial institutions. The Community Reinvestment Act (CRA)—which requires regulated banks and thrifts to lend, invest, and provide services consistent with safety and sound- ness to the areas where they take deposits—was not a significant factor in sub- prime lending. However, community lending commitments not required by the CRA were clearly used by lending institutions for public relations purposes. CHRG-111hhrg55809--150 Mr. Gutierrez," Mr. Bernanke, it is good to see you here again this morning. Mr. Chairman, this week, the FDIC passed another special assessment on our Nation's banks to help shore-up the Deposit Insurance Fund. It is true that most of the losses to this Fund have been the result of failures of small lending institutions. These community banks have also suffered from severe decreases in the values of housing and commercial real estate markets caused by loans financed by some of the largest banks in our system. I have legislation in front of the committee, H.R. 2897, and I would appreciate if you could take a look at it and kind of write us a note back on your more expansive opinion on it. I would appreciate that. And it would require the riskiest banks in our financial system to pay more, not only into the Deposit Insurance Fund, but also into the systemic risk fund. My goal is to create a more efficient pricing regime that would disincentivize banks from becoming or remaining ``too-big-to-fail.'' What are your recommendations for creating a system that would prevent or discourage banks from becoming ``too-big-to-fail'' and what relationship do you think they should have to paying into a fund? Do you think there should be differences? " fcic_final_report_full--486 The Commission majority did not discuss the significance of mark-to- market accounting in its report. This was a serious lapse, given the views of many that accounting policies played an important role in the financial crisis. Many commentators have argued that the resulting impairment charges to balance sheets reduced the GAAP equity of financial institutions and, therefore, their capital positions, making them appear financially weaker than they actually were if viewed on the basis of the cash flows they were receiving. 53 The investor panic that began when unanticipated and unprecedented losses started to appear among NTMs generally and in the PMBS mortgage pools now spread to financial institutions themselves; investors were no longer sure which of these institutions could survive severe mortgage-related losses. This process was succinctly described in an analysis of fair value or mark-to-market accounting in the financial crisis issued by the Institute of International Finance, an organization of the world’s largest banks and financial firms: [O]ften-dramatic write-downs of sound assets required under the current implementation of fair-value accounting adversely affect market sentiment, in turn leading to further write-downs, margin calls and capital impacts in a downward spiral that may lead to large-scale fire-sales of assets, and destabilizing, pro-cyclical feedback effects These damaging feedback effects worsen liquidity problems and contribute to the conversion of liquidity problems into solvency problems. 54 [emphasis in the original] At least one study attempted to assess the effect of this on financial institutions overall. In January 2009, Nouriel Roubini and Elisa Parisi-Capone estimated the mark-to-market losses on MBS backed by both prime loans and NTMs. Their estimate was slightly over $1 trillion, of which U.S. banks and investment banks were estimated to have lost $318 billion on a mark-to-market basis. 55 This would be a dramatic loss if all of it were realized. In 2008, the U.S. banking system had total assets of $10 trillion; the five largest investment banks had 53 54 FCIC Draft Staff Report, “The Role of Accounting During the Financial Crisis,” p.16. Institute of International Finance, “IIF Board of Directors - Discussion Memorandum on Valuation in Illiquid Markets,” April 7, 2008, p.1. 55 Nouriel Roubini and Elisa Parisi-Carbone, “Total $3.6 Trillion Projected Loan and Securities Losses in U.S. $1.8 Trillion of Which Borneby U.S. Banks/Brokers,” RGE Monitor , January 2009, p.8. 481 total assets of $4 trillion. 56 If we assume that the banks had a leverage ratio of about 15-to-1 in 2008 and the investment banks about 30-to-1, that would mean that the equity capital position of the banking industry as a whole would be about $650 billion and the same number for the investment banks would be about $130 billion, for a total of $780 billion. Under these circumstances, the collapse of the PMBS market alone reduced the capital positions of U.S. banks and investment banks by approximately 41 percent on a mark-to-market basis. This does not mean that any actual losses were suffered, only that the assets concerned might have to be written down or could not be sold for the price at which they were previously carried on the firm’s balance sheet. CHRG-111shrg54533--52 Secretary Geithner," If what we are proposing today had been in place, it is--banks would not have taken on so much risk. Institutions that were not regulated as banks would not have been permitted to take on that level of risk. Consumers would have been less vulnerable to the kind of predation that we saw, particularly in mortgage products, and the government would have had the ability to act earlier, more swiftly, to contain the damage posed by the inevitable pressures that come when firms fail. You know, again, we want a system where innovation can happen, when firms can fail, where investors are accountable for the risks they take in some sense, but you have to create a system that is strong enough to allow that to happen. So that is a simple way to say banks would not have been able to take on this much risk. You wouldn't see this much risk buildup, leverage buildup outside the banking system to a point where it would threaten the stability of the system. And consumers would have been less vulnerable to the kind of predation we saw, and the government would have been able to act sooner. Senator Bennet. In sort of the combination of the council versus the Fed versus the Consumer Protection Agency and all this, who would have detected that we have got these things out here called credit default swaps that are mounting on the balance sheets of our banks and that is a cause for concern, and to whom would they have communicated that and what action would have been taken as a result? " CHRG-111hhrg53245--193 Mr. Sherman," Thank you, Mr. Chairman. Mr. Mahoney, thank you for focusing on the portion of the White Paper dealing with resolution authority. It is being sold as if it is just a tweaking of the Bankruptcy Code, but as you illustrate it is permanent TARP and not limited to $700 billion. It is unlimited TARP. Wall Street will love the money. Treasury will love the power. It has absolutely no chance in that form of passing the House of Representatives on a fair up or down vote. So the question really is whether my party will fall in love of the idea to the point where we try to force Members to vote on it in the dead of night or as part of some major appropriations bill because I think the only thing less popular than TARP in an emergency is unlimited permanent TARP. The economists here have asked us to design a system that implies the possibility of bailouts, at least as a possibility. And I would hope that whether that is great economics or not, you would recognize the political situation and help us design whatever the best economic regulatory system is that absolutely shuts the door permanently and absolutely on bailouts. I do not think there are many Members of the House who do not want to shut that door. The idea of hiding which companies are tier one seems absurd. First, we are in favor of transparency. Second, everybody will know anyway. And, third, I think if we are going to require additional capital of certain companies, that will identify who is tier one. If we do not require additional capital of tier one companies, then we are going to give them the possibility of being bailed out and being a systemic risk without even requiring additional capital. Professor Johnson, you put forward an interesting idea of trying to limit size but pointed out how do we apply this to foreign-based banks? One idea would be to say that no financial institution could have actual or contingent liabilities to Americans in excess of $100 billion or $200 billion or whatever the figure is. So that Deutsche Bank or Bank of America could pose the same level of risk to the United States economy. If the German government wants Deutsche Bank to have liabilities to Germans of a couple of trillion, that is up to them, but if a bailout is necessary, it will be because of the effect its collapse could have on the German economy and presumably that money would come from Berlin. Could you comment on the idea of setting an absolute limit on the size that a financial institution could be in the American economy measured by its actual or contingent liabilities to Americans? " FOMC20080318meeting--100 98,VICE CHAIRMAN GEITHNER.," Mr. Chairman, I'm going to cede all of my time to you, except to acknowledge and to point out that there's much I agree with that has been said around the table, particularly with how people characterize the growth outlook and the risks and what's happening in financial markets and to the outlook. I can't say that stuff better than it has been said. But there's much I disagree with in what's been said, particularly on the inflation side, about the lack of credibility. I just want very quickly to say a couple of things about how we talk about this stuff based on what's been said. First, some of you at this table may believe that we are losing credibility, and you may be losing confidence in the capacity of this Committee to mitigate the risk to our long-term inflation objectives. If you say that in public, you will magnify that problem, and just because you believe it does not make it true. I believe that you should have more confidence in the commitment of this Committee to do what is necessary to keep those expectations stable over time. Second, the stuff about capital and the financial system is very, very important. It is very hard to make the judgment now that the financial system as a whole or the banking system as a whole is undercapitalized. Some people out there are saying that. In some states of the world, particularly if there is no liquidity, then any financial system will be systematically insolvent. But based on everything we know today, if you look at very pessimistic estimates of the scale of losses across the financial system, on average relative to capital, they do not justify that concern. It is very important to make distinctions in what we say about that. It is very different to say that their distribution is uneven and to say that for some institutions those losses may be large relative to capital. That is obviously the case; we have already seen that to be the case. It is important to make the distinction between the average and the distribution. Although the average losses look relatively manageable relative to capital, the system is short of capital relative to what would be ideal, given that we've had the collapse of a very large part of the nonbank financial system. Banks as a whole are not large enough now, even with their capital cushions, to compensate for the scale of disintermediation of that type of nonbank finance. Those are very important distinctions to make in this case. There is nothing more dangerous in what we're facing now than for people who are knowledgeable about this stuff to feed these broad concerns about our credibility and about the basic core strength of the financial system. So I just want to underscore the importance of exceptional care in how we talk about those things, even in private. A lot of people out there who should know better--none of us is guilty of this--are casting broad aspersions about solvency that are very dangerous in this context. May we get to the point where those concerns are justified? Of course we may get to that point. If we systematically mismanage policy, we may get to that point. But please be careful in that context. I'm sorry, Mr. Chairman. I meant to cede all my time to you. [Laughter] Finally, I have to state for the record that I did submit our forecast. To state the obvious, it's close enough to the Greenbook on most things, and, given the range of uncertainty, there's no material between our view and the Greenbook's. " CHRG-111shrg50564--118 Mr. Volcker," Well, what was intended by that--you go back in history a little bit. Money market funds developed because--to escape regulation, effectively. This is a way to provide a banking service outside of banks, and they had some competitive advantages because they weren't banks and they didn't subject to banking regulations. So when a crisis came along, the framework was not adequate. In some cases, they were owned by rich parents and it was OK. When they weren't owned by a rich parent, you had a collapse with widespread repercussions. We said, you should not essentially say we should not have institutions out there that promise to act like a bank, but they are not regulated and protected like a bank. And if they are going to be protected de facto, which is what happened here, in effect, they got a free ride, and they shouldn't have gotten a free ride. So if they are going to act--if they are going to talk like a bank and squawk like a bank, they ought to be regulated like a bank. Senator Crapo. Well, one of the principles that I tend to follow as I approach this issue is that similar products or similar functions should be regulated with the same rules or by the same regulators. Would you agree with that principle? " FinancialCrisisReport--208 Because OTS has been abolished, its turf war with the FDIC is over. But witnesses from the FDIC told the Subcommittee that the remaining banking regulators also sometimes resist its participation in bank oversight. In particular, a senior FDIC official told the Subcommittee that, although the FDIC has the statutory authority to take an enforcement action against a bank, the FDIC has never used that authority because the other regulators would view it as “an act of war.” The WaMu case history demonstrates how important it is for our federal regulators to view each other as partners rather than adversaries in the effort to ensure the safety and soundness of U.S. financial institutions. D. Regulatory Failures In a market economy, the purpose of regulation within the financial markets is to provide a level playing field that works for everyone involved, from the financial institutions, to the investors, to the consumers and businesses that rely on well functioning financial systems. When financial regulators fail to enforce the rules in an effective and even handed manner, they not only tilt the playing field in favor of some and not others, but also risk creating systemic problems that can damage the markets and even the entire economy. At the April 16, 2010 hearing of the Subcommittee, Senator Coburn had the following exchange with Inspectors General Thorson and Rymer, which explains in part why OTS failed as a regulator to address WaMu’s harmful lending policies: Senator Coburn: As I sat here and listened to both the opening statement of the Chairman and to your statements, I come to the conclusion that actually investors would have been better off had there been no OTS because, in essence, the investors could not get behind the scene to see what was essentially misled by OTS because they had faith the regulators were not finding any problems, when, in fact, the record shows there are tons of problems, just there was no action taken on it. ... I mean, we had people continually investing in this business on the basis—as a matter of fact, they raised an additional $7 billion before they collapsed, on the basis that OTS said everything was fine, when, in fact, OTS knew everything was not fine and was not getting it changed. Would you agree with that statement or not? Mr. Thorson: Yes, sir. I think ... basically assigning a ‘satisfactory’ rating when conditions are not is contradictory to the very purpose for which regulators use a rating system. I think that is what you are saying. Senator Coburn: Any comments on that Mr. Rymer? Mr. Rymer: I would agree with Mr. Thorson. ... 795 Id. at 66. CHRG-110shrg46629--31 Chairman Bernanke," What they are referring to is situations, there are situations where banks under the old system are forced to hold a lot of capital against which is essentially very safe assets. That part of the capital is excess capital. One of the problems they face is that foreign banks that do not have as much capital against these very safe assets will be able to just come and take that business away because they do not cost as much. So against a safe asset and one whose risk is appropriately calibrated, it seems to me appropriate to reduce capital. But against risky assets, we need to have enough capital to ensure safety. Senator Shelby. We want to make sure our banking system is strong. We have a great banking system. And we do not need to weaken the pillars in any way. Mr. Chairman, thank you. " CHRG-110hhrg46596--238 Mr. Dodaro," No. Ms. Brown-Waite. Mr. Kashkari, you have a difficult job to do. You really and truly do. But you have to realize that we have a responsibility to the taxpayers. Right now I can tell you, and I think members, whether they voted for it or voted against it, are viewing the action that was taking place with the bailout as the great taxpayer train robbery. Because while you made a statement, and I wrote it down, you said that it did not--that the public is not considering the fact that you did not allow the financial system to collapse--am I correct that was your statement? " CHRG-111shrg52619--55 Mr. Polakoff," Mr. Chairman, if I could offer--in our written testimony--and I tried to synopsize it in my oral--we believe the dual banking system, State and Federal, makes sense. But we believe that the business model and the strategy of the organization should then dictate what regulatory agency oversees it. So from our perspective, there is a clear distinction between a commercial bank and a community and consumer bank. And it does not make a difference whether it is a Federal charter or State charter. Under our approach, we would submit to you that you have a Federal regulator and a Federal charter for commercial banks. And you have the same for community and consumer banks. And then if it is a State-chartered entity that fits one of those two business strategies, the relevant Federal regulator works with it. So it retains the dual banking system. It prevents the ability of the individual institution to select a regulator. Instead, this schematic would suggest that the business strategy determines the regulator. " CHRG-111hhrg55809--106 Mr. Bernanke," Well, the FDIC has some tough choices because they are trying to replenish the fund without creating a ``procyclical effect,'' that is, without hurting the banking system in a way at a bad time when we want the banking system to be lending. The solution they have, as I understand it, is that even though there would be prepayments by the banks, that those prepayments would be treated as assets on the bank balance sheets, and therefore capital would not, at least in the a regulatory sense, be affected. And that is the solution they have chosen. " CHRG-110hhrg44900--5 Mr. Bachus," I thank the chairman for holding this hearing on systemic risk and the appropriate regulatory responses to managing that risk and I know there will be short-term responses, and at some time in the future maybe a new regulatory structure which will take time. The two public servants before us today I think are eminently qualified to speak to these issues and we welcome Secretary Paulson and Chairman Bernanke. They had agencies whose mandates and responsibilities are broad and are deep, but the issue of systemic risk also requires the involvement of other significant and capable regulators, including particularly the SEC and the Federal banking regulators. It is my expectation that the leaders of these agencies will appear at a subsequent hearing with their comments and that will supplement our understanding and the testimony we gather today on this difficult issue, and I trust that Secretary Paulson and Chairman Bernanke agree that a collaborative effort that includes these agencies is going to be needed if we are to have a successful outcome. To say we are living through interesting times in our financial markets is to state the painfully obvious. We have seen a run on what was then the Nation's 5th largest investment bank, Bear Stearns. We have seen the Federal Reserve intervene in order to avoid a cascading effect from Bear Stearns's collapse that could have spread throughout the financial system with what I believe would have been decidedly negative implications for the larger economy. And we have seen the Federal Reserve take steps or a series of steps that in the short term at least have brought a measure of confidence and stability to the financial markets. But now that the immediate crisis created by the run on Bear Stearns has passed, we face some difficult, long-term policy questions. Perhaps the most critical question is, have we arrived at the place where virtually every primary dealer is considered too big or too interconnected to fail? The logical extension of this too big to fail perception is that markets no longer work and that the government must not only exercise greater control of our capital markets, but also be the ultimate guarantor of financial solvency; that would be a conclusion I could not endorse. And in reading over the remarks of Secretary Paulson in London, I see that you did not endorse it, either. A far better alternative is to restore market discipline within appropriate regulatory bounds. I believe we have reached a consensus that we must establish a modern, regulatory structure to strengthen the safety and soundness of our institutions and discourage unsound practices and conduct. However, these regulations should not and cannot ensure that institutions will never fail. And if one does fail, we must ensure that taxpayers are not left holding the bag. Thanks to the fast action of the Federal Reserve in cooperation with the SEC and the Treasury, we dodged a bullet when Bear Stearns collapsed. We may not be so lucky next time. For that reason, I look forward to hearing from today's witnesses about what we can do to provide for an orderly resolution in the event a large financial institution fails. The regulatory regime we establish and follow must accomplish three things: ensure market discipline; provide a shock absorber against systemic risk; and, first and foremost, protect the taxpayer. To preserve market discipline and discourage moral hazard, we must see to it that no firm should be considered too big or interconnected to fail. To protect against systemic risk, we must ensure that when a firm fails, it does not bring down the entire financial system with it, i.e., an orderly liquidation. And to protect the taxpayer, we have to make sure that the cost of that failure is borne by the firm's shareholders and creditors, and not passed on to the taxpaying public. In conclusion, of necessity we have to plan for how to handle the failure of a major institution. It is important, however, that we create a system focused not on failure, but on success. In doing so, we must also resist the temptation to over-regulate in our zeal to discourage practices such as overleveraging an excessive risk-taking that put institutions at risk of failure. This is a tall order. Thank you, Mr. Chairman, for holding this hearing, and thank you to our witnesses. " fcic_final_report_full--169 COMMISSION CONCLUSIONS ON CHAPTER 8 The Commission concludes declining demand for riskier portions (or tranches) of mortgage-related securities led to the creation of an enormous volume of col- lateralized debt obligations (CDOs). These CDOs—composed of the riskier tranches—fueled demand for nonprime mortgage securitization and contributed to the housing bubble. Certain products also played an important role in doing so, including CDOs squared, credit default swaps, synthetic CDOs, and asset- backed commercial paper programs that invested in mortgage-backed securities and CDOs. Many of these risky assets ended up on the balance sheets of systemi- cally important institutions and contributed to their failure or near failure in the financial crisis. Credit default swaps, sold to provide protection against default to purchasers of the top-rated tranches of CDOs, facilitated the sale of those tranches by con- vincing investors of their low risk, but greatly increased the exposure of the sellers of the credit default swap protection to the housing bubble’s collapse. Synthetic CDOs, which consisted in whole or in part of credit default swaps, enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market. By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed. The high ratings erroneously given CDOs by credit rating agencies encour- aged investors and financial institutions to purchase them and enabled the con- tinuing securitization of nonprime mortgages. There was a clear failure of corporate governance at Moody’s, which did not ensure the quality of its ratings on tens of thousands of mortgage-backed securities and CDOs. The Securities and Exchange Commission’s poor oversight of the five largest investment banks failed to restrict their risky activities and did not require them to hold adequate capital and liquidity for their activities, contributing to the fail- ure or need for government bailouts of all five of the supervised investment banks during the financial crisis. fcic_final_report_full--567 Bloomberg. 29. Ibid., pp. 197–205; Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000), pp. 36–54, 77–84, 94–105, 123–30. 30. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” pp. 11–12. 31. William J. McDonough, president of the Federal Reserve Bank of New York, statement before the House Committee on Banking and Financial Services, 105th Cong., 2nd sess., October 1, 1998. 32. GAO, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk,” GAO/GGD-00-3 (Report to Congressional Requesters), October 1999, p. 39. 33. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” pp. 13–14. 34. Lowenstein, When Genius Failed, pp. 205–18. 35. McDonough, statement before the House Committee on Banking and Financial Services, October 1, 1998. 36. Andrew F. Brimmer, “Distinguished Lecture on Economics in Government: Central Banking and Systemic Risks in Capital Markets,” Journal of Economic Perspectives , no. 2 (Spring 1989) (lecture by a for- mer Fed governor, analyzing the Fed’s market interventions in 1970, 1980 and 1987, and concluding that the Fed had consciously assumed a “strategic role as the ultimate source of liquidity in the economy at large”); Keith Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve Bank of New York Economic Policy Review (May 2006): 33. 37. Harvey Miller, interview by FCIC, August 5, 2010. 38. Stanley O’Neal, interview by FCIC, September 16, 2010. 39. Fed Chairman Alan Greenspan, “Do efficient financial markets mitigate financial crises?” remarks before the 1999 Financial Markets Conference of the Federal Reserve Bank of Atlanta, October 19, 1999 (www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm). 40. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” p. 16. 41. Ibid. 42. Ibid. 43. Philip Goldstein, et al. v. SEC, Opinion, Case No. 04-1434 (D.C. Cir.  June 23, 2006). 44. Time, February 15, 1999; Bob Woodward, Maestro: Greenspan’s Fed and the American Boom (New York: Simon & Schuster, 2000). 45. SIFMA (Securities Industry and Financial Markets Association), Fact Book 2008, pp. 9–10. 46. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States, 4th Qtr. 1996, p. 88 (Table L.213, line 18); 4th Qtr. 2001, p. 90 (Table L.213, line 20). 47. SEC Chairman William H. Donaldson, “Testimony Concerning Global Research Analyst Settle- ment,” before the Senate Committee on Banking, Housing and Urban Affairs, 108th Cong., 1st sess., May 7, 2003. 48. SEC, “SEC Fact Sheet on Global Analyst Research Settlements,” April 30, 2003; Financial Industry Regulatory Authority news release, “NASD Fines Piper Jaffray $2.4 Million for IPO Spinning,” July 12, 2004. 49. Arthur E. Wilmarth Jr., “Conflicts of Interest and Corporate Governance Failures at Universal Banks During the Stock Market Boom of the 1990s: The Cases of Enron and WorldCom,” George Wash- ington University Public Law and Legal Theory Working Paper 234 (2007). 50. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the Council on Foreign Relations, Washington, DC, November 19, 2002. 51. Ferguson, “The Future of Financial Services—Revisited.” 52. Spillenkothen, “Notes on the performance of prudential supervision in the years preceding the fi- nancial crisis,” p. 28. 53. “First the Put; Then the Cut?” Economist, December 16, 2000, p. 81. 54. Fed Chairman Alan Greenspan, “Risk and Uncertainty in Monetary Policy,” remarks at the Meet- ings of the American Economic Association, San Diego, California, January 3, 2004. See also Fed Gover- nor Ben S. Bernanke, “Asset-Price ‘Bubbles’ and Monetary Policy,” remarks before the N.Y. Chapter of the National Association of Business Economics, New York, October 15, 2002. 55. Fed Chairman Alan Greenspan, “Reflections on Central Banking,” remarks at a symposium spon- sored by the Federal Reserve Board of Kansas City, Jackson Hole, Wyoming, August 26, 2005. 56. Lawrence Lindsey, interview by FCIC, September 20, 2010. 57. The NYSE decided in 1970 to allow members to be publicly traded. See Andrew von Norden- flycht, “The Demise of the Professional Partnership? The Emergence and Diffusion of Publicly-Traded Professional Service Firms” (draft paper, Faculty of Business, Simon Fraser University, September 2006), pp. 20–21. 58. Peter Solomon, written testimony for the FCIC, First Public Hearing of FCIC, day 1, panel 2: Fi- nancial Market Participants, January 13, 2010, p. 2. 59. Brian R. Leach, interview by FCIC, March 4, 2010, p. 22. 60. Jian Cai, Kent Cherny, and Todd Milbourn, “Compensation and Risk Incentives in Banking and CHRG-111shrg53085--209 PREPARED STATEMENT OF WILLIAM R. ATTRIDGE President, Chief Executive Officer, and Chief Operating Officer, Connecticut River Community Bank March 24, 2009 Mr. Chairman, Ranking Member Shelby, and Members of the Committee, my name is William Attridge, I am President and Chief Executive Officer of Connecticut River Community Bank. I am also a member of the Congressional Affairs Committee of the Independent Community Bankers of America. \1\ My bank is located in Wethersfield, Connecticut, a 350-year-old town of over 27,000 people. ICBA is pleased to have this opportunity to testify today on the modernization of our financial system regulatory structure.--------------------------------------------------------------------------- \1\ The Independent Community Bankers of America represents nearly 5,000 community banks of all sizes and charter types throughout the United States and is dedicated exclusively to representing the interests of the community banking industry and the communities and customers we serve. ICBA aggregates the power of its members to provide a voice for community banking interests in Washington, resources to enhance community bank education and marketability, and profitability options to help community banks compete in an ever-changing marketplace. With nearly 5,000 members, representing more than 18,000 locations nationwide and employing over 268,000 Americans, ICBA members hold more than $908 billion in assets, $726 billion in deposits, and more than $619 billion in loans to consumers, small businesses and the agricultural community. For more information, visit ICBA's Web site at www.icba.org.---------------------------------------------------------------------------Summary of ICBA Recommendation ICBA commends the Chairman and the Committee for tackling this issue quickly. The current crisis demands bold action, and we recommend the following: Address Systemic Risk Institutions. The only way to maintain a vibrant banking system where small and large institutions are able to fairly compete--and to protect taxpayers--is to aggressively regulate, assess, and eventually break up institutions posing a risk to our entire economy. Support Multiple Federal Banking Regulators. Having more than a single federal agency regulating depository institutions provides valuable regulatory checks-and-balances and promotes ``best practices'' among those agencies--much like having multiple branches of government. Maintain the Dual Banking System. Having multiple charter options--both federal and state--is essential for maintaining an innovative and resilient regulatory system. Access to FDIC Deposit Insurance for All Commercial Banks, Both Federal and State Chartered. Deposit insurance as an explicit government guarantee has been the stabilizing force of our Nation's banking system for 75 years. Sufficient Protection for Consumer Customers of Depository Institutions in the Current Federal Bank Regulatory Structure. One benefit of the current regulatory structure is that the federal banking agencies have coordinated their efforts and developed consistent approaches to enforcement of consumer regulations, both informally and formally, as they do through the Federal Financial Institutions Examination Council (FFIEC). Reduce the Ten Percent Deposit Concentration Cap. The current economic crisis illustrates the dangerous overconcentration of financial resources in too few hands. Support the Savings Institutions Charter and the OTS. Savings institutions play an essential role in providing residential mortgage credit in the U.S. The thrift charter should not be eliminated and the Office of Thrift Supervision should not be merged into the Office of the Comptroller of the Currency. Maintain GSEs Liquidity Role. Many community bankers rely on Federal Home Loan Banks for liquidity and asset/liability management through the advance window. The following will elaborate on these concepts and provide ICBA's reasons for advocating these principles.State of Community Banking Is Strong Despite the challenges we face, the community bank segment of the financial system is still working and working well. We are open for business, we are making loans, and we are ready to help all Americans weather these difficult times. Community banks are strong, common sense lenders that largely did not engage in the practices that led to the current crisis. Most community banks take the prudent approach of providing loans that customers can repay, which best serves both banks and customers alike. As a result of this common sense approach to banking, the community banking industry, in general, is well-capitalized and has fewer problem assets than other segments of the financial services industry. That is not to suggest community banks are unaffected by the recent financial crisis. The general decline in the economy has caused many consumers to tighten their belts thus reducing the demand for credit. Commercial real estate markets in some areas are stressed. Many bank examiners are overreacting, sending a message contradicting recommendations from Washington that banks maintain and increase lending. For these reasons, it is essential the government continue its efforts to stabilize the financial system. But, Congress must recognize these efforts are blatantly unfair. Almost every Monday morning for months, community banks have awakened to news the government has bailed out yet another too-big-to-fail institution. On many Saturdays, they hear the FDIC has summarily closed one or two too-small-to-save institutions. And, just recently, the FDIC proposed a huge special premium to shore up the Deposit Insurance Fund (DIF) to pay for losses caused by large institutions. This inequity must end, and only Congress can do it. The current situation--if left uncorrected--will damage community banks and the consumers and small businesses we serve.Congress Must Address Excessive Concentration ICBA remains deeply concerned about the continued concentration of banking assets in the U.S. The current crisis has made it painfully obvious the financial system has become too concentrated, and--for many institutions--too loosely regulated. Today, the four largest banking companies control more than 40 percent of the Nation's deposits and more than 50 percent of the assets held by U.S. banks. We do not believe it is in the public interest to have four institutions controlling most of the assets of the banking industry. A more diverse financial system would reduce risk, and promote competition, innovation, and the availability of credit to consumers of various means and businesses of all sizes. Our Nation is going through an agonizing series of bankruptcies, failures and forced buy-outs or mergers of some of the Nation's largest banking and investment houses that is costing American taxpayers hundreds of billions of dollars and destabilizing our economy. The doctrine of too big--or too interconnected--to fail, has finally come home to roost, to the detriment of American taxpayers. Our Nation cannot afford to go through this again. Systemic risk institutions that are too big or inter-connected to manage, regulate or fail should either be broken up or required to divest sufficient assets so they no longer pose a systemic risk. In a recent speech Federal Reserve Chairman Ben S. Bernanke outlined the risks of the too-big-to-fail system: [T]he belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to- fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem. \2\--------------------------------------------------------------------------- \2\ Financial Reform To Address Systemic Risk, at the Council of Foreign Relations, March 10, 2009. FDIC Chairman Sheila Bair, in remarks before the ICBA annual convention last Friday said, ``What we really need to do is end too-big-to-fail. We need to reduce systemic risk by limiting the size, complexity and concentration of our financial institutions.'' \3\ The Group of 30 report on financial reform stated, ``To guard against excessive concentration in national banking systems, with implications for effective official oversight, management control, and effective competition, nationwide limits on deposit concentration should be considered at a level appropriate to individual countries.'' \4\--------------------------------------------------------------------------- \3\ March 20, 2009. \4\ ``Financial Reform; A Framework for Financial Stability,'' January 15, 2009, p. 8.--------------------------------------------------------------------------- The 10 percent nationwide deposit concentration cap established by the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 should be immediately reduced and strengthened. The current cap is insufficient to control the growth of systemic risk institutions the failure of which will cost taxpayers dearly and destabilize our economy. Unfortunately, government interventions necessitated by the too-big-to-fail policy have exacerbated rather than abated the long-term problems in our financial structure. Through Federal Reserve and Treasury orchestrated mergers, acquisitions and closures, the big have become bigger. Congress should not only consider breaking up the largest institutions, but order it to take place. It is clearly not in the public interest to have so much power and concentrated wealth in the hands of so few, giving them the ability to destabilize our entire economy.Banking and Antitrust Laws Have Failed To Prevent Undue Concentration; Large Institutions Must Be Regulated and Broken Up Community bankers have spent the past 25 years warning policy makers of the systemic risk that was being created in our Nation by the unbridled growth of the Nation's largest banks and financial firms. But, we were told we didn't get it, that we didn't understand the new global economy, that we were protectionist, that we were afraid of competition, and that we needed to get with the ``modern'' times. Sadly, we now know what modern times look like and the picture isn't pretty. Our financial system is imploding around us. Why is this the case, and why must Congress take bold action? One important reason is that banking and antitrust laws fail to address the systemic risks posed by excessive financial concentration. Their focus is too narrow. Antitrust laws are designed to maintain competitive geographic and product markets. So long as the courts and agencies can discern that there are enough competitors in a particular market that is the end of the inquiry. This type of analysis often prevents local banks from merging. But, it has done nothing to prevent the creation of giant nationwide franchises competing with each other in various local markets. No one asked, is the Nation's banking industry becoming too concentrated and are individual firms becoming too powerful both economically and politically. The banking laws are also subject to misguided tunnel vision. The question is always whether a given merger will enhance the safety and soundness of an individual firm. The answer has been that ``bigger'' is almost necessarily ``stronger.'' A bigger firm can--many said--spread its risk across geographic areas and business lines. No one wondered what would happen if one firm, or a group of firms, decides to jump off a cliff as they did in the subprime mortgage market. Now we know. It is time for Congress to change the laws and direct that the Nation's regulatory system take systemic risk into account and take steps to reduce and eventually eliminate it. These are ICBA specific recommendations to deal with this issue:Summary of Systemic Risk Recommendations Congress should direct a fully staffed interagency task force to immediately identify financial institutions that pose a systemic risk to the economy. These institutions should be put immediately under prudential supervision by a Federal agency--most likely the Federal Reserve. The Federal systemic risk agency should impose two fees on these institutions that would: compensate the agency for the cost of supervision; and capitalize a systemic risk fund comparable to the FDIC's Deposit Insurance Fund. The FDIC should impose a systemic risk premium on any insured bank that is affiliated with a firm designated as a systemic risk institution. The systemic risk regulator should impose higher capital charges to provide a cushion against systemic risk. The Congress should direct the systemic risk regulator and the FDIC to develop procedures to resolve the failure of a systemic risk institution. The Congress should direct the interagency systemic risk task force to order the break up of systemic risk institutions over a 5-year period. Congress should direct the systemic risk regulator to review all proposed mergers of major financial institutions and to block any merger that would result in the creation of a systemic risk institution. Congress should direct the systemic risk regulator to block any financial activity that threatens to impose a systemic risk. The only way to maintain a vibrant banking system where small and large institutions are able to fairly compete--and to protect taxpayers--is to aggressively regulate, assess, and eventually break up those institutions posing a risk to our entire economy.Identification and Regulation of Systemic Risk Institutions ICBA recommends Congress establish an interagency task force to identify institutions that pose a systemic financial risk. At a minimum, this task force should include the agencies that regulate and supervise FDIC-insured banks--including the Federal Reserve--plus the Treasury and Securities and Exchange Commission. This task force would be fully staffed by individuals from those agencies, and should be charged with identifying specific institutions that pose a systemic risk. The task force should be directed by an individual appointed by the President and confirmed by the Senate. Once the task force has identified systemic risk institutions, they should be referred to the systemic risk regulator. Chairman Bernanke's March 10 speech provides a good description of the systemic risk regulator's duties: ``Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards.'' Bernanke continued: ``The consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of the organization, not just the holding company.'' Of course, capital is the first line of defense against losses. Community banks have known this all along and generally maintain higher than required levels. This practice has helped many of our colleagues weather the current storm. The new systemic risk regulator should adopt this same philosophy for the too-big-to-fail institutions that it regulates. Clearly, the systemic risk regulator should also have the authority to step in and order the institution to cease activities that impose a systemic risk. Many observers warned that many players in the Nation's mortgage market were taking too many risks. Unfortunately, no one agency attempted to intervene and stop imprudent lending practices across the board. An effective systemic risk regulator must have the unambiguous duty and authority to block any financial activity that threatens to impose a systemic risk.Assessment of Systemic Risk Regulatory Fees The identification, regulation, and supervision of these institutions will impose significant costs to the systemic risk task force and systemic risk regulator. Systemic risk institutions must be assessed the full costs of these government expenses. This would entail a fee, similar to the examination fees banks must pay to their chartering agencies.Resolving Systemic Risk Institutions Chairman Bair and Chairman Bernanke have each recommended the United States develop a mechanism for resolving systemic risk institutions. This is essential to avoid a repeat of the series of the ad hoc weekend bailouts that have proven so costly and infuriating to the public and unfair to institutions that are too-small-to-save. Again, Bernanke's March 10 speech outlined some key considerations: The new resolution regime would need to be carefully crafted. For example, clear guidelines must define which firms could be subject to the alternative regime and the process for invoking that regime, analogous perhaps to the procedures for invoking the so-called systemic risk exception under the FDIA. In addition, given the global operations of many large and complex financial firms and the complex regulatory structures under which they operate, any new regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization. This resolution process will, obviously, be expensive. Therefore, Congress should direct the systemic risk regulator to establish a fund to bear these costs. The FDIC provides a good model. Congress has designated a minimum reserve ratio for the FDIC's Deposit Insurance Fund (DIF) and directed the agency to assess risk-based premiums to maintain that ratio. Instead of deposits, the ratio for the systemic risk fund should apply as broadly as possible to ensure all the risks covered are assessed. Some of the systemic risk institutions will include FDIC-insured banks within their holding companies. These banks would certainly not be resolved in the same way as a stand-alone community bank; all depositors would be protected beyond the statutory limits. Therefore, Congress should direct the FDIC to impose a systemic risk fee on these institutions in addition to their regular premiums. The news AIG was required by contract to pay hundreds of millions of dollars in bonuses to the very people that ruined the company point to another requirement for an effective systemic risk regulator. Once a systemic risk institution becomes a candidate for open-institution assistance or resolution, the regulator should have the same authority to abrogate contracts as the FDIC does when it is appointed conservator and receiver of a bank. If the executives and other highly paid employees of these institutions understood they could not design employment contracts that harmed the public interest, their willingness to take unjustified risk might diminish.Breaking Up Systemic Risk Institutions and Preventing Establishing New Threats ICBA believes compelling systemic risk regulation and imposing systemic risk fees and premiums will provide incentives to firms to voluntarily divest activities or not become too big to fail. However, these incentives may not be adequate. Therefore, Congress should direct the systemic risk task force to order the break up of systemic risk institutions over a 5-year period. These steps will reverse the long-standing regulatory policy favoring the creation of ever-larger financial institutions. ICBA understands this will be a controversial recommendation, and many firms will object. We do not advocate liquidation of ongoing, profitable activities. Huge conglomerate holding companies should be separated into business units that make sense. This could be done on the basis of business lines or geographical divisions. Parts of larger institutions could be sold to other institutions. The goal is to reduce systemic risk, not to reduce jobs or services to consumers and businesses.Maintain a Diversified Financial Regulatory System While ICBA strongly supports creation of an effective systemic risk regulator, we oppose the establishment of a single, monolithic regulator for the financial system. Having more than a single federal agency regulating depository institutions provides valuable regulatory checks-and-balances and promotes ``best practices'' among those agencies--much like having multiple branches of government. The collaboration required by multiple federal agencies on each interagency regulation insures all perspectives and interests are represented, that no one type of institution will benefit over another, and the resulting regulatory or supervisory product is superior. A monolithic federal regulator such as the UK's Financial Service Authority would be dangerous and unwise in a country with a financial services sector as diverse as the United States, with tens of thousands of banks and other financial services providers. Efficiency must be balanced against good public policy. With the enormous power of bank regulators and the critical role of banks in the health and vitality of the national economy, it is imperative the bank regulatory system preserves real choice, and preserves both state and federal regulation. For over three generations, the U.S. banking regulatory structure has served this Nation well. Our banking sector was the envy of the world and the strongest and most resilient financial system ever created. But we have gotten off the track. Nonbank financial regulation has been lax and our system has allowed--and even encouraged--the establishment of financial institutions that are too big to manage, too big to regulate, and too big to fail. ICBA supports a system of tiered regulation that subjects large, complex institutions that pose the highest risks to more rigorous supervision and regulation than less complex community banks. Large banks should be subject to continuous examination, and more rigorous capital and other safety and soundness requirements than community banks in recognition of the size and complexity and the amount of risk they pose. They should pay a ``systemic risk premium'' in addition to their regular deposit insurance premiums to the FDIC. Community banks should be examined on a less intrusive schedule and should be subject to a more flexible set of safety and soundness restrictions in recognition of their less complex operations and the fact that community banks are not ``systemic risk'' institutions. Public policy should promote a diversified economic and financial system upon which our Nation's prosperity and consumer choice is built and not encourage further consolidation and concentration of the banking industry by discouraging current community banking operations or new bank formation. Congress need not waste time rearranging the regulatory boxes to change the system of community bank regulation. The system has worked, is working, and will work in the future. The failure occurred in the too-big-to-fail sector. That is the sector Congress must fix.Maintain and Strengthen the Separation of Banking and Commerce Congress has consistently followed one policy that has prevented the creation of some systemic risk institutions. The long-standing policy prohibiting affiliations or combinations between banks and nonfinancial commercial firms (such as Wal-Mart and Home Depot) has served our Nation well. ICBA opposes any regulatory restructuring that would allow commercial entities to own a bank. If it is generally agreed that the current financial crisis is the worst crisis to strike the United States since the Great Depression, how much worse would this crisis have been had the commercial sector been intertwined with banks as well? Regulators are unable to properly regulate the existing mega-financial firms, how much worse would it be to attempt to regulate business combinations many times larger than those that exist today? This issue has become more prominent with recent Federal Reserve encouragement of greater equity investments by commercial companies in financial firms. This is a very dangerous path. Mixing banking and commerce is bad public policy because it creates conflicts of interest, skews credit decisions, and produces dangerous concentrations of economic power. It raises serious safety and soundness concerns because the companies operate outside the consolidated supervisory framework Congress established for owners of insured banks. It exposes the bank to risks not normally associated with banking. And it extends the FDIC safety net putting taxpayers at greater risk. Mixing banking and commerce was at the core of a prolonged and painful recession in Japan. Congress has voted on numerous occasions to close loopholes that permitted the mixing of banking and commerce, including the nonbank bank loophole in 1987 and the unitary thrift holding company loophole in 1999. However, the Industrial Loan Company loophole remains open. Creating greater opportunities to widen this loophole would be a serious public policy mistake, potentially depriving local communities of capital, local ownership, and civic leadership.Maintain the Dual Banking System ICBA believes strongly in the dual banking system. Having multiple charter options--both federal and state--that financial institutions can choose from is essential for maintaining an innovative and resilient regulatory system. The dual banking system has served our Nation well for nearly 150 years. While the lines of distinction between state and federally chartered banks have blurred in the last 20 years, community banks continue to value the productive tension between state and federal regulators. One of the distinct advantages to the current dual banking system is that it ensures community banks have a choice of charters and the supervisory authority that oversees their operations. In many cases over the years the system of state regulation has worked better than its federal counterparts. State regulators bring a wealth of local market knowledge and state and regional insight to their examinations of the banks they supervise.The Current Federal Bank Regulatory Structure Provides Sufficient Protections for Consumer Customers of Depository Institutions One benefit of the current regulatory structure is the federal banking agencies have coordinated their efforts and developed consistent approaches to enforcement of consumer regulations, both informally and formally, as they do through the Federal Financial Institutions Examination Council (FFIEC). This interagency cooperation has created a system that ensures a breadth of input and discussion that has produced a number of beneficial interagency guidelines, including guidelines on nontraditional mortgages and subprime lending, as well as overdraft protection, community reinvestment and other areas of concern to consumers. Perhaps more important for consumer interests than interagency cooperation is the fact that depository institutions are closely supervised and regularly examined. This examination process ensures consumer financial products and services offered by banks, savings associations and credit unions are regularly and carefully reviewed for compliance. ICBA believes nonbank providers of financial services, such as mortgage companies, mortgage brokers, etc., should be subject to greater oversight for consumer protection. For the most part, unscrupulous and in some cases illegal lending practices that led directly to the subprime housing crisis originated with nonbank mortgage providers. The incidence of abuse was much less pronounced in the highly regulated banking sector.Retain the Savings Institutions Charter and the OTS Savings institutions play an essential role in providing residential mortgage credit in the United States. The thrift charter should not be eliminated and the Office of Thrift Supervision should not be merged into the Office of the Comptroller of the Currency. The OTS has expertise and proficiency in supervising those financial institutions choosing to operate with a savings institution charter with a business focus on housing finance and other consumer lending.Government-Sponsored Enterprises Play an Important Role Many community bankers rely on Federal Home Loan Banks for liquidity and asset/liability management through the advance window. Community banks place tremendous reliance upon the FLHBs as a source of liquidity and an important partner in growth. Community banks also have been able to provide mortgage services to our customers by selling mortgages to Fannie Mae and Freddie Mac. ICBA strongly supported congressional efforts to strengthen the regulation of the housing GSEs to ensure the ongoing availability of these services. We urge the Congress to ensure these enterprises continue their vital services to the community banking industry in a way that protects taxpayers and ensures their long-term viability. There are few ``rules of the road'' for the unprecedented government takeover of institutions the size of Fannie and Freddie, and the outcome is uncertain. Community banks are concerned that the ultimate disposition of the GSEs by the government may fundamentally alter the housing finance system in ways that disadvantage consumers and community bank mortgage lenders alike. The GSEs have performed their central task and served our Nation well. Their current challenges do not mean the mission they were created to serve is flawed. ICBA firmly believes the government must preserve the historic mission of the GSEs, that is, to provide capital and liquidity for mortgages to promote homeownership and affordable housing in both good times and bad. Community banks need an impartial outlet in the secondary market such as Fannie and Freddie--one that doesn't compete with community banks for their customers. Such an impartial outlet must be maintained. This is the only way to ensure community banks can fully serve their customers and their communities and to ensure their customers continue to have access to affordable credit. As the future structure of the GSEs is considered, ICBA is concerned about the impact on their effectiveness of either an elimination of the implied government guarantee for their debt or limits on their asset portfolios. These are two extremely important issues. The implied government guarantee is necessary to maintain affordable 30-year, fixed rate mortgage loans. Flexible portfolio limits should be allowed so the GSEs can respond to market needs. Without an institutionalized mortgage-backed securities market such as the one Freddie and Fannie provide, mortgage capital will be less predictable and more expensive, and adjustable rate mortgages could become the standard loan for home buyers, as could higher down payment requirements.Conclusion Mr. Chairman, to say this is a complex and complicated undertaking would be a great understatement. Current circumstances demand our utmost attention and consideration. Many of the principles laid out in our testimony are controversial, but we feel they are necessary to preserve and maintain America's great financial system and make it stronger coming out of this crisis. ICBA greatly appreciates this opportunity to testify. Congress should avoid doing damage to the regulatory system for community banks, a system that has been tremendously effective. However, Congress should take a number of steps to regulate, assess, and ultimately break up institutions that pose unacceptable systemic risks to the Nation's financial system. The current crisis provides an opportunity to strengthen our Nation's financial system and economy by taking these important steps. ICBA looks forward to working with this Committee on these very important issues. CHRG-111shrg53176--148 PREPARED STATEMENT OF ARTHUR LEVITT Former Chairman, Securities and Exchange Commission March 26, 2009 Thank you, Chairman Dodd and Ranking Member Shelby, for the opportunity to appear before the Committee at this critical moment facing our markets, our economy, and our Nation. 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 build upon that testimony and focus your attention on the prime victim of deregulation--investors. Because of failures at every level of our financial system, investors no longer feel that they receive correct information or enjoy meaningful protections. Their confidence in fair, open, and efficient markets has been badly damaged. And not surprisingly, our markets have suffered from this lack of investor confidence. Above all the issues you now face, whether it is public anger 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 must not 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 status. In coming months, you will adopt specific regulatory and policy solutions to the problems we face, yet none of that work will matter much unless we find a way to restore investor confidence. If at the end of the process you don't place investor confidence at the heart of your efforts, no system of regulation and no amount of spending on regulatory agencies can be expected to succeed.Core Principles You are focusing now on the issue of systemic risk, and therefore whatever response you take must be systemic as well. Specifically, some have suggested that we should re-impose Glass-Steagall rules regarding the activities and regulation of banks. Those rules kept the Nation's commercial banks away from the kinds of risky activities of investment banks. But by 1999, the law no longer had the same teeth--multiple workarounds had developed, and it no longer was practical to keep it in place. Perhaps we were too hasty in doing away with it, and should have held onto several key principles that made Glass-Steagall an effective bulwark against systemic risk in America's banking sector. That does not mean we should pursue ``turn-back-the-clock'' regulation reforms and re-impose Glass-Steagall. The world of finance has changed greatly since 1999 and we have to change with it. But we can borrow some important principles from Glass-Steagall, apply them to today's environment, as we address the serious weaknesses of our current system of financial regulation. Those principles, in short, are: Regulation needs to match the market action. If an entity is engaged in trading securities, it should be regulated as a securities firm. If an entity takes deposits and holds loans to maturity, it should be regulated as a depository bank. Moreover, regulation and regulatory agencies must be suited to the markets they seek to oversee. Regulation is not one size fits all. Accounting standards serve a critical purpose by making information accessible and comprehensible in a consistent way. I understand that 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. That principle supports mark-to-market accounting, which should not be suspended under any condition. The proper role of a securities regulator is to be the guardian of capital markets. There is an inherent tension at times between securities regulators and banking supervisors. That tension is to be expected and even desired. But under no circumstance should the securities regulator be subsumed--if your goal is to restore investor confidence, you must embolden those who protect capital markets from abuse. You must fund them appropriately, give them the legal tools they need to protect investors, and, most of all, hold them accountable, so that they enforce the laws you write. And finally, all regulatory reforms and improvements must be done in a coordinated and systemic way. The work of regulation is rarely done well in a piecemeal fashion. Rather, your focus should be to create a system of rules that comprise a complete approach, where each part complements the other, and to do it all at once.Specific Reforms 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 single super-regulator. I would suggest that a more diverse approach should be adopted, taking advantage of the relative strengths of our existing regulatory agencies. For example, the Federal Reserve, as a banking supervisor, has a deep and ingrained culture that is oriented towards the safety and soundness of our banking system. But when banks--or any financial institution--engage in securities transactions, either by making a market in securities, or by securitizing and selling loans, or by creating derivatives backed by equities or debt, they fundamentally require oversight from trained securities regulators. What serves the health of banks may run exactly counter to the interests of investors--and we have seen situations where bank regulators have kept information about poorly performing assets from the public in order to give a bank time enough to dispose of them. In that case, banking regulators will work at cross-purposes with securities regulators. Ultimately, the only solution to that tension is to live with it. When I was at the SEC, there was tension between banking regulators and securities regulators all the time. This creative tension served the ultimate goal of reducing overall risk to our economy, even if it occasionally was frustrating for the regulators and the financial institutions themselves. And so we should not be surprised if regulatory reforms yield a bit of regulatory overlap. That is both natural, considering the complexity of financial institutions, and even desirable. Second: Mark to market or fair value standards should not be suspended under any circumstance. Some have come forward and suggested that these are unusual times, and we need to make concessions in our accounting standards to help us through it. But if we obscure investor understanding of the value of assets currently held by banking institutions, we would exacerbate the crisis, and hurt investors in the bargain. Unfortunately, recent steps taken by the FASB, at the behest of some politicians, weaken fair value accounting. Those who argue for a suspension of mark-to-market accounting argue this would punish risk-taking. I strongly disagree. Our goal should be to make sure risk can be priced accurately. Failure to account for risk, and failure to present it in a consistent way, makes it impossible to price it, and therefore to manage it. And so any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake, and contribute to greater systemic risk. I would add that mark-to-market accounting has important value for internal management of risk within a firm. Mark-to-market informs investment bank senior managers of trading performance, asset prices, and risk factor volatilities. It supports profit and loss processes and hedge performance analyses, facilitates the generation and validation of risk metrics, and enables a controlled environment for risk-taking. If treated seriously by management, mark-to-market is a force for internal discipline and risk management, not much different than a focus on internal controls. Yes, valuing illiquid or complex structured products is difficult. But that doesn't mean the work should not be done. I would argue that it has to be done, both inside the firm and by those outside it, to reduce risk throughout our system. And so I agree with the Chairman of the Federal Reserve, and the heads of the major accounting firms, that the maintenance of mark-to-market standards is essential. Third: As this Committee and other policymakers seek to mitigate systemic risk, I would suggest taking a broad approach to the challenge. It would be a mistake, I believe, to designate only one agency to focus on systemic risk, because systemic risk emanates in multiple ways. You may find the task best accomplished by enacting a series of complementary regulatory enhancements aimed at promoting transparency and information discovery across multiple markets. Those remaining pockets of financial activity covered by self-regulation and protected from litigation should be brought in under a more vigorous regulatory structure with fully independent regulators and legal remedies. For years, credit ratings agencies have been able to use legal defenses to keep from the SEC from inspecting the way they do their ratings the way the PCAOB is empowered to examine the way audits are done, even though these agencies dispense investment advice and sit at a critical nexus of financial information and potential risk. In addition, these ratings agencies cannot be fined by the SEC and they operate with significant protections from private rights of action. These protections from regulatory review and legal remedies need to be reconsidered. The credit ratings agencies have an abysmal record of performance in recent years and their failure has had an outsized impact on the health of our entire financial system. They are not merely expressing views that would ordinarily receive legal protections. They are playing a much larger role, and their activities should be treated in the same way as other market actors who are subject to SEC review and regulation. 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. This is the market where Wall Street and Main Street collide. Since the New York City crisis of 1975, this market has grown to a size and complexity that few anticipated. It now includes not-for-profit institutions and even for-profit business corporations who sell securities through government conduit entities. The debt and derivative products sold are substantially the same as those sold in the corporate market. Small investors make up a substantial part of this market and because of the Tower Amendment many participants--insurers, rating agencies, financial advisors to issuers, underwriters, hedge funds, money managers and even some issuers--have abused the protection granted by Congress from SEC regulation. This market has shown that self-regulation by bankers and brokers through the Municipal Services Rulemaking Board all too often has come at the expense of the public interest. The New York City debacle in 1975, the San Diego pension fund fraud in 2006, the Orange County California derivatives crisis in 1994, the Washington Public Power System defaults in 1980, the auction securities settlements of 2008, and the current investigations into derivatives, bid rigging, pay to play and other scandals--this is an industry prone to scandal. In recent months, we have even seen several well-documented scandals where small municipalities and public agencies were encouraged to float bonds even though the money was not to be spent on public purposes, but rather used as an investment pool. We may not want to treat municipals like we do other securities--but we do need to level the playing field between the corporate and municipal markets and address all risks to the financial system. Municipal issuers are ill-equipped and some are reluctant to do this on their own. We may have to develop ways protect small municipal issuers from over regulation just as we do for small corporations, so long as we do not develop a double standard for principles of disclosure, transparency, finance and compliance with market rules. Former Chairman Cox has suggested granting the SEC authority to regulate the municipal bond industry to promote integrity, competition and efficiency, and I agree. 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 what some have called the ``shadow markets''--those areas of finance beyond the oversight of regulators. In particular, I would urge that you require banks and hedge funds create an audit trail and clearinghouse for all trades, to create a better awareness of investment products that could pose risks to overall markets. I would also recommend placing hedge funds under SEC regulation in the context of their role as money managers and investment advisors. There will be some who argue that SEC oversight of some aspects of hedge funds will come at the expense of financial market innovation. In fact, such regulation could help improve the environment for financial innovation. For example, we know that new investment vehicles can be a source for risk even as they supply investors with a desired financial product. How do we balance those competing qualities? Perhaps the SEC could increase the margin requirement for the purchase of new products, until those products are road-tested and have developed a strong history of performance in different economic conditions. Nor are all forms of regulation going to simply involve more disclosure requirements. I could see a greater focus on better disclosure, so that investors and regulators receive information that has more value. For example, a system that allows financial institutions to make their own risk assessments, or relies on credit rating agencies for purposes of determining how much capital they should have, lacks adequate independence and credibility. At the same time, adopting a one size fits all approach is likely to be shortsighted and ineffective. As SEC Chairman, I favored risk-based principles for regulation, and think greater application of those principles is needed. Such a system should be forward-looking, independent and free of bias in its assessment of risks and liquidity needs within an entity, overseen by a regulator with a mission, culture and necessary resources to do the job, and finally, be fully transparent not only to regulators but also to investors, taxpayers and Congress. Such a system would be far more useful than our current system. And it would contribute greatly to our awareness of potential sources of systemic risk. These steps would require OTC derivative 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 to combine the resources and responsibilities of the SEC and CFTC. In today's financial markets, the kinds of financial instruments regulated by these two agencies share much in common as economic substitutes, and this change would allow regulators to share their skillsets, coordinate their activities, and share more information, thus providing a deeper level of understanding about risk. Supporting all these activities will require an appropriately funded, staffed and empowered SEC. Under the previous administration, SEC funding and staffing either stayed flat or dropped in significant areas--enforcement staff dropped 11 percent from 2005 to 2008, for example. We have seen that regulators are often overmatched, both in staffing and in their capacity to use and deploy technology, and they can't even meet even a modest calendar of regular inspections of securities firms. Clearly, if we are to empower the SEC to oversee the activities of municipal bond firms and hedge funds, we will need to create not only a stronger agency, but one which has an adequate and dedicated revenue stream, just as the Federal Reserve does. My final recommendation relates to something you must not do. Under no condition should the SEC lose any of its current regulatory responsibilities. As the primary guardian of capital markets, the SEC is considered the leading investor representative and advocate. Any regulatory change you make that reduces the responsibility or authority of the SEC will be viewed as a reduction in investor protections. That view will be correct, because no agency has the culture, institutional knowledge, staff, and mission as the SEC to protect investors.Conclusion These actions would affirm the core principles which served the Nation's financial markets so well, from 1933 to 1999--regulation meeting the realities of the market, accounting standards upheld and strengthened, regulators charged with serving as the guardians of capital markets, and a systemic approach to regulation. The resulting regulatory structure would be flexible enough to meet the needs of today's market, and would create a far more effective screen for potential systemic risks throughout the marketplace. Financial innovations would continue to be developed, but under a more watchful eye from regulators, who would be able to track their growth and follow potential exposure. Whole swaths of the shadow markets would be exposed to the sunlight of oversight, without compromising the freedom investors have in choosing their financial managers and the risks they are willing to bear. Most importantly, these measures would help restore investor confidence by putting in place a strong regulatory structure, enforcing rules equally and consistently, and making sure those rules serve to protect investors from fraud, misinformation, and outright abuse. These outcomes won't come without a price to those who think only of their own self-interest. As we have seen in the debate over mark-to-market accounting rules, there will be strong critics of strong, consistent regulatory structure. The self-interested have reasons of their own to void mark-to-market accounting, but that does not make them good reasons for all of us. Someone must be the guardian of the capital market structure, and 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 maintain a common front to favor the rights of the investor, whose confidence will determine the health of our markets, our economy, and ultimately, our Nation. ______ CHRG-111shrg53822--69 Mr. Baily," Thank you. First of all, I agree with you very much that we failed to address the risks and companies failed to manage their risks. One of the most interesting and revealing documents that I read in all of this was written by UBS, the Swiss Bank, at the insistence of the Swiss Central Bank, that described its own risk management procedures and how they had failed. And it is an extraordinary document of how they did not follow their own internal risk management. They jeopardized their own company. They subsequently had to be supported by the Swiss Central Bank, which in turn has had to rely, to some extent, on our federal reserve. It is an extraordinary story, which goes to the point that you mentioned. I agree with Peter, generally, in the remarks that he made, that we require these very large banks. When the crisis hit, for example, there was a huge collapse in global trade. Traders in India could not import and export because they had relied on financing coming through New York. So I agree with him very much that we need these large banks, particularly if they are growing and providing services to the U.S. and the global economy and are doing it efficiently. At the same time--and I think, again, we have some not complete agreement, but some broad agreement, that as banks become bigger or more interconnected--it is not always size, obviously--that we need special supervision, either increased cap requirements, increased supervision of their portfolios, or some mechanism to make sure that we do not get a repeat of what happened to UBS. Now, I do not think we are going to get that next year because I think a lot of people have learned their lesson. But we have to have in place a system that 10 years from now, 20 years from now, when some of these lessons have been forgotten, that we have in place a better regulatory regime. I would say one more thing about that regulatory regime. We cannot, probably in this country, ever pay regulators what people earn on Wall Street. Some countries pay their regulators very high salaries. There are limits to what we can do here. But I do think it would make a difference if we could pay reasonably competitive salaries, more than they are currently making. We should insist on training regulators so we give ourselves the best chance of avoiding some of the regulatory failures that happened in the course of this crisis. Thank you. Senator Akaka. Thank you very much, Mr. Baily. " Mr. Rajan," " CHRG-110hhrg46593--152 Mr. Neugebauer," Well, let me make a general comment, which is, I know what the downside was, and the downside was the collapse of the financial system, which would have wreaked huge havoc on this economy for many years. Now, part of the issue that we have in answering the question precisely is because these programs are very different. For instance, let's just take a $250 billion bank capital plan. That is not an expenditure; it is an investment. I think it would be extraordinarily unusual if we, the government, did not get that money back and more. And so that gets accounted for as an expenditure against the deficit. That will be coming back in, for instance. The Fannie and Freddie, that is a, you know, there is, the government is standing up there for the credit of those entities and making good on what I believe our responsibilities were and what investors in this country and around the world understood our responsibilities to be, in that situation. The liquidity programs by the Fed are not expenditures, but they are impacting the markets, and right now, for instance, this year, we will issue roughly $1.5 trillion of treasuries, roughly 3 times than we ever have before. Now, right now, there is huge demand for those securities, huge demand all over the world. But that is to fund liquidity programs that are shorter in duration. Ben, I don't know, what about you? " CHRG-109hhrg23738--119 Mr. Gillmor," Thank you, Madam Chairwoman. Mr. Greenspan, I want to commend you for the great job you have done over the years, and for your service to the country. You are going to be missed. I have a couple of questions regarding ILCs, industrial loan companies, I would like your views on. Could you give us your thoughts about the rapid expansion of commercial firms obtaining industrial loan company charters and what that means for the overall banking system? And in respect to that, are there any risks, or even systemic risk, to our banking system in the avoidance of Fed oversight that an ILC charter allows? " CHRG-111hhrg51585--15 Mr. Price," Thank you, Mr. Chairman. It is extremely important for us to be discussing the Lehman Brothers bankruptcy in the context of the full committee. But I would also suggest and like to draw attention to the fact that we still haven't had a hearing on the collapse of Bear Stearns, which undeniably shaped the public expectations for the government bailout of Lehman Brothers. On April 7, 2008, Ranking Member Bachus and 16 members of this committee sent a letter to the chairman requesting a hearing specifically on Bear Stearns, which has not yet occurred. We have not had a hearing focused specifically on the events that led to the Lehman bankruptcy, derivatives, or the SEC's now defunct Consolidated Supervised Entities Program, which supervised Lehman and the four other investment banks. In the wake of Bear Stearns, and leading up to the bankruptcy of Lehman, many investors continued to purchase bonds or commercial paper issued by Lehman Brothers. In a normal functioning market, without suspicion of government backing or bailouts, investors would have likely been much more cautious, investing elsewhere and spreading their risk. Protecting risk seems to be the primary issue that has brought us here today. Our Nation has a system that, though painful, works extremely well in times of great challenge. It is the bankruptcy system. And I would suggest that the Lehman bankruptcy actually unfolded relatively smoothly. While many would like to attribute this unprecedented event to the inadequacies of the bankruptcy system, the more accurate culprit is the government's unpredictable meddling in the market. This certainly contributed more than any insufficiencies within the Bankruptcy Code. The situation with Lehman Brothers, the government created an unreasonable expectation that led to increased economic turmoil. Part of getting this country back on track is getting the government out of the market and out of the business of eliminating risk. Investments involve risk and reward. If we take away all the risk, there will be no reward for anyone, no opportunity for anyone, and no reason to invest in the future. We should look at that. " CHRG-111hhrg54869--109 Mr. Volcker," I think capital requirements and amount of capital are obviously important. But if you try to fine-tune it too far--the banking regulators have struggled with this--how much capital in each particular kind of risk basket? It is very hard to define different risks very precisely. And they went from a system, or trying to go from a system that was very crude, back when I was Chairman of the Federal Reserve--which we had installed--to say it is not sophisticated enough, it doesn't have all those baskets that you are talking about. But boy, they have run into more difficulty. They have spent 10 years trying to define this and they put a lot of weight on credit rating agencies. Now, that no longer looks so great. But that is illustrative of the kind of problem you run into. So I am kind of on the side of, yes, adequate capital. Yes, make sure capital is big enough, but recognize it has to be pretty crude, and don't try to be too sophisticated about it. I do think, and you may be getting at this, when you get into nonbanks, bank capital is already--whether it is adequate or not, no doubt it is a matter of a supervisory concern. When you get outside of the banking system, then I think there ought to be some residual authority for those few institutions that get so big they really look dangerous from the standpoint of financial stability, somebody has the authority to say, look, you are too leveraged. You have to provide some more capital, or you have to cut down on your assets; or you cut down on your activities and you have to hold more liquidity. I think the need for that will be rare. I do believe in registration of hedge funds, I do believe there ought to be some reporting of hedge funds. But I think there are very few hedge funds that present a systemic risk. They are a different kind of operation, a different kind of financing. We have seen failures of hedge funds that were successfully absorbed without much difficulty. Interestingly enough, where that was not true was the hedge funds owned by Bear Stearns. What sent Bear Stearns in the beginning of its downward slide was the failure of or losses in its own hedge funds, which is illustrative of why I don't want commercial banks to be holding hedge funds, because that would be a point of vulnerability. " CHRG-111shrg54789--188 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM EDWARD L. YINGLINGQ.1. In assessing the need for and scope of a new Consumer Financial Protection Agency (CFPA), the Committee must conduct an objective evaluation regarding the responsibility of various types of financial services providers for the lending problems that have occurred in recent years. In your written testimony, you identify nonbank lenders as the source for the vast majority of abusive mortgage lending in recent years. Specifically you write that `` . . . the Treasury's plan noted that 94 percent of high cost mortgages were made outside the traditional banking system.'' Your testimony also says that `` . . . it is likely that an even higher percent of the most abusive loans were made outside our sector.'' On the other hand, the Committee heard testimony from Professor McCoy of the University of Connecticut on March 3, 2009, that such an assertion, ``fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.'' Professor McCoy cites data indicating that national banks and thrifts issued mortgage loans from 2006-2008 with higher default rates than State-chartered thrifts and banks. Moreover, Assistant Secretary Barr testified on the panel prior to you that ``about one-half of the subprime originations in 2005 and 2006--the shoddy that set off the wave of foreclosures--were by banks and thrifts and their affiliates.'' Is it your view that national banks and thrifts did not play a significant role, either directly or through their subsidiaries, in offering abusive or unsustainable mortgage loans?A.1. Thank you for your question, Mr. Chairman. Certainly, some banks--both national and State chartered--were involved in subprime lending, but the fundamental fact remains that the vast majority of banks in the country never made a toxic subprime loan. These regulated banks did not cause the problem; rather, they are the solution to the economic problem we face. The comment by Professor McCoy you cite in your question is not directed at the Treasury's statistic we referenced, i.e., that a very high percentage of high cost loans were made outside the banking industry. In fact, Professor McCoy refers to a study by the OCC which finds that national banks only accounted for 10 percent of subprime lending in 2006--thus confirming the evidence that the heart of the problem is with nonbanks. Even though attempts have been made to increase Federal regulation of the nonbank sector, the fact remains that in the key areas of examination and enforcement, nonbanks still are not regulated as strictly or robustly as banks. In fact, the GAO recently released a study on Fair Lending (July 2009) which found that the independent mortgage lenders represented ``higher fair lending risks than depository institutions'' yet ``Federal reviews of their activities are limited.'' Furthermore, GAO found that ``[d]epository institution regulators also have established varying policies to help ensure that many lenders not identified through HMDA screening routinely undergo compliance examinations, which may include fair lending components.'' This increased focus on insured depository institutions occurs because the banking agencies ``have large examination staffs and other personnel to carry out fair lending oversight.'' Traditional banks are the survivors of this financial crisis, not the cause. The fly-by-night nonbank mortgage lenders have disappeared as fast as they appeared. As I mentioned in detail in my written statement, the focus of policymaking should be on the core cause of the problem--the unregulated nonbank financial sector--and not end up punishing the very institutions that are most likely to restart our economy. ------ CHRG-111hhrg53246--104 Mr. Royce," And I would add two more questions in writing, if you could submit. I think going forward it would help the committee members. What led to failures in financial institutions to recognize the inadequacy of their own risk management systems and strategy in time to avert a collapse? And second, how did many investors get lulled into complacency and not adequately do their own due diligence as well? You probably will have some perspectives at the SEC on those two questions, and I think a better understanding of the failure on that front as well. Ms. Schapiro. I would be very happy to do that. " CHRG-111hhrg53245--256 Mr. Donnelly," One of the other things the investor, this fellow, talked about was, and he talked to all of us, was maybe what we ought to do is just throw a couple of cents on every tray and have in effect a quasi-public rating system so that we do not have to speculate on the opinion of Moody's or that they be part of in effect almost become like a public utility, that it is too important getting this right to our economy, to the global economy. We had the Fed chairman in today who said if we had let this get out of hand, the whole global economy would have collapsed. And so much of it was tied in to these incorrect ratings given by Moody's and others. " CHRG-110hhrg46593--18 Secretary Paulson," Mr. Chairman, two things. First, I need to just say a word about AIG, because the primary purpose of the bill was to protect our system from collapse. AIG was a situation, a company that would have failed had the Fed not stepped in. Had we had the TARP at that time, this is right down the middle of the plate for what we would have used the TARP for. As it turned out--because it should have had preferred and a Fed facility. And as it turned out, we needed to come in, again, to stabilize that situation and maximize the chances that the government would get money back. So I just wanted-- " CHRG-111shrg57709--204 Mr. Volcker," But, in essence, that is what we are---- Senator Menendez. Now, with that, if we pass a law preventing commercial banks from engaging in proprietary lending, one possibility is that a Goldman Sachs or a J.P. Morgan will simply drop their bank holding company status and continue to engage in proprietary trading, hedge fund, private equity activity. If they do that, will our financial system be less systemically at risk? " CHRG-111hhrg55809--51 Mr. Bernanke," That would make us look very much like the Bank of England and some other central banks that have been brought back to monetary policy-making. I think the experience of the recent crisis is that, and this is the case in the U.K., that the fact that the bank did not have the information it needed about the crisis, about what was happening in the banking system and so on, was a real drawback in terms of the ability of the Central Bank to help stabilize the system. So, of course, you could have a central bank that was focused only on monetary policy, absolutely. But I think that it is very important for the Central Bank to have the information, the expertise, the insight about the banking system in order to both make better monetary policy and to be able to play an appropriate role whenever there is a crisis. " CHRG-111shrg61651--55 Mr. Johnson," Senator, the evidence that I have seen suggests it would have a relatively small impact on the profitability of these banks, with the possible exception of Goldman Sachs, as Mr. Corrigan emphasized. That 10 percent over the cycle of net revenues is probably an outlier for a bank holding company, and, of course, there is discussion about whether people who have bank licenses would be allowed to hand those licenses back and go off and become some independent structure not regulated by the Federal Reserve. If that were to be the outcome of the Volcker Rule, if that were permitted by the rules that you draw up and how they are implemented, that would be a complete disaster, because you can't have a situation where banks are very big doing banking activities not subject to comprehensive, tough regulation, which is, I hope, what we will get out of the regulatory structure that you create. You can't just go off and take those massive risks and then when you face a collapse say, oh, I would like my banking license back. And Goldman Sachs, I think, got a one-time-only pass--I hope--when they were allowed to go to bank holding company in September 2009--2008. Senator Johnson. My time has expired. " FinancialCrisisInquiry--417 BASS: I think I would respectfully disagree with Mr. Mayo on this. I think we need to determine—if an institution is systemically important to the United States and to our system, we need to determine what appropriate level of leverage are, and we need to force those companies to live within those leverage bounds. You know, today, as I mentioned, it’s somewhere between 16 and 25. And I will just assert to you that that is— that’s too high. So what we need to determine is—to Mr. Solomon’s point—if you’re going to be a proprietary trading firm and you want to engage in risk and it is the U.S. way and it’s capitalism, go do it. But there will be no safety net for you if you fail. All right. Don’t become systemically important. January 13, 2010 So you can make that happen. You can separate those two. And it goes back to the Glass- Steagall argument. But I think, of the institutions—we have four banks in the United States that owns 45 percent of the assets. We have 8,300 others that own the balance. Our whole system is very top-heavy here, and the reason that they’re systemically important is they’re that big. So I think, more holistically, we need to figure out what the structure of the system needs to look like, and we need to set what the leverage ratios are of those systemically important institutions. That’s my opinion. fcic_final_report_full--551 Session : Firm Structure and Risk Management Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance and Richard N. Rosett Faculty Fellow, University of Chicago Session : Shadow Banking Gary Gorton, Professor of Finance, School of Management, Yale University Public Hearing on Subprime Lending and Securitization and Government-Spon- sored Enterprises (GSEs), Rayburn House Office Building, Room , Washington, DC, Day , April ,  Session : The Federal Reserve Alan Greenspan, Former Chairman, Board of Governors of the Federal Reserve System Session : Subprime Origination and Securitization Richard Bitner, Managing Director of Housingwire.com; Author, Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud, and Ignorance Richard Bowen, Former Senior Vice President and Business Chief Underwriter, CitiMortgage, Inc. Patricia Lindsay, Former Vice President, Corporate Risk, New Century Financial Corporation Susan Mills, Managing Director of Mortgage Finance, Citi Markets & Banking, Global Securi- tized Markets Session : Citigroup Subprime-Related Structured Products and Risk Management Murray C. Barnes, Former Managing Director, Independent Risk, Citigroup, Inc. David C. Bushnell, Former Chief Risk Officer, Citigroup, Inc. Nestor Dominguez, Former Co-head, Global Collateralized Debt Obligations, Citi Markets & Banking, Global Structured Credit Products Thomas G. Maheras, Former Co-chief Executive Officer, Citi Markets & Banking Public Hearing on Subprime Lending and Securitization and Government-Spon- sored Enterprises (GSEs), Rayburn House Office Building, Room , Washington, DC, Day , April ,  Session : Citigroup Senior Management Charles O. Prince, Former Chairman of the Board and Chief Executive Officer, Citigroup, Inc. Robert Rubin, Former Chairman of the Executive Committee of the Board of Directors, Citi- group, Inc. Session : Office of the Comptroller of the Currency John C. Dugan, Comptroller, Office of the Comptroller of the Currency John D. Hawke Jr., Former Comptroller, Office of the Comptroller of the Currency Public Hearing on Subprime Lending and Securitization and Government-Spon- sored Enterprises (GSEs), Rayburn House Office building, Room , Washington, DC, Day , April ,  Session : Fannie Mae Robert J. Levin, Former Executive Vice President and Chief Business Officer, Fannie Mae Daniel H. Mudd, Former President and Chief Executive Officer, Fannie Mae Session : Office of Federal Housing Enterprise Oversight Armando Falcon Jr., Former Director, Office of Federal Housing Enterprise Oversight James Lockhart, Former Director, Office of Federal Housing Enterprise Oversight CHRG-111shrg55278--103 PREPARED STATEMENT OF SHEILA C. BAIR Chairman, Federal Deposit Insurance Corporation July 23, 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. The issues under discussion today rival in importance those before the Congress in the wake of the Great Depression. The proposals put forth by the Administration regarding the structure of the financial system, the supervision of financial entities, the protection of consumers, and the resolution of organizations that pose a systemic risk to the economy provide a useful framework for discussion of areas in vital need of reform. However, these are complex issues that can be addressed in a number of different ways. We all agree that we must get this right and enact regulatory reforms that address the fundamental causes of the current crisis within a carefully constructed framework that guards against future crises. It is clear that one of these causes was the presence of significant regulatory gaps within the financial system. Differences in the regulation of capital, leverage, complex financial instruments, and consumer protection provided an environment in which regulatory arbitrage became rampant. Reforms are urgently needed to close these regulatory gaps. At the same time, we must recognize that much of the risk in recent years was built up, within and around, financial firms that were already subject to extensive regulation and prudential supervision. One of the lessons of the past several years is that regulation and prudential supervision alone are not sufficient to control risk taking within a dynamic and complex financial system. Robust and credible mechanisms to ensure that market participants will actively monitor and control risk taking must be in place. We must find ways to impose greater market discipline on systemically important institutions. In a properly functioning market economy there will be winners and losers, and when firms--through their own mismanagement and excessive risk taking--are no longer viable, they 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 year have reinforced the idea that some financial organizations are too-big-to-fail. The solution must involve a practical, effective and highly credible 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.'' The notion of ``too-big-to-fail'' creates a vicious circle that needs to be broken. Large firms are able to raise huge amounts of debt and equity and are given access to the credit markets at favorable terms without consideration of the firms' risk profile. Investors and creditors believe their exposure is minimal since they also believe the Government will not allow these firms to fail. The large firms leverage these funds and become even larger, which makes investors and creditors more complacent and more likely to extend credit and funds without fear of losses. In some respects, investors, creditors, and the firms themselves are making a bet that they are immune from the risks of failure and loss because they have become too big, believing that regulators will avoid taking action for fear of the repercussions on the broader market and economy. If anything is to be learned from this financial crisis, it is that market discipline must be more than a philosophy to ward off appropriate regulation during good times. It must be enforced during difficult times. Given this, we need to develop a resolution regime that provides for the orderly wind-down of large, systemically important financial firms, without imposing large costs to the taxpayers. In contrast to the current situation, this new regime would not focus on propping up the current firm and its management. Instead, under the proposed authority, the resolution would concentrate on maintaining the liquidity and key activities of the organization so that the entity can be resolved in an orderly fashion without disrupting the functioning of the financial system. Losses would be borne by the stockholders and bondholders of the holding company, and senior management would be replaced. Without a new comprehensive resolution regime, we will be forced to repeat the costly, ad hoc responses of the last year. My testimony discusses ways to address and improve the supervision of systemically important institutions and the identification of issues that pose risks to the financial system. The new structure should address such issues as the industry's excessive leverage, inadequate capital, and overreliance on short-term funding. In addition, the regulatory structure should ensure real corporate separateness and the separation of the bank's management, employees, and systems from those affiliates. Risky activities, such as proprietary and hedge fund trading, should be kept outside of insured banks and subject to enhanced capital requirements. Although regulatory gaps clearly need to be addressed, supervisory changes alone are not enough to address these problems. Accordingly, policy makers should focus on the elements necessary to create a credible resolution regime that can effectively address the resolution of financial institutions regardless of their size or complexity and assure that shareholders and creditors absorb losses before the Government. This mechanism is at the heart of our proposals--a bank and bank holding company resolution facility that will impose losses on shareholders and unsecured debt investors, while maintaining financial market stability and minimizing systemic consequences for the national and international economy. The credibility of this resolution mechanism would be further enhanced by the requirement that each bank holding company with subsidiaries engaged in nonbanking financial activities would be required to have, under rules established by the FDIC, a resolution plan that would be annually updated and published for the benefit of market participants and other customers. The combined enhanced supervision and unequivocal prospect of an orderly resolution will go a long way to assuring that the problems of the last several years are not repeated and that any problems that do arise can be handled without cost to the taxpayer.Improving Supervision and Regulation The widespread economic damage that has occurred over the past 2 years 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. Our current system clearly failed in many instances to manage risk properly and to provide stability. 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. 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. A strong case can be made for creating incentives that reduce the size and complexity of financial institutions. A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet on the performance of those banks and that regulator. 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 procyclicality, the capital standards should provide for higher capital buffers that increase during expansions and are available to be drawn down during contractions. In addition, these firms should be subject to higher Prompt Corrective Action standards under U.S. laws and holding company capital requirements that are no less stringent than those applicable to insured banks. Regulators also should take into account off-balance-sheet assets and conduits as if these risks were on-balance-sheet.The Need for a Financial Services Oversight Council 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. 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 entity. Entities that are already subject to a prudential supervisor, such as insured depository institutions and financial holding companies, should retain those supervisory relationships. 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. As a result, for this latter role, the FDIC supports the creation of a Council to oversee systemic risk issues, develop needed prudential policies and mitigate developing systemic risks. 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. Supervisors across the financial system failed to identify the systemic nature of the risks before they were realized as widespread industry losses. The performance of the regulatory system in the current crisis 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 systemwide perspective. The Administration's proposal addresses the need for broader-based identification of systemic risks across the economy and improved interagency cooperation through the establishment of a new Financial Services Oversight Council. The Oversight Council described in the Administration's proposal currently lacks sufficient authority to effectively address systemic risks. In designing the role of the Council, it will be important to preserve the longstanding principle that bank regulation and supervision are best conducted by independent agencies. Careful attention should be given to the establishment of appropriate safeguards to preserve the independence of financial regulation from political influence. The Administration's plan gives the role of Chairman of the Financial Services Oversight Council to the Secretary of the Treasury. To ensure the independence and authority of the Council, consideration should be given to a configuration that would establish the Chairman of the Council as a Presidential appointee, subject to Senate confirmation. This would provide additional independence for the Chairman and enable the Chairman to focus full time on attending to the affairs of the Council and supervising Council staff. Other members on the Council could include, among others, the Federal financial institution, securities and commodities regulators. In addition, we would suggest that the Council include an odd number of members in order to avoid deadlocks. The Council should complement existing regulatory authorities by bringing a macroprudential perspective to regulation and being able to set or harmonize prudential standards to address systemic risk. Drawing on the expertise of the Federal regulators, the Oversight Council should have broad authority and responsibility for identifying institutions, products, practices, services and markets that create potential systemic risks, implementing actions to address those risks, ensuring effective information flow, and completing analyses and making recommendations. In order to do its job, the Council needs the authority to obtain any information requested from systemically important entities. The crisis has clearly revealed that regulatory gaps, or significant differences in regulation across financial services firms, can encourage regulatory arbitrage. Accordingly, 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, and investment funds to determine the extent to which differing standards circumvent regulatory efforts to contain excess leverage in the system. The Council could also 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 Council also could consider requiring financial companies to issue contingent debt instruments--for example, long-term debt that, while not counting toward the satisfaction of regulatory capital requirements, automatically converts to equity under specific conditions. Conditions triggering conversion could include the financial companies' capital falling below prompt corrective action mandated capital levels or regulators declaring a systemic emergency. Financial companies also could be required to issue a portion of their short-term debt in the form of debt instruments that similarly automatically convert to long-term debt under specific conditions, perhaps tied to liquidity. Conversion of long-term debt to equity would immediately recapitalize banks in capital difficulty. Conversion of short-term debt to long-term debt would ameliorate liquidity problems. Also, the Council should be able to harmonize rules regarding systemic risks to serve as a floor that could be met or exceeded, as appropriate, by the primary prudential regulator. Primary regulators would be charged with enforcing the requirements set by the Council. However, if the primary regulators fail to act, the Council should have the authority to do so. The standards set by the Council should 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. Any standards set by the Council should be construed as a minimum floor for regulation that can be exceeded, as appropriate, by the primary prudential regulator. The Council should have the authority to consult with systemic and financial regulators from other countries in developing reporting requirements and in identifying potential systemic risk in the global financial market. The Council also should report to Congress annually about its efforts, identify emerging systemic risk issues and recommend any legislative authority needed to mitigate systemic risk. Some have suggested that a council approach would be less effective than having this authority vested in a single agency because of the perception that a deliberative council such as this would need additional time to address emergency situations that might arise from time to time. Certainly, some additional thought and effort will be needed to address any dissenting views in council deliberations. However, a Council with regulatory agency participation will provide for an appropriate system of checks and balances to ensure that decisions reflect the various interests of public and private stakeholders. In this regard, it should be noted that the board structure at the FDIC, with the participation of the Comptroller of the Currency and the Director of the Office of Thrift Supervision, is not very different from the way the Council would operate. In the case of the FDIC, quick decisions have been made with respect to systemic issues and emergency bank resolutions on many occasions. Based on our experience with a board structure, we believe that decisions could be made quickly by a deliberative council.Resolution Authority Even if risk-management practices improve dramatically and we introduce effective macroprudential supervision, the odds are that a large systemically significant firm will become troubled or fail at some time in the future. The current crisis has clearly demonstrated the need for a single resolution mechanism for financial firms that will preserve stability while imposing the losses on shareholders and creditors and replacing senior management to encourage market discipline. A timely, orderly resolution process that could be applied to both banks and nonbank financial institutions, and their holding companies, would prevent instability and contagion and promote fairness. It would enable the financial markets to continue to function smoothly, while providing for an orderly transfer or unwinding of the firm's operations. The resolution process would ensure that there is the necessary liquidity to complete transactions that are in process at the time of failure, thus addressing the potential for systemic risk without creating the expectation of a bailout. Under the new resolution regime, Congress should raise the bar higher than existing law and eliminate the possibility of open assistance for individual failing entities. The new resolution powers should result in the shareholders and unsecured creditors taking losses prior to the Government, and consideration also should be given to imposing some haircut on secured creditors to promote market discipline and limit costs potentially borne by the Government.Limitations of the Current Resolution Authority The FDIC's resolution powers are very effective for most failed bank situations (see Appendix). However, systemic financial organizations present additional issues that may complicate the FDIC's process of conducting an efficient and economical resolution. As noted above, many financial activities today take place in financial firms that are outside the insured depository institution where the FDIC's existing authority does not reach. These financial firms must be resolved through the bankruptcy process, as the FDIC's resolution powers only apply to insured depository institutions. Resolving large complex financial firms through the bankruptcy process can be destabilizing to regional, national, and international economies since the timing is uncertain and the process can be complex and protracted and may vary by jurisdiction. By contrast, the powers that are available to the FDIC under its statutory resolution authorities can resolve financial entities much more rapidly than under bankruptcy. The FDIC bears the unique responsibility for resolving failed depository institutions and is therefore able to plan for an orderly resolution process. Through this process, the FDIC works with the primary supervisor to gather information on a troubled bank before it fails and plans for the transfer or orderly wind-down of the bank's assets and businesses. In doing so, the FDIC is able to maintain public confidence and perform its public policy mandate of ensuring financial stability.Resolution Authority for Systemically Important Financial Firms To ensure an orderly and comprehensive resolution mechanism for systemically important financial firms, Congress should adopt a resolution process that adheres to the following principles: The resolution scheme and processes should be transparent, including the imposition of losses according to an established claims priority where stockholders and creditors, not the Government, are in the first loss position. The resolution process should seek to minimize costs and maximize recoveries. The resolution should be conducted to achieve the least cost to the Government as a whole with the FDIC allocating the losses among the various affiliates and subsidiaries proportionate to their responsibilities for the cost of the failure. There should be a unified resolution process housed in a single entity. The resolution entity should have the responsibility and the authority to set assessments to fund systemic resolutions to cover working capital and unanticipated losses. The resolution process should allow the continuation of any systemically significant operations, but only as a means to achieve a final resolution of the entity. A bridge mechanism, applicable to the parent company and all affiliated entities, allows the Government to preserve 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 financial organization and its assets, which can reduce losses to the receivership. The resolution entity must effectively manage its financial and operational risk exposure on an ongoing basis. The receivership function necessarily entails certain activities such as the establishment of bridge entities, implementing purchase and assumption agreements, claims processing, asset liquidation or disposition, and franchise marketing. The resolving entity must establish, maintain, and implement these functions for a covered parent company and all affiliated entities. Financial firms often operate on a day-to-day basis without regard to the legal structure of the firm. That is, employees of the holding company may provide vital services to a subsidiary bank because the same function exists in both the bank and the holding company. However, this intertwining of functions can present significant issues when trying to wind down the firm. For this reason, there should be requirements that mandate greater functional autonomy of holding company affiliates. In addition, to facilitate the resolution process, the holding companies should have an acceptable resolution plan that could facilitate and guide the resolution in the event of a failure. Through a carefully considered rule making, each financial holding company should be required to make conforming changes to their organization to ensure that the resolution plans could be effectively implemented. The plans should be updated annually and made publicly available. Congress also should alter the current process that establishes a procedure for open bank assistance that benefits shareholders and eliminates the requirement that the resolution option be the least costly to the Deposit Insurance Fund (DIF). As stated above, shareholders and creditors should be required to absorb losses from the institution's failure before the Government. Current law allows for an exception to the standard claims priority where the failure of one or more institutions presents ``systemic risk.'' In other words, once a systemic risk determination is made, the law permits the Government to provide assistance irrespective of the least cost requirement, including ``open bank'' assistance which inures to the benefit of shareholders. The systemic risk exception is an extraordinary procedure, requiring the approval of super majorities of the FDIC Board, the Federal Reserve Board, and the Secretary of the Treasury in consultation with the President. We believe that the systemic risk exception should be narrowed so that it is available only where there is a finding that support for open institutions is necessary to address problems which pervade the system, as opposed to problems which are particular to an individual institution. Whatever support is provided should be broadly available and justified in that it will result in least cost to the Government as a whole. If the Government suffers a loss as a result an institution's performance under this exception, the institution should be required to be resolved in accordance with the standard claims priority. Had this narrower systemic risk exception been in place during the past year, open institution assistance would not have been permitted for individual institutions. An individual institution would likely have been put into a bridge entity, with shareholders and unsecured creditors taking losses before the Government. Broader programs that benefit the entire system, such as the Temporary Liquidity Guarantee Program and the Federal Reserve's liquidity facilities, would have been permitted. However if any individual institution participating in these programs had caused a loss, the normal resolution process would be triggered. The initiation of this type of systemic assistance should require the same concurrence of the supermajority of the FDIC Board, the Federal Reserve Board and the Treasury Department (in consultation with the President) as under current law. No single Government entity should be able to unilaterally trigger a resolution strategy outside the defined parameters of the established resolution process. Further, to ensure transparency, these determinations should be made in consultation with Congress, documented and reviewed by the Government Accountability Office.Other Improvements to the Resolution Process Consideration should be given to allowing the resolution authority to impose limits on financial institutions' abilities to use collateral to mitigate credit risk ahead of the Government for some types of activities. The ability to fully collateralize credit risks removes an institution's incentive to underwrite exposures by assessing a counterparty's ability to perform from revenues from continuing operations. In addition, the recent crisis has demonstrated that collateral calls generate liquidity pressures that can magnify systemic risks. For example, up to 20 percent of the secured claim for companies with derivatives claims against the failed firm could be haircut if the Government 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 Government from losses. Other approaches could include increasing regulatory and supervisory disincentives for excessive reliance on secured borrowing. As emphasized at the beginning of this statement, a regulatory and resolution structure should, among other things, ensure real corporate separateness and the separation of the bank's management, employees, and systems from those of its affiliates. Risky activities, such as proprietary trading, should be kept outside the bank. Consideration also should be given to enhancing restrictions against transactions with affiliates, including the elimination of 23A waivers. In addition, the resolution process could be greatly enhanced if companies were required to have an acceptable resolution plan that and guides the liquidation in the event of a failure. Requiring that the plans be updated annually and made publicly available would provide additional transparency that would improve market discipline.Funding Systemic Resolutions To be credible, a resolution process for systemically significant institutions must have the funds necessary to accomplish the resolution. It is important that funding for this resolution process be provided by the set of potentially systemically significant financial firms, rather than by the taxpayer. To that end, Congress should establish a Financial Company Resolution Fund (FCRF) to provide working capital and cover unanticipated losses for the resolution. One option for funding the FCRF is to prefund it through a levy on larger financial firms--those with assets above a certain large threshold. The advantage of prefunding the FCRF is the ability to impose risk-based assessments on large or complex institutions that recognize their potential risks to the financial system. This system also could provide an economic incentive for an institution not to grow too large. In addition, building the fund over time through consistent levies would avoid large procyclical charges during times of systemic stress. Alternatively, the FCRF could be funded after a systemic failure through an assessment on other large, complex institutions. The advantage to this approach is that it does not take capital out of institutions until there is an actual systemic failure. The disadvantages of this approach are that it is not risk sensitive, it is initially dependent on the ability to borrow from the Treasury, it assess institutions when they can least afford it and the institution causing the loss is the only one that never pays an assessment. The systemic resolution entity should have the authorities needed to manage this resolution fund, as the FDIC does for the DIF. The entity should also be authorized to borrow from the Treasury if necessary, but those borrowings should be repaid by the financial firms that contribute to the FCRF.International Issues Some significant challenges exist for international banking resolution actions since existing bank crisis management and resolution arrangements are not designed to deal specifically with cross-border banking problems. However, providing resolution authority to a specific entity in the U.S. would enhance the ability to enter into definitive memoranda of understanding with other countries. Many of these same countries have recognized the benefits of improving their resolution regimes and are considering improvements. This provides a unique opportunity for the U.S. to be the leader in this area and provide a model for the effective resolution of failed entities. Dealing with cross-border banking problems is difficult. For example, provisions to allow the transfer of assets and liabilities to a bridge bank or other institution may have limited effectiveness in a cross-border context because these actions will not necessarily be recognized or promptly implemented in other jurisdictions. In the absence of other arrangements, it is presumed that ring fencing will occur. Ring fencing may secure the interests of creditors or individuals in foreign jurisdictions to the detriment of the resolution as a whole. In the United States, the Foreign Bank Supervision Enhancement Act of 1991 requires foreign banks that wish to do a retail deposit-taking business to establish a separately chartered subsidiary bank. This structural arrangement ensures that assets and capital will be available to U.S. depositors or the FDIC should the foreign parent bank and its U.S. subsidiary experience difficulties. In this sense, it is equivalent to ``prepackaged'' ring fencing. An idea to consider would be to have U.S. banks operating abroad to do so through bank subsidiaries. This could streamline the FDIC's resolution process for a U.S. bank with foreign operations. U.S. operations would be resolved by the FDIC and the foreign operations by the appropriate foreign regulator. However, this would be a major change and could affect the ability of U.S. banks to attract foreign deposits overseas.Resolution Authority for Depository Institution Holding Companies To have a process that not only maintains liquidity in the financial system but also terminates stockholders' rights, it is important that the FDIC have the authority to resolve both systemically important and nonsystemically important depository institution holding companies, affiliates and majority-owned subsidiaries in the case of failed or failing insured depository institutions. When a failing bank is part of a large, complex holding company, many of the services essential for the bank's operation may reside in other portions of the holding company, beyond the FDIC's authority. The loss of essential services can make it difficult to preserve the value of a failed institution's assets, operate the bank or resolve it efficiently. The business operations of large, systemic financial organizations are intertwined with business lines that may span several legal entities. When one entity is in the FDIC's control while the other is not, it significantly complicates resolution efforts. Unifying the holding company and the failed institution under the same resolution authority can preserve value, reduce costs and provide stability through an effective resolution. Congress should enhance the authority of the FDIC to resolve the entire organization in order to achieve a more orderly and comprehensive resolution consistent with the least cost to the DIF. When the holding company structure is less complex, the FDIC may be able to effect a least cost resolution without taking over the holding company. In cases where the holding company is not critical to the operations of the bank or thrift, the FDIC should be able to opt out--that is, allow the holding company to be resolved through the bankruptcy process. The decision on whether to employ enhanced resolution powers or allow the bank holding company to declare bankruptcy would depend on which strategy would result in the least cost to the DIF. Enhanced authorities that allow the FDIC to efficiently resolve failed depository institutions that are part of a complex holding company structure when it achieves the least costly resolution will provide immediate efficiencies in bank resolutions.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 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.AppendixThe FDIC's Resolution Authority The FDIC has standard procedures that go into effect when an FDIC-insured bank or thrift is in danger of failing. When the FDIC is notified that an insured institution is in danger of failing, we begin assembling an information package for bidders that specifies the structure and terms of the transaction. FDIC staff review the bank's books, contact prospective bidders, and begin the process of auctioning the bank--usually prior to its failure--to achieve the best return to the bank's creditors, and the Deposit Insurance Fund (DIF). When the appropriate Federal or State banking authority closes an insured depository institution, it appoints the FDIC as conservator or receiver. On the day of closure by the chartering entity, the FDIC takes control of the bank and in most cases removes the failed bank's management. Shareholder control rights are terminated, although shareholders maintain a claim on any residual value remaining after depositors' and other creditors' claims are satisfied. Most bank failures are resolved by the sale of some or all of the bank's business to an acquiring bank. FDIC staff work with the acquiring bank, and make the transfer as unobtrusive, seamless and efficient as possible. Generally, all the deposits that are transferred to the acquiring bank are made immediately available online or through ATMs. The bank usually reopens the next business day with a new name and under the control of the acquiring institution. Those assets of the failed bank that are not taken by the acquiring institution are then liquidated by the FDIC. Sometimes banks must be closed quickly because of an inability to meet their funding obligations. These ``liquidity failures'' may require that the FDIC set up a bridge bank. The bridge bank structure allows the FDIC to provide liquidity to continue the bank's operations until the FDIC has time to market and sell the failed bank. The creation of a bridge also terminates stockholders rights as described earlier. Perhaps the greatest benefit of the FDIC's process is the quick reallocation of resources. It is a process that can be painful to shareholders, creditors and bank employees, but history has shown that early recognition of losses with closure and sale of nonviable institutions is the fastest path back to economic health. ______ CHRG-111hhrg55814--123 Secretary Geithner," Now GM was managed under the established bankruptcy procedures of the laws of the land. The Congress recognized many, many years ago that those procedures do not work for banks, because banks borrow short, they take on leverage, they cannot function effectively under that kind of regime. Thus, a different regime, very much modeled on the Bankruptcy Code, that establishes clear priorities for creditors. But again, that system exists today for banks and thrifts. " CHRG-111shrg53085--210 PREPARED STATEMENT OF AUBREY B. PATTERSON Chairman and Chief Executive Officer, BancorpSouth, Inc. March 24, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, my name is Aubrey Patterson. I am Chairman and Chief Executive Officer of BancorpSouth, Inc., a $13.3 billion-asset bank financial holding company whose subsidiary bank operates over 300 commercial banking, mortgage, insurance, trust and broker dealer locations in Mississippi, Tennessee, Alabama, Arkansas, Texas, Florida, Louisiana, and Missouri. I currently serve as co-chair of the Future Regulatory Reform Task Force at the American Bankers Association (ABA) and was a former chairman of ABA's Board of Directors. 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 $13.9 trillion in assets and employ over 2.2 million men and women. ABA congratulates the Committee on the approach it is taking to respond to the financial crisis. There is a great need to act, but to do so in a thoughtful and thorough manner, and with the right priorities. That is what this Committee is doing. On March 10, Federal Reserve Board Chairman Bernanke gave an important speech laying out his thoughts on regulatory reform. He laid out an outline of what needs to be addressed in the near term and why, along with general recommendations. We are in broad agreement with the points Chairman Bernanke made in that speech. Chairman Bernanke focused on three main areas: first, the need for a systemic regulator; second, the need for a preexisting method for an orderly resolution of a systemically important nonbank financial firm; and third, the need to address gaps in our regulatory system. Statements by the leadership of this Committee have also focused on a legislative plan to address these three areas. We agree that these three issues--a systemic regulator, a new resolution mechanism, and addressing gaps--should be the priorities. This terrible crisis should not be allowed to happen again, and addressing these three areas is critical to making sure it does not. ABA strongly supports the creation of a systemic regulator. In retrospect, it is inexplicable that we have not had a regulator that has the explicit mandate and the needed authority to anticipate, identify, and correct, where appropriate, systemic problems. To use a simple analogy, think of the systemic regulator as sitting on top of Mount Olympus looking out over all the land. From that highest point the regulator is charged with surveying the land, looking for fires. Instead, we have had a number of regulators, each of which sits on top of a smaller mountain and only sees its part of the land. Even worse, no one is effectively looking over some areas. This needs to be addressed. While there are various proposals as to who should be the systemic regulator, most of the focus has been on giving the authority to the Federal Reserve. It does make sense to look for the answer within the parameters of the current regulatory system. It is doubtful that we have the luxury, in the midst of this crisis, to build a new system from scratch, however appealing that might be in theory. There are good arguments for looking to the Federal Reserve, as outlined in the Bernanke speech. This could be done by giving the authority to the Federal Reserve or by creating an oversight committee chaired by the Federal Reserve. ABA's concern in this area relates to what it may mean for the independence of the Federal Reserve in the future. We strongly believe that Federal Reserve independence in setting monetary policy is of utmost importance. ABA believes that systemic regulation cannot be effective if accounting policy is not part of the equation. To continue my analogy, the systemic regulator on Mount Olympus cannot function if part of the land is held strictly off limits and under the rule of some other body that can act in a way that contradicts the systemic regulator's policies. That is, in fact, exactly what happened with mark-to-market accounting. As Chairman Bernanke pointed out, as part of a systemic approach, the Federal Reserve should be given comprehensive regulatory authority over the payments system, broadly defined. ABA agrees. We should not run the risk of a systemic implosion instigated by gaps in payment system regulations. ABA also supports creating 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. Indeed, many experts believe the Lehman Brothers failure was the event that greatly accelerated the crisis. We believe that existing models for resolving troubled or failed institutions provide an appropriate starting point--particularly the FDIC model, but also the more recent handling of Fannie Mae and Freddie Mac. 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.'' \1\--------------------------------------------------------------------------- \1\ Ben Bernanke, speech to the Council on Foreign Relations, Washington, DC, March 10, 2009.--------------------------------------------------------------------------- The third area for focus is where there are gaps in regulation. These gaps have proven to be major factors in the crisis, particularly the role of largely unregulated mortgage lenders. Credit default swaps and hedge funds also should be addressed in legislation to close gaps. There seems to be a broad consensus to address these three areas. The specifics will be complex and, in some cases, contentious. But at this very important time, with Americans losing their jobs, their homes, and their retirement savings, all of us should work together to develop a stronger regulatory structure. ABA pledges to be an active and constructive participant in this critical effort. In fact, even before the turmoil of last fall, ABA's board of directors recognized this need to address the difficult questions about regulatory reform and the desirability of a systemic risk regulator. As a consequence, Brad Rock, ABA's chairman at that time, and chairman, president, and CEO of Bank of Smithtown, Smithtown, New York, appointed a task force to develop principles and recommendations for change. I am co-chair of that task force. I will highlight many of the principles developed by this group--and adopted by ABA's board of directors--throughout my statement today. In the rest of my statement today, I would like to expand on the priorities for change: Establish a regulatory structure that provides a mechanism to oversee and address systemic risks. Included under this authority is the ability to mitigate risk-taking from systemically important institutions, authority over how accounting rules are developed and applied, and protections to maintain the integrity of the payments system. Establish a method to handle the failure of nonbank institutions that threaten systemic risk. Close the gaps in regulation. This might include the regulation of hedge funds, credit default swaps, and particularly nonbank mortgage brokers. I would like to touch briefly on each of these priorities to highlight issues that underlie them.I. Establish a Regulatory Structure That Provides a Mechanism To Oversee and Address Systemic Risks ABA supports the formation of a systemic risk 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. I will discuss and highlight ABA's guiding principles on each of these.A. There is a need for a regulator with explicit systemic risk responsibility A systemic risk regulator would strengthen the financial infrastructure. As Chairman Bernanke noted: ``[I]t would help make the financial system as a whole better able to withstand future shocks, but also to mitigate moral hazard and the problems of too big to fail by reducing the range of circumstances in which systemic stability concerns might prompt government intervention.'' ABA believes the following principles should apply to any systemic risk regulator: Systemic risk oversight should utilize existing regulatory structures to the maximum extent possible and involve a limited number of large market participants, both bank and nonbank. The primary responsibility of the systemic risk regulator should be to protect the economy from major shocks. The systemic risk regulator should pursue this objective by gathering information, monitoring exposures throughout the system and taking action in coordination with other domestic and international supervisors to reduce the risk of shocks to the economy. The systemic risk regulator should work with supervisors to avoid pro-cyclical reactions and directives in the supervisory process. There should not be a new consumer regulator for financial institutions. Safety and soundness implications, financial risk, consumer protection, and other relevant issues need to be considered together by the regulator of each institution. It is clear we need a systemic regulator that looks across the economy and identifies problems. To fulfill that role, the systemic regulator would need broad access to information. It may well make sense to have that same regulator have necessary powers, alone or in conjunction with the Treasury, and a set of tools to address major systemic problems. (Although based on the precedents set over the past few months, it is clear that those tools are already very broad.) At this point, there seems to be a strong feeling that the Federal Reserve should take on this role in a more robust, explicit fashion. That may well make sense, as the Federal Reserve has been generally thought to be looking over the economy. We are concerned, however, that any expansion of the role of the Federal Reserve could interfere with the independence required when setting monetary policy. One of the great strengths of our economic infrastructure has been our independent Federal Reserve. We urge Congress to carefully consider the long-term impact of changes in the role of the Federal Reserve and the potential for undermining its effectiveness on monetary policy. Thus, ABA offers these guiding principles: An independent central bank is essential. The Federal Reserve's primary focus should be the conduct of monetary policy.B. To be effective, the systemic risk regulator must have some authority over the development and implementation of accounting rules Accounting standards are not only measurements designed to ensure accurate financial reporting, but they also have an increasingly profound impact on the financial system--so profound that they must now be part of any systemic risk calculation. 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. Thus, ABA sets forth the following principles to guide the development of a new system: The setting of accounting standards needs to be strengthened and expanded to include oversight from the regulators responsible for systemic risk. Accounting should be a reflection of economic reality, not a driver. Accounting rules, such as loan-loss reserves and fair value accounting, should minimize pro-cyclical effects that reinforce booms and busts. Clearer guidance is urgently needed on the use of judgment and alternative methods, such as estimating discounted cash flows when determining fair value in cases where asset markets are not functioning and for recording impairment based on expectations of loss. For several years, long before the current downturn, ABA argued that mark-to-market was pro-cyclical and should not be the model used for financial institutions as required by the Financial Accounting Standards Board (FASB). Even now, the FASB's stated goal is to continue to expand the use of mark-to-market accounting for all financial instruments. For months, we have specifically asked FASB to address the problem of marking assets to markets that were dysfunctional. Our voice has been joined by more and more people who have been calling for FASB and the Securities and Exchange Commission to address this issue, including Federal Reserve Chairman Bernanke and, as noted below, former Federal Reserve Chairman Paul Volcker. For example, in his recent speech, Chairman Bernanke stated: ``[R]eview of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their pro-cyclical effects without compromising the goals of disclosure and transparency.'' \2\ Action is needed, and quickly, so that first quarter reports can be better aligned with economic realities. We hope that FASB and SEC will take the significant action that is needed; this is not the time to merely tinker with the current rules.--------------------------------------------------------------------------- \2\ Ibid.--------------------------------------------------------------------------- In creating a new oversight structure for accounting, independence from outside influence should be an important component, as should the critical role in the capital markets of ensuring that accounting standards result in financial reporting that is credible and transparent. But accounting policy can no longer be divorced from its impact; the results on the economy and on the financial system must be considered. We are very much in agreement with the recommendations of Group of 30, headed by Paul Volcker and Jacob Frenkel on fair value accounting in its Financial Reform: A Framework for Financial Stability. That report stated: ``The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards that better reflect the business model of these institutions.'' The Group of 30 suggests that accounting standards be reviewed: 1. to develop ``more realistic guidelines for dealing with less- liquid instruments and distressed markets''; 2. by ``prudential regulators to ensure application in a fashion consistent with safe and sound operation of [financial] institutions''; and 3. to be more flexible ``in regard to the prudential need for regulated institutions to maintain adequate credit-loss reserves''. Thus, ABA recommends the creation of a board that could stand in place of the functions currently served by the SEC.C. Uniform standards are needed to maintain the reliability of the payments system An important part of the conduct of monetary policy is the reliability of the payments system, including the efficiency, security, and integrity of the payments system. Therefore, ABA offers these three principles: The Federal Reserve should have the duty to set the standards for the reliability of the payments system, and have a leading role in the oversight of the efficiency, integrity, and security thereof. Reforms of the payments system must recognize that merchants and merchant payment processors have been the source of the largest number of abuses and lost customer information. All parts of the payments system must be responsible for its reliability. Ensuring the integrity of the payments system against financial crime and abuse should be an integral part of the supervisory structure that oversees system reliability. Banks have long been the primary players in the payments system ensuring safe, secure, and efficient funds transfers for consumers and businesses. Banks are subject to a well-defined regulatory structure and are examined to ensure compliance with the standards. Unfortunately, the current regulatory scheme does not apply comparable standards for nonbanks that participate in the payments system. This is a significant gap that needs to be filled. In recent years, nonbanks have begun offering ``nontraditional'' payment services in greater numbers. Internet technological advances combined with the increase in consumer access to the Internet have contributed to growth in these alternative payment options. These activities introduce new risks to the system. Another key difference between banks and nonbanks in the payments system is the level of protection granted to consumers in case of a failure to perform. It is important to know the level of capital held by a payment provider where funds are held, and what the effect of a failure would be on customers using the service. This information is not always as apparent as it might be. The nonbanks are not subject to the same standards of performance and financial soundness as banks, nor are they subject to regular examinations to ensure the reliability of their payments operations. In other words, this is yet another gap in our regulatory structure, and one that is growing. This imbalance in standards becomes a competitive problem when customers do not recognize the difference between banks and nonbanks when seeking payment services. In addition, the current standard designed to provide security to the retail payment system, the Payment Card Industry Data Security Standard, compels merchants and merchant payment processors to implement important information security controls, yet tends to be checklist and point-in-time driven, as opposed to the risk-based approach to information security required of banks pursuant to the Gramm-Leach-Bliley Act. \3\ Through the Bank Service Company Act, federal bank regulatory agencies can examine larger core payment processors and other technology service providers for GLB compliance. \4\ We would encourage the Federal Reserve to use this power more aggressively going forward, and examine an increased number of payment processors and other technology providers.--------------------------------------------------------------------------- \3\ 16 C.F.R. 314. \4\ 12 U.S.C. 1861-1867(c).--------------------------------------------------------------------------- In order to ensure that consumers are protected from financial, reputational, and systemic risk, all banks and nonbank entities providing significant payment services should be subject to similar standards. This is particularly important for the operation of the payments system, where uninterrupted flow of funds is expected and relied upon by customers. Thus, ABA believes that the Federal Reserve should develop standards for reliability of the payments system that would apply to all payments services providers, comparable to the standards that today apply to payments services provided by banks. The Federal Reserve should review its own authority to supervise nonbank service providers in the payments system and should request from Congress those legislative changes that may be needed to clarify the authority of the Federal Reserve to apply comparable standards for all payments system providers. We support the statement made by Chairman Bernanke: ``Given how important robust payment and settlement systems are to financial stability, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.'' \5\--------------------------------------------------------------------------- \5\ Ibid.---------------------------------------------------------------------------II. Establish a Method To Handle the Failure of Nonbank Institutions That Threaten Systemic Risk We fully agree with Chairman Bernanke when he said: ``[T]he United States also needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm, including a mechanism to cover the costs of the resolution.'' \6\ Recent government actions have clearly demonstrated a policy to treat certain financial institutions as if they were too big or too complex to fail. Such a policy can have serious competitive consequences for the banking industry as a whole. Without accepting the inevitability of such a policy, clear actions must be taken to address and ameliorate negative consequences of such a policy, including efforts to strengthen the competitive position of banks of all sizes.--------------------------------------------------------------------------- \6\ Ibid.--------------------------------------------------------------------------- The current ad hoc approach, used with Bear Stearns and Lehman Brothers, has led to significant unintended consequences and needs to be replaced with a concrete, well-understood method of resolution. There is such a system for banks, and that system can serve as a model. However, the system for banks is based in an elaborate system of bank regulation and the bank safety net. The system for nonbanks should not extend the safety net, but rather should provide a mechanism for failure designed to limit contagion of problems in the financial system. These concerns should inform the debate about the appropriate actor to resolve systemically significant nonbanks. While some suggest that the FDIC should have broader authority to resolve all systemically significant financial institutions, we respectfully submit that the FDIC's mission must not be compromised by a dilution of resources or focus. Confidence in federal deposit insurance is essential to the health of the banking system. Our system of deposit insurance is paid for by insured depository institutions and, until very recently, has been focused exclusively on insured depository institutions. The costs of resolving nonbanks must not be imposed on insured depository institutions; rather, institutions subject to the new resolution authority should pay the costs of its execution. Given that these costs are likely to be very high, it is doubtful that institutions that would be subject to the new resolution authority would be able to pay premiums large enough to fully fund the resolution costs. In that case, the FDIC would need to turn to the taxpayer and, thereby, jeopardize confidence in the banking industry as a whole. Even if systemically significant nonbanks could fully fund the new resolution authority, one agency serving as both deposit insurer and the agency that resolves nondepository institutions creates the risk of a conflict of interest, as Comptroller Dugan recently observed in testimony before this Committee. \7\ The FDIC must remain focused on preserving the insurance fund and, by extension, the public's confidence in our Nation's depository institutions. Any competing role that distracts from that focus must be avoided.--------------------------------------------------------------------------- \7\ Testimony of John C. Dugan, Comptroller of the Currency, before the Senate Committee on Banking, Housing, and Urban Affairs, March 19, 2009.--------------------------------------------------------------------------- Thus, ABA offers several principles to guide this discussion: Financial regulators should develop a program to watch for, monitor, and respond effectively to market developments relating to perceptions of institutions being too big or too complex to fail--particularly in times of financial stress. Specific authorities and programs must be developed that allow for the orderly transition of the operations of any systemically significant financial institution. The creation of a systemic regulator and of a mechanism for addressing the resolution of entities, of course, raises the important and difficult question of what institutions should be considered systemically important, or in other terms, too-big-to-fail. The theory of too-big-to-fail (TBTF) has in this crisis been expanded to include institutions that are too intertwined with other important institutions to be allowed to fail. We agree with Chairman Bernanke when he said that the ``clear guidelines must define which firms could be subject to the alternative [resolution] regime and the process for invoking that regime.'' \8\--------------------------------------------------------------------------- \8\ Ibid.--------------------------------------------------------------------------- ABA has always sought the tightest possible language for the systemic risk exception in order to limit the TBTF concept as much as possible. We did this for two reasons, reasons that still apply today: first, TBTF presents the classic moral hazard problem--it can encourage excess risk-taking by an entity because the government will not allow it to fail; second, TBTF presents profound competitive fairness issues--TBTF entities will have an advantage--particularly in funding, through deposits and otherwise--over institutions that are not too big to fail. Our country has now stretched the systemic risk exception beyond what could have been anticipated when it was created. In fact, we have gone well beyond its application to banks, as we have made nonbanks TBTF. Ideally, we would go back and strictly limit its application, but that may not be possible. Therefore, we need to adopt a series of policies that will address the moral hazard and unfair competition issues while protecting our financial system and the taxpayers. This may be the most difficult question Congress will face as it reforms our financial system. For one thing, this cannot be done in isolation from what is being done in other countries. Systemic risk clearly does not stop at the border. In addition, the ability to compete internationally will be a continuing factor in designing and evolving our regulatory system. Our largest financial institutions compete around the world, and many foreign institutions have a large presence in the United States. This is also a huge issue for the thousands of U.S. banks that will not be considered too big to fail. As ABA has noted on many occasions, these are institutions that never made a subprime loan, are well capitalized, and are lending. Yet we have been deeply and negatively affected by this crisis--a crisis caused primarily by less regulated or unregulated entities like mortgage brokers and by Wall Street firms. We have seen the name ``bank'' sullied as it is used very broadly; we have seen our local economies hurt, and sometimes devastated, which has led to loan losses; and we have seen deposit insurance premiums drastically increased to pay for the excessive risk-taking of institutions that have failed. At the same time, there is a clear unfairness in that many depositors believe their funds, above the insurance limit, are safer in a TBTF institution than other banks. And, in fact, this notion is reinforced when large uninsured depositors lose money--take a ``haircut''--when the FDIC closes some not-too-big-to-fail banks. There are many difficult questions. How will a determination be made that an institution is systemically important? When will it be made? What extra regulations will apply? Will additional capital and risk management requirements be imposed? How will management issues be addressed? Some have argued that the largest, most complex institutions are too big to manage. Which activities will be put off-limits and which will require special treatment, such as extra capital to protect against losses? How do we avoid another AIG situation, where, it is widely agreed, what amounted to a risky hedge fund was attached to a strong insurance company and brought the whole entity down? And, importantly, how do we make sure we maintain the highly diversified financial system that is unique to the United States?III. Close the Gaps in Regulation 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. Given the causes of the current problem, there has been a logical move to begin applying more bank-like regulation to the less-regulated and un-regulated parts of the financial system. For example, when certain securities firms were granted access to the discount window, they were quickly subjected to bank-like leverage and capital requirements. Moreover, as regulatory change points more toward the banking model, so too has the marketplace. The biggest example, of course, is the movement of Goldman Sachs and Morgan Stanley to Federal Reserve holding company regulation. 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. This Committee has worked hard in recent years to temper the impact of regulation on banks. You have passed bills to remove unnecessary regulation, and you have made existing regulation more efficient and less costly. 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? There are so many issues related to closing the regulatory gaps that it would be impossible to cover each in detail in this statement. Therefore, let me summarize the important issues by providing the key principles that should guide any discussion about filling the regulatory gaps: The current system of bank regulators has many advantages. These advantages should be preserved as the system is enhanced to address systemic risk and nonbank resolutions. Regulatory restructuring should incorporate systemic checks and balances among equals and a federalist system that respects the jurisdictions of state and federal powers. These are essential elements of American law and governance. We support the roles of the Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), Federal Reserve, the Office of Thrift Supervision (OTS) and the state banking commissioners with regard to their diverse responsibilities and charters within the U.S. banking system. Bank regulators should focus on bank supervision. They should not be in the business of running banks or managing bank assets and liabilities. The dual banking system is essential to promote an efficient and competitive banking sector. The role of the dual banking system as incubator for advancements in products and services, such as NOW and checking accounts, is vital to the continued evolution of the U.S. banking sector. Close coordination between federal bank regulators and state banking commissioners within Federal Financial Institutions Examination Council (FFIEC) as well as during joint bank examinations is an essential and dynamic element of the dual banking system. Charter choice and choice of ownership structure are essential to a dynamic, innovative banking sector that responds to changing consumer needs, customer preferences, and economic conditions. Choice of charter and form of ownership should be fully protected. ABA strongly opposes charter consolidation. Unlike the flexibility and business options available under charter choice, a consolidated universal charter would be unlikely to serve evolving customer needs or encourage market innovation. Diversity of ownership, including S corporations, limited liability corporations, mutual ownership, and other forms of privately held and publicly traded banks, should be strengthened. Diversity of business models is a distinctive feature of American banking that should be fostered. Full and fair competition within a robust banking sector requires a diversity of participants of all sizes and business models with comparable banking powers and appropriate oversight. Community banks, development banks, and niche-focused financial institutions are vital components of the financial services sector. A housing-focused banking system based on time-tested underwriting practices and disciplined borrower qualification is essential to sustained homeownership and community development. An optional federal insurance charter should be created. Similar activities should be subject to similar regulation and capital requirements. These regulations and requirements should minimize pro-cyclical effects. Consumer confidence in the financial sector as a whole suffers when nonbank actors offer bank-like services while operating under substandard guidelines for safety and soundness. Credit unions that act like banks should be required to convert to a bank charter. Capital requirements should be universally and consistently applied to all institutions offering bank-like products and services. Credit default swaps and other products that pose potential systemic risk should be subject to supervision and oversight that increase transparency, without unduly limiting innovation and the operation of markets. Where possible, regulations should avoid adding burdens during times of stress. Thus, for instance, deposit insurance premium rates need to reflect a balance between the need to strengthen the fund and the need of banks to have funds available to meet the credit needs of their communities in the midst of an economic downturn. The FDIC should remain focused on its primary mission of ensuring the safety of insured deposits. The FDIC plays a crucial role in maintaining the stability and public confidence in the Nation's financial system by insuring deposits, and in conducting activities directly related to that mission, including examination and supervision of financial institutions as well as managing receiverships and assets of failed banking institutions so as to minimize the costs to FDIC resources. To coordinate anti-money laundering oversight and compliance, a Bank Secrecy Act ``gatekeeper,'' independent from law enforcement and with a nexus to the payments system, should be incorporated into the financial regulatory structure.Conclusion Thank you for the opportunity to present the ABA's views on the regulation of systemic risk and restructuring of the financial services marketplace. The financial turmoil over the last year, and particularly the protection provided to institutions deemed to be ``systemically important,'' require a system that will more efficiently and effectively prevent such problems from arising in the first place and a procedure to deal with any problems that do arise. Clearly, it is time to make changes in the financial regulatory structure. We hope that the principles laid out in this statement will help guide the discussion. 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-111shrg57319--474 Mr. Killinger," As I mentioned in my comments, I think Washington Mutual was very well positioned with its capital and operating plan to work itself through this financial crisis and I think it was making excellent progress on that. And I think that it was seized, in my opinion, in an unnecessary manner. Clearly, there was a lot of pressure on the financial system and regulators and policy leaders at that point in time in the wake of the collapse of Lehman. However, I just don't think the company was treated in the same equal-handed, fair manner that all other financial institutions were. And it is very much like oxygen--I will use an analogy of oxygen. None of us can live if oxygen is choked off for a brief period of time, and liquidity is that equivalent in financial services. Liquidity did start to become tight, not just for Washington Mutual, but for the entire industry for a brief period of time. But policy leaders elected to open up those tubes of oxygen for most banks and gave them a huge amount of benefits and Washington Mutual inexplicably, in my opinion, was not allowed to have the benefits of having that oxygen come to them for that brief period of time. And now, in hindsight, we can see for those that were able to get through that brief period and start to get back on the mend that the financial position is just extraordinarily different today than it was 12 months ago, and I believe Washington Mutual could have and should have been able to be one of those surviving banks. Senator Kaufman. Why was Washington Mutual specifically? I mean, is it just bad luck? " CHRG-111hhrg48674--67 Mr. Bernanke," Well, Congresswoman, one very important fact about the American financial system is that only about half of the loans in normal times come through banks. The other half go through other kinds of markets, like securitization markets. And all the programs I described today are about getting credit card lending, auto loans, student loans, commercial paper loans, mortgage loans, commercial mortgage-backed securities, all those things going again. That program will help get credit flowing outside the bank. So that is an important part because that is about half of our credit system. Then the other part of the program that Secretary Geithner talked about this morning is about recapitalizing, taking away the bad assets and getting the banks working again. So it is really two parts, and I think you have to address both parts or else you will not give people the access to the credit that they need in order to carry on their lives and their businesses. " CHRG-111hhrg55814--187 Secretary Geithner," Bankruptcy just, again, I think Lehman makes this clear and compelling. And it's why Congress designed a bankruptcy-like system, but it's a different kind of system. We call it resolution authority for banks and thrifts because banks are different. And if they lose the capacity to fund, then they can cause enormous damage to the system as whole. So, you need a slightly different regime for banks because banks are different from regular companies. " CHRG-111shrg55117--132 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKEQ.1. Back in March, Secretary Geithner, who was FOMC Vice-Chair under you and Chairman Greenspan, said he now thinks easy money policies by central banks were a cause of the housing bubble and financial crisis. Do you agree with him?A.1. I do not believe that money policies by central banks in advanced economies were a significant cause of the recent boom and bust in the U.S. housing sector and the associated financial crisis. The accommodative stance of monetary policy in the United States was necessary and appropriate to address the economic weakness and deflationary pressures earlier in this decade. As I have noted previously, I believe that an important part of the crisis was caused by global saving imbalances. Those global saving imbalances increased the availability of credit to the U.S. housing sector and to other sectors of the U.S. economy, leading to a boom in housing construction and an associated credit boom. The role of global savings imbalances in the credit and housing boom and bust was amplified by a number of other factors, including inadequate mortgage underwriting, inadequate risk management practices by investors, regulatory loopholes that allowed some key financial institutions to assume very large risk positions without adequate supervision, and inaccurate assessments of risks by credit ratings agencies.Q.2. You said you think you can stop the expansion of the money supply from being inflationary. Does that mean you think the expansion of the money supply is permanent?A.2. Broad measures of the money supply, such as M2, have not grown particularly rapidly over the course of the financial crisis. By contrast, narrower measures, such as the monetary base, have grown significantly more rapidly. That growth can be attributed to the rapid expansion of bank reserves that has resulted from the liquidity programs that the Federal Reserve has implemented in order to stabilize financial markets and support economic activity. Nearly all of the increase in reserve is excess reserves--that is, reserves held by banks in addition to the level that they must hold to meet their reserve requirements. As long as banks are willing to hold those excess reserves, they will not contribute to more rapid expansion of the money supply. Moreover, as the Federal Reserve's acquisition of assets slows, growth of reserves will also slow. When economic conditions improve sufficiently, the Federal Reserve will begin to normalize the stance of monetary policy; those actions will involve a reduction in the quantity of excess reserves and an increase in short-term market rates, which will likely result in a reduction in some narrow measures of the money supply, such as the monetary base, and will keep the growth of the broad money aggregates to rates consistent with sustainable growth and price stability. As a result of appropriate monetary policy actions, the above-trend expansion of narrow measures of money supply will not be permanent and will not lead to inflation pressures.Q.3. Do you think a permanent expansion of the money supply, even if done in a noninflationary matter, is monetization of Federal debt?A.3. As noted above, growth of broad measures of the money supply, such as M2, has not been particularly rapid, and any above-trend growth of the money stock will not be permanent. Monetization of the debt generally is taken to mean a purchase of Government debt for the purpose of making deficit finance possible or to reduce the cost of Government finance. The Federal Reserve's liquidity programs, including its purchases of Treasury securities, were not designed for such purposes; indeed, it is worth noting that even with the expansion of the Federal Reserve's balance sheet, the Federal Reserve's holdings of Treasury securities are lower now than in 2007 before the onset of the crisis. The Federal Reserve's liquidity programs are intended to support growth of private spending and thus overall economic activity by fostering the extension of credit to households and firms.Q.4. Do you believe forward-looking signs like the dollar, commodity prices, and bond yields are the best signs of coming inflation?A.4. We use a variety of indicators, including those that you mention, to help gauge the likely direction of inflation. A rise in commodity prices can add to firms' costs and so create pressure for higher prices; this is especially the case for energy prices, which are an important component of costs for firms in a wide variety of industries. Similarly, a fall in the value of the dollar exerts upward pressure on prices of both imported goods and the domestic goods that compete with them. A central element in the dynamics of inflation, however, is the role played by inflation expectations. Even if firms were to pass higher costs from commodity prices or changes in the exchange rate into domestic prices, unless any such price increases become built into expectations of inflation and so into future wage and price decisions, those price increases would likely be a one-time event rather than the start of a higher ongoing rate of inflation. In this regard, it should be noted that survey measures of long-run inflation expectations have thus far remained relatively stable, pointing to neither a rise in inflation nor a decline in inflation to unwanted levels. A rise in bond yields--the third indicator you mention--could itself be evidence of an upward movement in expected inflation. More specifically, a rise in yields on nominal Treasury securities that is not matched by a rise in yields on inflation-indexed securities (TIPS) could reflect higher expected inflation. Indeed, such movements in yields have occurred so far this year. However, the rise in nominal Treasury yields started from an exceptionally low level that likely reflected heightened demand for the liquidity of these securities and other special factors associated with the functioning of Treasury markets. Those factors influencing nominal Treasury yields have made it particularly difficult recently to draw inferences about expected inflation from the TIPS market. The FOMC will remain alert to these and other indicators of inflation as we gauge our future policy actions in pursuit of our dual mandate at maximum employment and price stability.Q.5.a. Other central banks that pay interest on reserves set their policy rate using that tool. Now that you have the power to pay interest on excess reserves, are you going to change the method of setting the target rate?A.5.a. At least for the foreseeable future, the Federal Reserve expects to continue to set a target (or a target range) for the Federal funds rate as part of its procedures for conducting monetary policy. The authority to pay interest on reserves gives the Federal Reserve an additional tool for hitting its target and thus affords the Federal Reserve the ability to modify its operating procedures in ways that could make the implementation of policy more efficient and effective. Also, the Federal Reserve is in the process of designing various tools for reserve management that could be helpful in the removal of policy accommodation at the appropriate time and that use the authority to pay interest on reserves. However, the Federal Reserve has made no decisions at this time on possible changes to its framework for monetary policy implementation.Q.5.b. Assuming you were to make such a change, would that lead to a permanent expansion of the money supply?A.5.b. No. These tools are designed to implement monetary policy more efficiently and effectively. Their use would have no significant effect on broad measures of the money supply. It is possible that such a change could involve a permanently higher level of reserves in the banking system. However, the level of reserves under any such regime would still likely be much lower than at present and, in any case, would be fully consistent with banks' demand for reserves at the FOMC's target rate. As a result, the higher level of reserves in such a system would not have any implication for broad measures of money.Q.5.c. Would such an expansion essentially mean you have accomplished a one-time monetization of the Federal debt?A.5.c. No. If the Federal Reserve were to change its operating procedures in a way that involved a permanently higher level of banking system reserves, it is possible that the corresponding change on the asset side of the Federal Reserve's balance sheet would be a permanently higher level of Treasury securities, but the change could also be accounted for by a higher level of other assets--for example, repurchase agreements conducted with the private sector. The purpose of any permanent increase in the level of the Federal Reserve's holdings of Treasury securities would be to accommodate a higher level of reserves in the banking system rather than to facilitate the Treasury's debt management.Q.6. Is the Government's refusal to rescue CIT a sign that the bailouts are over and there is no more ``too-big-to-fail'' problem?A.6. The Federal Reserve does not comment on the condition of individual financial institutions such as CIT.Q.7. Do you plan to hold the Treasury and GSE securities on your books to maturity?A.7. The evolution of the economy, the financial system, and inflation pressures remain subject to considerable uncertainty. Reflecting this uncertainty, the way in which various monetary policy tools will be used in the future by the Federal Reserve has not yet been determined. In particular, the Federal Reserve has not developed specific plans for its holdings of Treasury and GSE securities.Q.8. Which 13(3) facilities do you think are monetary policy and not rescue programs?A.8. The Federal Reserve developed all of the facilities that are available to multiple institutions as a means of supporting the availability of credit to firms and households and thus buoying economic growth. Because supporting economic growth when the economy has been adversely affected by various types of shocks is a key function of monetary policy, all of the facilities that are available to multiple institutions can be considered part of the Federal Reserve's monetary policy response to the crisis. In contrast, the facilities that the Federal Reserve established for single and specific institutions would ordinarily not be considered part of monetary policy.Q.9. Given the central role the President of the New York Fed has played in all the bailout actions by the Fed, why shouldn't that job be subject to Senate confirmation in the future?A.9. Federal Reserve policy makers are highly accountable and answerable to the Government of the United States and to the American people. The seven members of the Board of Governors of the Federal Reserve System are appointed by the President and confirmed by the Senate after a thorough process of public examination. The key positions of Chairman and Vice Chairman are subject to presidential and congressional review every four years, a separate and shorter schedule than the 14-year terms of Board members. The members of the Board of Governors account for seven seats on the FOMC. By statute, the other five members of the FOMC are drawn from the presidents of the 12 Federal Reserve Banks. District presidents are appointed through a process involving a broad search of qualified individuals by local boards of directors; the choice must then be approved by the Board of Governors. In creating the Federal Reserve System, the Congress combined a Washington-based Board with strong regional representation to carefully balance the variety of interests of a diverse Nation. The Federal Reserve Banks strengthen our policy deliberations by bringing real-time information about the economy from their district contacts and by their diverse perspectives.Q.10. The current structure of the regional Federal Reserve Banks gives the banks that own the regional Feds governance powers, and thus regulatory powers over themselves. And with investment banks now under Fed regulation, it gives them power over their competitors. Don't you think that is conflict of interest that we should address?A.10. Congress established the makeup of the boards of directors of the Federal Reserve Banks. The potential for conflicts of interest that might arise from the ownership of the shares of a Federal Reserve Bank by banking organizations in that Bank's district are addressed in several statutory and policy provisions. Section 4 of the Federal Reserve Act provides that the board of directors of Reserve Banks ``shall administer the affairs of said bank fairly and impartially and without discrimination in favor of or against any member bank or banks.'' 12 U.S.C. 301. Reserve Bank directors are explicitly included among officials subject to the Federal conflict of interest statute, 18 U.S.C. 208. That statute imposes criminal penalties on Reserve Bank directors who participate personally and substantially as a director in any particular matter which, to the director's knowledge, will affect the director's financial interests or those of his or her spouse, minor children, or partner, or any firm or person of which the director is an officer, director, trustee, general partner, or employee, or any other firm or person with whom the director is negotiating for employment. Reserve Banks routinely provide training for their new directors that includes specific training on section 208, and Reserve Bank corporate secretaries are trained to respond to inquiries regarding possible conflicts in order to assist directors in complying with the statute. The Board also has adopted a policy specifically prohibiting Reserve Bank directors from, among other things, using their position for private gain or giving unwarranted preferential treatment to any organization. Reserve Bank directors are not permitted to be involved in matters relating to the supervision of particular banks or bank holding companies nor are they consulted regarding bank examination ratings, potential enforcement actions, or similar supervisory issues. In addition, while the Board of Governors' rules delegate to the Reserve Banks certain authorities for approval of specific types of applications and notices, Reserve Bank directors are not involved with oversight of those functions. Moreover, in order to avoid even the appearance of impropriety, the Board of Governors' delegation rules withdraw the Reserve Banks' authority where a senior officer or director of an involved party is also a director of a Reserve Bank or branch. Directors are also not involved in decisions regarding discount window lending to any financial institution. Finally, directors are not involved in awarding most contracts by the Reserve Banks. In the rare case where a contract requires director approval, directors who might have a conflict as a result of affiliation or stock ownership routinely recuse themselves or resign from the Reserve Bank board, and any involvement they would have in such a contract would be subject to the prohibitions in section 208 discussed above.Q.11. Do you think access to the discount window should be opened to nonbanks by Congress?A.11. The current episode has illustrated that nonbank financial institutions can occasionally experience severe liquidity needs that can pose significant systemic risks. In many cases, the Federal Reserve's 13(3) authority may be sufficient to address these situations, which should arise relatively infrequently. However, a case could be made that certain types of nonbank institutions, such as primary dealers, should have ongoing access to the discount window; any such increased access would need to be coupled with more stringent regulation and supervision. The Federal Reserve also believes that the smooth functioning of various types of regulated payment, clearing, and settlement utilities, some of which are organized as nonbanks, is critical to financial stability; a case could also be made that such organizations should be granted ongoing access to discount window credit.Q.12. Do you think any of the 13(3) facilities should be made permanent by Congress?A.12. As noted above, the issue of appropriate access to central bank credit by certain types of nonbank financial institutions deserves careful consideration by policy makers. The financial crisis has illustrated that various types of nonbank financial institutions can experience severe liquidity strains that pose risks to the entire financial system. However, whether access to the discount window should be granted to such institutions depends on a wide range of considerations and any decision would need to be based on careful study of all of the relevant issues.Q.13. For several reasons, I am doubtful that the Fed or anyone else can effectively regulate systemic risk. A better approach may be to limit the size and scope of firms so that future failures will not pose a danger to the system. Do you think that is a better way to go?A.13. I believe that it is important to improve the U.S. financial regulatory system so as to contain systemic risk and to address the related problem of ``too-big-to-fail'' financial institutions. The Federal Reserve and the Administration have proposed a number of ways to limit systemic risk and the problem of ``too-big-to-fail'' financial institutions. Imposing artificial limits on the size of scope of individual firms will not necessarily reduce systemic risk and could reduce competitiveness. A challenge of this approach would be to address the financial institutions that already are large and complex. Such institutions enjoy certain competitive benefits including global access to credit. At any point in time, the systemic importance of an individual firm depends on a wide range of factors. Size is only one relevant consideration. The impact of a firm's financial distress depends also on the degree to which it is interconnected, either receiving funding from, or providing funding to, other potentially systemically important firms, as well as on whether it performs crucial services that cannot easily or quickly be executed by other financial institutions. In addition, the impact varies over time: the more fragile the overall financial backdrop and the condition of other financial institutions, the more likely a given firm is to be judged systemically important. If the ability of the financial system to absorb adverse shocks is low, the threshold for systemic importance will more easily be reached. Judging whether a financial firm is systemically important is thus not a straightforward task, especially because a determination must be based on an assessment of whether the firm's failure would likely have systemic effects during a future stress event, the precise parameters of which cannot be fully known. I am confident that the Federal Reserve is well positioned both to identify systemically important firms and to supervise them. We look forward to working with Congress and the Administration to enact meaningful regulatory reform that will strengthen the financial system and reduce both the probability and severity of future crises.Q.14. Given your concerns about opening monetary policy to GAO review, what monetary policy information, specifically, do you not want in the hands of the public?A.14. The Federal Reserve believes that a substantial degree of transparency in monetary policymaking is appropriate and has initiated numerous measures to increase its transparency. In addition to a policy announcement made at the conclusion of each FOMC meeting, the Federal Reserve releases detailed minutes of each FOMC meeting 3 weeks after the conclusion of the meeting. These minutes provide a great deal of information about the range of topics discussed and the views of meeting participants at each FOMC meeting. Regarding its liquidity programs, the Federal Reserve has provided a great deal of information regarding these programs on its public Web site at http://www.federalreserve.gov/monetarypolicy/bst.htm. In addition, the Federal Reserve has initiated a monthly report to Congress providing detailed information on the operations of its programs, types, and amounts of collateral accepted, and quarterly updates on Federal Reserve income and valuations of the Maiden Lane facilities. This information is also available on the Web site at http://www.federalreserve.gov/monetarypolicy/bst_reportsresources.htm. The Federal Reserve believes that it should be as transparent as possible consistent with the effective conduct of the responsibilities with which it has been charged by the Congress. The Federal Reserve has noted its effectiveness in conducting monetary policy depends critically on the confidentiality of its policy deliberations. It has also noted that the effectiveness of its tools to provide liquidity to the financial system and the economy depends importantly on the willingness of banks and other entities in sound financial condition to use the Federal Reserve's credit facilities when appropriate. That willingness is supported by assuring borrowers that their usage of credit facilities will be treated as confidential by the Federal Reserve. As a result of these considerations, the Federal Reserve believes that the release of detailed information regarding monetary policy deliberations or the names of firms borrowing from Federal Reserve facilities would not be in the public interest. ------ CHRG-111shrg53085--23 Mr. Attridge," Mr. Chairman, Ranking Member Shelby, and Members of the Committee, my name is Bill Attridge. I am President and Chief Executive Officer of Connecticut River Community Bank. My bank is located in Wethersfield, Connecticut, a 375-year-old town with about 27,000 people. Our bank opened in 2002 and has offices in Wethersfield, Glastonbury, and West Hartford--all suburbs of Hartford. We have 30 employees and about $185 million in total assets at this time. We are a full-service bank, but the bank's focus is on lending to the business community. I am also a former President of the Connecticut Community Bankers Association. I am here to represent the Independent Community Bankers of America and its 5,000 member banks. ICBA is pleased to have this opportunity to testify today, and ICBA commends your bold action to address the current issues. Mr. Chairman, community bankers are dismayed by the current situation. We have spent the past 25 years warning policymakers of the systemic risk by the unbridled growth of the Nation's largest banks and financial firms. But we were told we did not get it, that we didn't understand the new global economy, that we were protectionist, that we were afraid of competition, and that we needed to get with the ``modern'' times. However, our financial system is now imploding around us. It is important for us to ask: How did this happen? And what must Congress do to fix the problem. For over three generations, the U.S. banking regulatory structure has served this Nation well. Our banking sector was the envy of the world and the strongest and most resilient financial system ever created. But we got off track. Our system has allowed--and even encouraged--the establishment of financial institutions that threaten our entire economy. Nonbank financial regulation has been lax. The crisis illustrates the dangerous overconcentration of financial resources in too few hands. To address this core issue, we recommend the following. Congress should require the financial agencies to identify, regulate, assess, and eventually break up institutions posing a risk to our entire economy. This is the only way to protect taxpayers and maintain a vibrant banking system where small and large institutions are able to fairly compete. Congress should reduce the 10-percent cap on deposit concentration. Congress should direct the systemic risk regulator to block any merger that would result in the creation of a systemic risk institution. An effective systemic risk regulator must have the duty and authority to block activity that threatens systemic risk. Congress should not establish a single, monolithic regulator for the financial system. The current structure provides valuable regulatory checks and balances and promotes best practices among those agencies. The dual banking system should be maintained. Multiple charter options, both Federal and State, are essential preserve an innovative and resilient regulatory system. Mr. Chairman, we do not make these recommendations lightly, but unless you take bold action, you will again be faced with a financial crisis brought on by mistakes made by banks that are too big to fail, too big to regulate, and too big to manage. Breaking up systemic risk institutions while maintaining the current regulatory system for community banks recognizes two key facts: first, our current problems stem from overconcentration; and, second, community banks have performed well and did not cause the crisis. ICBA also believe nonbank providers of financial services, such as mortgage companies and mortgage brokers, should be subject to greater oversight for consumer protection. The incidence of abuse was much less pronounced in the highly regulated banking sector. Many of the proposals in our testimony are controversial, but we feel they are necessary to safeguard America's great financial system and make it stronger coming out of this crisis. Congress should avoid doing damage to the regulatory system for community banks, a system that has been tremendously effective. However, Congress should take a number of steps to regulate, assess, and ultimately break up institutions that pose unacceptable systemic risks to the Nation's financial system. ICBA looks forward to working with you on this very important issue, and we appreciate this opportunity to testify. " CHRG-111hhrg48867--106 Mrs. McCarthy," Thank you, Mr. Chairman. Since we are discussing a systemic risk regulator, it would be appropriate to see how systemic risk is being evaluated now by our government. And most recently, or very much in front of us today, is AIG which was saved because it was a systemic risk to the American economy. Yet when we saw the counterparties that were released this week because of the constant requests from this committee, we find out that a significant amount, billions and billions, tens of billions of dollars, went to foreign banks. Now I would like to ask the panelists, do you feel that bailing out foreign banks is important to systemic risk of the financial institutions of our country? I would think that bailing out foreign banks would be important to the governments of their country, but why is our government bailing out foreign banks? And the reason I ask this is when we are talking in a general sense about systemic risk, we have an example before us in concrete terms of how it is being interpreted by our own government. I do not believe we should be bailing out foreign banks. I believe other governments should bail out their own banks. I would like to ask the panelists, do you feel that that is a proper use of taxpayers' money, under the guidelines that it protects the systemic risk of the financial institutions of America? Do you believe we should be bailing out foreign banks? Are they a systemic risk to the American economy? " CHRG-111hhrg51698--451 Mr. Marshall," Thank you, Mr. Chairman. And, Mr. Pickel, one more thought. You described CDSs as not being at fault for the mess we are in at the moment. But a number of people suggest that the availability of CDSs, the lack of transparency, the lack of required margining, and things like that are the problem. While the instrument itself is a good thing, the interwoven nature of exposure that has occurred with the major institutions where nobody can really tell what is going to happen next has caused investors to sit by the sideline, and has caused our money supply essentially to collapse dramatically. And CDSs are a large part of what has caused this interwoven ``almost unfathomable to the individual institution, let alone outsiders who are trying to figure out what is going on'' nature of our banking system right now. And so, if that is the case, maybe in your response on the record to the Committee, a written response--if you would send a copy to me, I would appreciate it--you could describe a future where we have solved that problem so that people do understand the exposures of these large institutions and, consequently, can comfortably invest or not invest instead of just sitting on the sideline, frightened, because you just cannot tell what the heck is happening. And, largely, it is derivatives and swaps that cause that dilemma for so many investors and for the institutions themselves. If you would. " fcic_final_report_full--574 Register 60, no. 86 (May 4, 1995): 22155–223. 83. Division of Consumer and Community Affairs, memorandum to Board of Governors, August 10, 1998. 84. Federal Reserve Board press release, “Order Approving the Merger of Bank Holding Companies,” August 17, 1998, pp. 63–64. 85. Lloyd Brown, interview by FCIC, February 5, 2010. 86. Andrew Plepler, interview by FCIC, July 14, 2010. 87. Assuming 75% AAA tranche ($1.20), 10% AA tranche ($0.20), 8% A tranche ($0.30), 5% BBB tranche ($0.40), and 2% equity tranche ($2.00). See Goldman Sachs, “Effective Regulation: Part 1, Avoid- ing Another Meltdown,” March 2009, p. 22. 88. David Jones, interview by FCIC, October 19, 2010. See David Jones, “Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues,” Journal of Banking and Finance 24, nos. 1–2 (January 2000): 35–58. 89. 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, p. 34. 90. Jones, interview. Chapter 7 1. For example, an Alt-A loan may have no or limited documentation of the borrower’s income, may have a high loan-to-value ratio (LTV), or may be for an investor-owned property. 2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar- ket (Bethesda, MD: Inside Mortgage Finance, 2009), p. 9, “Mortgage & Asset Securities Issuance” (show- ing Wall St. securitizing a third more than Fannie and Freddie); p. 13, “Non-Agency MBS Issuance by Type.” FCIC staff calculations from 2004 to 2006 (for growth in private label MBS). 3. Charles O. Prince, interview by FCIC, March 17, 2010. 4. John Taylor, interview by FCIC, September 23, 2010. 5. William A. Fleckenstein and Frederick Sheeham, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (New York: McGraw-Hill, 2008), p. 181. 6. Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” Wall Street Journal, March 11, 2009. See also Ben Bernanke, “Monetary Policy and the Housing Bubble,” speech at the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010. 7. Alan Greenspan, testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 109th Cong., 1st sess., February 16, 2005. 8. Fed Chairman Ben S. Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” re- marks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10, 2005. 9. Frederic Mishkin, interview by FCIC, October 1, 2010. 10. Pierre-Olivier Gourinchas, written testimony for the FCIC, Forum to Explore the Causes of the Financial Crisis, day 1, session 2: Macroeconomic Factors and U.S. Monetary Policy, February 26, 2010, pp. 25–26. . 11. Paul Krugman, interview by FCIC, October 6, 2010. 571 12. Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners,” Center for Responsible Lending, December 2006, p. 22. 13. 2009 Mortgage Market Statistical Annual , vol. 1, The Primary Market , p. 4, “Mortgage Originations by Product.” 14. Christopher Mayer, Karen Pence, and Shane M. Sherlund, “The Rise in Mortgage Defaults,” Jour- nal of Economic Perspectives 23, no. 1 (Winter 2009): Table 2, Attributes for Mortgages in Subprime and Alt-A Pools, p. 31. 15. 2009 Mortgage Market Statistical Annual, 2:13, “Non-Agency MBS Issuance by Type.” 16. 2009 Mortgage Market Statistical Annual , 1:6, “Alternative Mortgage Originations”; previous data extrapolated in FCIC estimates from Golden West, Form 10-K for fiscal year 2005, and Federal Reserve, “Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for First Lien Guidance,” November 30, 2005. 17. Inside Mortgage Finance. 18. Countrywide, 2005 Form 10-K, p. 39; 2007 Form 10-K, p. 47 (showing the growth in Country- wide’s originations). 19. Angelo Mozilo, email to Sambol and Kurland re: Sub-prime Seconds. See also Angelo Mozilo, email to Sambol, Bartlett, and Sieracki, re: “Reducing Risk, Reducing Cost,” May 18, 2006; Angelo Mozilo, interview by FCIC. September 24, 2010. 20. David Sambol, interview by FCIC, September 27, 2010. 21. See Countrywide, Investor Conference Call, January 27, 2004, transcript, p. 5. See also Jody Shenn, “Countrywide Adding Staff to Boost Purchase Share,” American Banker, January 28, 2004. 22. Patricia Lindsay, written testimony for the FCIC, hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, sess. 2: Subprime Origination and Securitization, April 7, 2010, p. 3 23. Andrew Davidson, interview by FCIC, October 29, 2020. 24. Ibid. 25. David Berenbaum, testimony before Senate Committee on Banking, Subcommittee on Housing, CHRG-111shrg56376--196 Mr. Baily," I think you must have a system that is countercyclical, while our current system is procyclical, and one that doesn't penalize the best community banks, which the current system does, and pay for the sins of the bad ones. So the system of assessments that funds this agency has to be one that takes into account not increasing the assessment for community banks and certainly not increasing the assessment for any banks in the storm, and I think that is achievable in terms of the way the institution is funded. " CHRG-109shrg24852--45 Chairman Greenspan," The general view that we are endeavoring to express is that when you have a Basel type capital accord down the road, which is essentially fully sensitive to the various different capital needs of an institution, that there is no further need for other measures because, by definition, the system is fully controlled. We are not yet there with respect to Basel II. As I have often said, there will be a Basel III and there will be a Basel IV because the technologies are changing, commercial banking is evolving, and supervision and regulation should not be fixed, it should actually endeavor to adjust to the changing structure of a financial or commercial banking system. So when we get to the point--and I do not think we are there yet--that the various structures defining what capital should be address everybody's concerns about supervision and control, then there is no longer a need for a minimum capital requirement. It would be merely duplicative, and indeed, if the system is working well, it is actually inoperative. We are not there yet, and I think what Governor Bies is trying to say is that we recognize that that not yet being there, there is still a role for minimum capital and a leverage ratio. But that does not change the fact that when we get a sufficiently sophisticated structure of capital supervision, that issue will become moot. So it is really a question of, as you quoted earlier, the word is ``eventually,'' and where that is, I do not yet know. But I do know, as indicated by both Governor Bies and Chairman Powell, that we are not there yet. Senator Sarbanes. One quick question and then I will---- " CHRG-110hhrg44903--33 Mr. Bachus," Thank you. I associate myself with those remarks. And I just hope the general public--I hope in our writing, we don't repeat rumors that are totally sensational without any basis. And I think the story that the American people need to hear is that our banking system is sound. It is well capitalized, and their deposit--I wouldn't say that. As a politician, the worst thing I could say is that there is a problem with the solvency of that. I would never want to say that if I didn't believe it 100 percent. Chairman Cox, in your June 19th editorial, you asked a question that I think this committee has to answer. And that is, should the extensive system of commercial banking supervision and regulation developed in large measure to counter the problem of moral hazard be extended to investment banks? And if so, who should be responsible? How would you answer your own question? And in doing so, are there characteristics that distinguish investment banks from commercial banks and argue for a different treatment, different regulatory treatment? " CHRG-111shrg55278--45 Chairman Dodd," Thank you very much, Senator. Senator Crapo. Senator Crapo. Thank you, Mr. Chairman, and Chairman Bair, I am going to focus most of my questions on you, although I may, if I have time, be able to get to the others on the same issue. I am going to focus on the resolution authority issue again. I know that you have proposed that the resolution authority be with the FDIC and that it be expanded to bank holding companies and there is a bit of a discussion as to how broadly it should be expanded and where this authority should reside, or should be placed. But when you look at the issue of the need for a resolution authority, we have, first of all, the fact that right now, we only have resolution authority for banks. You indicated that we should expand that to bank holding companies. We also have the issue or a piece of the issue that Senator Bunning raised with regard to international holdings and what we deal with when we have American institutions that have acquired sometimes dozens if not hundreds of foreign subsidiaries and how we deal with those kinds of jurisdictional issues. I would just be curious as to your thoughts about where should the resolution authority be placed--I think I know the answer to that--but also how broad do we need to be in terms of the establishment of such resolution authority. Ms. Bair. Well, as you said, for bank holding companies, the FDIC would like to be the resolution authority simply because we already are for the insured depository institutions and you need a consistent single unified resolution regime. For other types of entities, if Congress wanted to give us that authority, we would take it. We are really the only place where this very specialized expertise resides. We have closed over 3,000 institutions throughout our existence, small ones, large ones, and we have the staff and the ability to ramp up very quickly, as we have done over the past 18 months and have in the past. Institutionally, this is what we are equipped to do, so I think it would make some sense. The international component of this is very difficult and we think that this will be a multiyear process to get some of these institutions in shape where their resolution could be much more streamlined. One of the things we suggest in my written testimony, it is also suggested in the Administration's white paper, is to require these large institutions to have their own will, so to speak. They need to have their own liquidation plan that they would update, say, on a quarterly basis. The plan would also be facilitated by having greater legal separateness among the functional components. Part of the problem is these functional components are so intertwined, so deposits you may get overseas may be funding assets in the United States. Trying to tease all of that out in an orderly fashion is difficult. So we do think there is some infrastructure that needs to be put in place here. By designating some entity as the resolution authority, it will facilitate international discussions. We are doing that now, but we just have the bank piece of it. I think whoever is designated with the resolution authority would be the entity that could negotiate agreements with other jurisdictions and have systems and agreements in place to deal with situations where an internationally active organization gets into trouble. Protocols would be in place to deal with that situation. Senator Crapo. Would expansion of the authority at FDIC to include bank holding companies have allowed you to reach to Lehman Brothers and AIG? Ms. Bair. Well, yes, theoretically it could have. AIG was a thrift holding company. Assuming that you expanded the authorities to both bank and thrift holding companies or the charters were collapsed under Federal Reserve jurisdiction, requiring everybody to become a bank holding company, yes, it would. Senator Crapo. And then where would we stop--or, I guess, is expansion to bank holding companies sufficient? I am thinking we have insurance companies, hedge funds---- Ms. Bair. Right. Senator Crapo. ----private equity firms, mutual funds, pension funds---- Ms. Bair. Yes. Senator Crapo. How broadly do we need to reach? Ms. Bair. Yes. Well, again---- Senator Crapo. What is the systemic system that we are talking about here? Ms. Bair. We would not want the FDIC to decide that. I think that is something that the Systemic Risk Council really would be best equipped to do. And also, our process does not contemplate that the FDIC would be the authority to decide to close the entity. That could be done a couple of different ways. One would be through the systemic risk process we have now. If it is a holding company, it could be done by the Federal Reserve Board as the primary regulator of the bank holding company. That is the way the process works now. The primary regulator makes the decision to close the institution--that is frequently done in consultation with us--but then appoints us as a receiver. Senator Crapo. Do you think it would be adequate to simply extend jurisdiction to bank holding companies? Ms. Bair. That would be an option if you wanted to do something quickly. As I said before, I am concerned that we are not out of the woods yet, and as the market starts to differentiate between weak and strong and we exit these Government programs, we may be back in the soup. I hope that is not the case, but I am not sure. I think as an interim measure, you could very easily extend our authority to bank holding companies. This approach would not require Congress to address systemic risk or anything else. I think we would still need to do address systemic risk down the road. But yes, this could be a short-term measure. We have drafted language at the request of some of you which would be a very simple amendment process. That would be a very good tool to have now. Senator Crapo. And I assume that you would agree that establishing an expanded resolution authority would help us to get away from the concern that creating a systemic risk regulator for those so-called ``too-large-to-fail'' firms---- Ms. Bair. Right. Senator Crapo. ----would create an implicit Government guarantee that they would be propped up as opposed to allowed to run down. Ms. Bair. That is right. We want it to be a bad thing, not a good thing, to be systemic. That is exactly right. I think you do that through a robust resolution regime that, as Chairman Schapiro said, makes it clear to the market that this is the process that will be used and shareholders and creditors will take losses. Senator Crapo. Well, thank you. My time is up. I would love to have had this same question answered by our other two witnesses. Maybe we will be able to get some---- " CHRG-111hhrg48674--359 Mr. Perlmutter," It has been a difficult time for all of us, but you have definitely been on the front line. So here are my questions to you: We have been in triage, we have been in the emergency room. We have systemic risk here and systemic risk here, and automakers, Fannie Mae, banks, investment banks and insurance companies. Is there something wrong with the system--not all these little things; is there something wrong with the system? And if you could go back in time, would you change one thing; Glass-Steagall, branch banking, securitizing loans? If you could go back in time, what would it be? " CHRG-111shrg52619--181 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM JOHN C. DUGANQ.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. Effective protection for consumers of financial products and services is a vital part of financial services regulation. The attractiveness of the single financial product protection agency model is that it would presumably centralize authority and functions in this area in a single agency, which could write and apply rules that would apply uniformly to all financial services providers, whether or not they are depository institutions. Because the agency would focus exclusively on consumer protection, proponents of the concept also argue that such a model eliminates the concerns sometimes expressed that prudential supervisors neglect consumer protection in favor of safety and soundness supervision. These asserted attributes need to be closely evaluated, however. In the case of federally regulated depository institutions, the benefits could well be outweighed by the costs of diminishing the real consumer protections that flow from the Federal banking agencies' comprehensive supervision and oversight of depository institutions. In the OCC's experience, and as the mortgage crisis illustrates, safe and sound lending practices are integral to consumer protection. Indeed, I believe that the best way to implement consumer protection regulation of banks--and the best way to protect their customers--is to do so through comprehensive prudential supervision. Effective consumer protection of financial institutions includes three vital components: (1) strong regulatory standards; (2) consistent and thorough oversight of compliance with these standards; and (3) an effective corrective/enforcement response when it is determined that those standards are not met. The appropriate structure for the rulemaking function can be debated. With respect to federally supervised banks that are subject to regular, ongoing supervision by the Federal banking agencies, there are good reasons why these agencies, by virtue of their familiarity with the issues these institutions present, should have a role in the rulemaking process. They bring expertise regarding potentially complex issues, and they are in a position to warn against potential unintended consequences of rulemaking initiatives under consideration. At the very least, if rulemaking for financial product consumer protection is vested in any single agency, there should be a requirement to consult with the Federal banking agencies with respect to the impact of proposed rules on federally regulated depository institutions. Next is the question of consistent and thorough oversight of applicable consumer protection standards. Here, significant differences exist in the manner in which federally regulated depository institutions are examined and supervised, and the oversight schemes applicable to the ``shadow banking system''--nonbank firms that provide products and services comparable to those offered by depository institutions. I think it would be a mistake to displace the extensive role of the Federal banking agencies in examination and supervision of the operations of depository institutions--including their compliance with consumer protection standards. The Federal banking agencies' regular and continual presence in institutions through the process of examination and supervision puts them in the best position to ensure compliance with applicable consumer protection laws and regulations. Examiners are trained to detect weaknesses in institutions' policies, systems, and procedures for implementing consumer protection mandates, as well as substantive violations of laws and regulations. Their regular communication with institutions occurs through examinations at least once every 18 months for smaller institutions, supplemented by quarterly contacts, and for the largest banks, the consumer compliance examination function is conducted continuously, by examiners on site at large banks every day. The extensive examination and supervisory presence creates especially effective incentives for achieving consumer protection compliance, and allows examiners to detect compliance weaknesses much earlier than would otherwise be the case. Moreover, in many respects, for purposes of examination and supervision by the Federal banking agencies, safety and soundness and consumer protection issues are inextricably linked. Take, for example, mortgage lending. Safe and sound credit underwriting for a mortgage loan requires sound credit judgments about a borrower's ability to repay a loan, while the same sound underwriting practices help protect a borrower from an abusive loan with terms that the borrower does not understand and cannot repay. Bank examiners see both perspectives and require corrections that respond to both aspects of the problem. This system did not fail in the current mortgage crisis. It is well recognized the overwhelming source of toxic mortgages precipitating the mortgage crisis were originated by lenders that were not federally supervised banks. To shift the responsibility for examining for and reacting to the consumer protection issues to an entirely separate agency is less efficient than the integrated approach bank examiners apply today. Shifting the examination and supervision role to a new and separate agency also would seem to require the establishment of a very substantial new workforce, with a major budget, to carry out those responsibilities. Where substantial enhancement of examination and supervision is warranted, however, is for nonbank firms that are not subject to federal examination and supervision. Again, it is important to remember that these nondepository institutions were the predominant source of the toxic subprime mortgages that fueled the current mortgage crisis. The providers of these mortgages--part of the ``shadow banking system''--are not subject to examination and supervision comparable to that received by federally supervised depository institutions. Rather than displace the extensive consumer protection examination and supervisory functions of the federal banking agencies, any new financial product protection agency should focus on ensuring that the ``shadow banking system'' is subject to the same robust consumer protection standards as are applicable to depository institutions, and that those standards are in fact effectively applied and enforced. Finally, in the area of enforcement, the Federal banking agencies have strong enforcement powers and exceptional leverage over depository institutions to achieve correction actions. As already mentioned, depository institutions are among the most extensively supervised firms in any type of industry, and bankers understand very well the range of negative consequences that can ensue from failing to be response to their regulator. As a result, when examiners detect consumer compliance weaknesses or failures, they have a broad range of tools to achieve corrective action, and banks have strong incentives to achieve compliance as promptly as possible. It is in the interests of consumers that this authority not be undermined by the role and responsibilities of any new consumer protection agency.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 flawed assumption that AIG was adequately regulated, and therefore no further scrutiny was necessary?A.2. A critical focus of our examination of trading activities at our large national banks is to assess how well the bank manages its counterparty exposures. We regularly review large counterparty exposures at our large national banks; however, the counterparty exposure to AIG did not trigger heightened regulatory scrutiny by the OCC because it was a AAA-rated company, was generally well-respected in the financial services industry, and was not a meaningful risk concentration to any of the banks under our supervision. Because AIG had such a strong credit rating, many counterparties, including national banks, did not require AIG to post collateral on its exposures. A key lesson learned for bankers and supervisors is the need to carefully manage all counterparty exposures, especially those that may have sizable unsecured exposures, regardless of the counterparty's rating. In particular, regulators need to revisit the issue of the extent to which collateral should be required in counterparty relationships, merely due to AAA ratings.Q.3. Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC?A.3. We did not have any meaningful dialogue with state insurance regulators or the SEC about AIG since we had no compelling reason to do so, given the lack of supervisory concerns at the time with regard to the exposure to AIG.Q.4. 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 in formation would have been available? How would you have used it?A.4. Because the transactions between AIG and its counterparties were highly customized to specific CDOs, it is unlikely that they would have been eligible for trading on an exchange or clearing through a clearinghouse. Transactions that use exchanges or clearinghouses generally require a fairly high degree of standardization. In addition, for a contract to trade on an exchange, the exchange/clearinghouse needs to be able to determine prices for the underlying reference entities, in this case super-senior ABS CDOs, yet, even the most sophisticated market participants had great difficulty valuing these securities. If the transactions could have been traded on an exchange, then AIG would have been forced to post initial and variation margin. These margin requirements would likely have limited the volume of trades that AIG could have done, or forced them to exit the transactions prior to the losses becoming so significant that they threatened the firm's solvency. In addition, because an exchange or clearinghouse provides for more price transparency, if these transactions had been cleared through a clearinghouse, market participants may have had greater knowledge of the pricing of the underlying CDO assets.Q.5. Over-Reliance on Credit Rating Agencies--While many national banks did not engage in substandard underwriting for the loans they originated, many of these institutions bought and held these assets in the form of triple-A rated mortgage-backed securities. Why was it inappropriate for these institutions to originate these loans, but it was acceptable for them to hold the securities collateralized by them?A.5. National banks are allowed to purchase and hold as investments various highly rated securities that are supported by a variety of asset types. Examples of such asset types include mortgages, autos, credit cards, equipment leases, and commercial and student loans. National banks are expected to conduct sufficient due diligence to understand and control the risks associated with such investment securities and the collateral that underlies those securities. In recent years, many national banks increased their holdings of highly rated senior ABS CDO securitization exposures. These senior positions were typically supported by subordinated or mezzanine tranches and equity or first-loss positions, as well as other forms of credit enhancement such as over-collateralization and, in certain instances, credit default swaps provided by highly rated counterparties. In hindsight, bankers, regulators, and the rating agencies put too much reliance on these credit enhancements and failed to recognize the leverage and underlying credit exposures embedded in these securities, especially with respect to a systematic decline in value of the underlying loans based on a nationwide decline in house prices. Our supervisory approach going forward will emphasize an increased need for banks to consider the underwriting on the underlying loans in a securitization and understand the potential effect of those underlying exposures on the performance of the securitized asset. In addition, as previously noted, another key lesson learned from the recent financial turmoil is the need for firms to enhance their ability to identify and aggregate risk exposures across business, product lines, and legal entities. With regard to subprime mortgage exposures, many national banks thought they had avoided subprime risk exposures by deliberately choosing to not originate such loans in the bank, only to find out after the fact that their investment bank affiliates had purchased subprime loans elsewhere to structure them into collateralized debt obligations.Q.6. What changes are you capable of making absent statutory changes, and have you made those changes yet?A.6. As noted above, while we expect bankers to conduct sufficient due diligence on their investment holdings, in recent years both bankers and regulators became too complacent in relying on NSRO ratings and various forms of credit enhancements for complex structured products, which often were based on various modeled scenarios. The market disruptions have made bankers and regulators much more aware of the risk within models, including over-reliance on historical information and inappropriate correlation assumptions. Because of our heightened appreciation of the limitation of models and the NSRO ratings that were produced from those models, we are better incorporating quantitative and qualitative factors to adjust for these weaknesses. We are also emphasizing the need for bankers to place less reliance on models and NSRO ratings and to better stress-test internal model results. We also have told banks that they need a better understanding of the characteristics of the assets underlying these securities. Finally, enhancements to the Basel II capital framework that were announced by the Basel Committee on Banking Supervision in January 2009 will require banks to hold additional capital for re-securitizations, such as collateralized debt obligations comprised of asset-back securities. In addition to the higher capital that banks will be required to hold, these enhancements will also require banks that use credit ratings in their measurement of required regulatory capital for securitization exposures to have: A comprehensive understanding on an ongoing basis of the risk characteristics of their individual securitization exposures. Access to performance information on the underlying pools on an ongoing basis in a timely manner. For re- securitizations, banks should have information not only on the underlying securitization tranches, such as the issuer name and credit quality, but also on the characteristics and performance of the pools underlying the securitization tranches. A thorough understanding of all structural features of a securitization transaction that would materially impact the performance of the bank's exposures to the transaction, such as the contractual waterfall and waterfall-related triggers, credit enhancements, liquidity enhancements, market value triggers, and deal-specific definitions of default. The comment period for the proposed enhancements has ended, and the Basel Committee is expected to adopt the final changes before year-end 2009. The U.S. federal banking agencies will consider whether to propose adding these or similar standards to their Basel II risk-based capital requirements.Q.7. 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.7. There are a myriad of a factors that influence a bank's liquidity risk profile and that need to be effectively managed. Some of these factors include the stability and level of a bank's core deposits versus its dependence on more volatile wholesale and retail funds; the diversification of the bank's overall funding base in terms of instrument types, nature of funds providers, repricing, and maturity characteristics; and the level of readily available liquid assets that could be quickly converted to cash. We do use a number of metrics, such as net short-term liabilities to total assets, to identify banks that may have significant liquidity risk. However, we believe that it has been difficult to distill all of the factors that influence a bank's liquidity risk into a single regulatory metric that is applicable to all types and sizes of financial institutions. As a result, we direct banks to develop a robust process for measuring and controlling their liquidity risk. A key component of an effective liquidity risk management process are cash flow projections that include discrete and cumulative cash flow mismatches or gaps over specified future time horizons under both expected and adverse business conditions. We expect bankers to have effective strategies in place to address any material mismatches under both normal and adverse operating scenarios. The Basel Working Group on Liquidity (WGL) issued revised principles last year that emphasized the importance of cash flow projections, diversified funding sources, comprehensive stress testing, a cushion of liquid assets, and a well-developed contingency funding plan. Financial institutions are in the process of implementing these additional principles into their existing risk management practices. The WGL is currently reviewing proposals for enhanced supervisory metrics to monitor a financial institution's liquidity position and the OCC is actively involved in those efforts.Q.8. What Is Really Off-Balance Sheet--Chairman Bair noted that structured investment vehicles (SIVs) played an important role in funding credit risk that are at the core of our current crisis. While the banks used the SIVs to get assets off their balance sheet and avoid capital requirements, they ultimately wound up reabsorbing assets from these SIV's. Why did the institutions bring these assets back on their balance sheet? Was there a discussion between the OCC and those with these off-balance sheet assets about forcing the investor to take the loss?A.8. For much of the past two decades, SIVs provided a cost effective way for financial companies to use the short-term commercial paper and medium term note (MTN) markets to fund various types of loans and credit receivables. Beginning in August 2007, as investor concerns about subprime mortgage exposures spilled over into the general asset-backed commercial paper (ABCP) and MTN markets, banks were facing increased difficulties in rolling over these funding sources for their SIVs. As a result, banks began purchasing their sponsored SIVs' ABCP as a short term solution to the market disruption. In some instances, banks had pre-approved liquidity facilities established for this purpose. Over time, it became apparent that market disruptions would continue for an extended period, making it impossible for SIVs to roll ABCP or MTNs as they matured. In order to avoid possible rating downgrades of senior SIV debt and to maintain investor relationships, banks supported their sponsored SIV structures by either purchasing SIV assets or maturing ABCP. As a result of these purchases, many banks were required to consolidate SIV assets under GAAP. The OCC had ongoing discussions with banks on this topic, and OCC examiners emphasized the need for bank management to consider all potential ramifications of their actions, including liquidity and capital implications, as well as other strategic business objectives.Q.9. How much of these assets are now being supported by the Treasury and the FDIC?A.9. Treasury's TAW Capital Purchase Program and the FDIC's Temporary Liquidity Guaranty Program are providing funds that are helping to bolster participating banks' overall capital and liquidity levels and thus may be indirectly supporting some of these assets that banks may still be holding on their balance sheets. However, given the fungible nature of this funding, it is not possible to identify specific assets that may be supported.Q.10. Based on this experience, would you recommend a different regulatory treatment for similar transactions in the future? What about accounting treatment?A.10. Regulatory capital requirements for securitization exposures generally are based on whether the underlying assets held by the securitization structure are reported on- or off-balance sheet of the bank under generally accepted accounting principles (GAAP). Most SIVs have been structured to qualify for off-balance sheet treatment under GAAP. As such, bank capital requirements are based on the bank's actual exposures to the structure, which may include, for example, recourse obligations, residual interests, liquidity facilities, and loans, and which typically are far less than the amount of assets held in the structure. The Financial Accounting Standards Board (FASB), in part as a response to banks' supporting SIV structures beyond their contractual obligation to do so, proposed changes to the standards that require banks to consolidate special purpose vehicles and conduits such as SIVs. Under the proposed new standards, which are expected to become effective January 1, 2010, the criteria for consolidation would require banks to conduct a qualitative analysis, based on facts and circumstances (power, rights, and obligations), to determine if the bank is the primary beneficiary of the structure. One factor in determining whether the bank sponsoring a SIV structure is the primary beneficiary would be whether the risk to the bank's reputation in the marketplace if the structure entity does not operate as designed would create an implicit financial responsibility for the bank to support the structure. The proposed new standards likely would require banks to consolidate more SIV structures than they are required to consolidate under current GAAP. The U.S. banking agencies are evaluating what changes, if any, to propose to our regulatory capital rules in response to the proposed FASB changes. In addition, in January 2009, the Basel Committee on Banking Supervision proposed enhancements to the Basel II framework that include increasing the credit conversion factor for short-term liquidity facilities from 20 percent to 50 percent. This change would make the conversion factor for short-term liquidity facilities equal to the credit conversion factor for long-term liquidity facilities. The U.S. banking agencies are evaluating whether to propose a rule change to increase the credit conversion factor for short-term liquidity facilities to 50 percent for banks operating in the United States under both Basel I and Basel II.Q.11. 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. 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.11. No. Receiving funding through assessments on regulated entities is the norm in the financial services industry. In the case of the OCC and OTS, Congress has determined that assessments and fees on national banks and thrifts, respectively, will fund supervisory activities, rather than appropriations from the United States Treasury. Neither the Federal Reserve Board nor the FDIC receives appropriations. State banking regulators typically are also funded by assessments on the entities they charter and supervise. Since enactment of the National Bank Act in 1864, the OCC has been funded by various types of fees imposed on national banks. Over the more than 145 years that the OCC has regulated national banks, in times of prosperity and times of economic stress, there has never been any evidence that this funding mechanism has caused the OCC to fail to hold national banks responsible for unsafe or unsound practices or violations of law, including laws that protect consumers. Rather, through comprehensive examination processes, the OCC's track record is one of proactively addressing both consumer protection and safety and soundness issues. Among the banking agencies, we have pioneered enforcement approaches, including utilization of section 5 of the Federal Trade Commission Act, to protect consumers. Indeed, the OCC frequently has been criticized for being too ``tough,'' and we have seen institutions leave the national banking system to seek more favorable regulatory treatment of their operations. \1\--------------------------------------------------------------------------- \1\ Applebaum, Washington Post, By Switching Their Charters, Banks Skirt Supervision, January 22, 2009; A01.--------------------------------------------------------------------------- Simply put, the OCC never has compromised robust bank supervision, including enforcement of consumer protection laws, to attract or retain bank charters.Q.12. 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 bank. 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.12. As noted in the previous responses to Senator Crapo, there is currently no system for the orderly resolution of nonbank firms. This needs to be addressed with an explicit statutory regime for facilitating the resolution of systemically important nonbank companies. This new statutory regime should provide tools that are similar to those the FDIC currently has for resolving banks, including the ability to require certain actions to stabilize a firm; access to a significant funding source if needed to facilitate orderly dispositions, such as a significant line of credit from the Treasury; the ability to wind down a firm if necessary, and the flexibility to guarantee liabilities and provide open institution assistance if necessary to avoid serious risk to the financial system. In addition, there should be clear criteria for determining which institutions would be subject to this resolution regime, and how to handle the foreign operations of such institutions. While such changes would make orderly resolutions of systemically important firms more feasibly, they would not eliminate the possibility of using extraordinary government assistance to protect the financial system.Q.13. 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 ?A.13. The question as to how best to address pro-cyclicality concerns associated with our present system of accounting and capital regulation is an area of significant focus for policy makers domestically and internationally. In addressing this matter, it is important to distinguish between cyclicality and pro-cyclicality. Due to their sensitivity to risk, the current accounting and capital regimes are clearly, and intentionally, cyclical, broadly reflecting the prevailing trends in the economy. The more difficult and unresolved issue is whether those regimes are also ``pro-cyclical,'' by amplifying otherwise normal business fluctuations. As noted, there are ongoing efforts to assess pro-cyclicality issues with respect to both our current accounting and regulatory capital regimes. The most recent public statement on this matter is found in the Financial Stability Board's April 2, 2009 document ``Report of the Financial Stability Forum on Addressing Pro-cyclicality in the Financial System'' (FSB Report). \2\ In this report, the FSB makes numerous policy recommendations to address pro-cyclicality concerns in three broad areas: regulatory capital; bank loan loss provisioning practices; and valuation.--------------------------------------------------------------------------- \2\ The FSB Report was developed as a result of collaborative work carried out by working groups composed of staff from: banking agencies from the U.S. and other jurisdictions; securities regulators from the U.S. and other jurisdictions; accounting standard setters; the Basel Committee on Banking Supervision; International Organization of Securities Commissions; and other organizations.--------------------------------------------------------------------------- With respect to capital, the FSB Report set forth various recommendations to address potential pro-cyclicality, including the establishment of counter-cyclical capital buffers. In that regard, the Report encouraged the Basel Committee to ``develop mechanisms by which the quality of the capital base and the buffers above the regulatory minimum are built up during periods of strong earnings growth so that they are available to absorb greater losses in stressful environments.'' In terms of benefits, building such a counter-cyclical capital buffer on banks' earnings capacity would provide a simple and practical link between: (i) the portfolio composition and risk profile of individual banks; (ii) the build-up of risk in the banking system; and (iii) cycles of credit growth, financial innovation and leverage in the broader economy. We also believe it is critically important to focus on the quality of capital, with common stock, retained earnings, and reserves for loan losses, being the predominant form of capital within the Tier 1 requirement. The establishment of counter-cyclical capital buffers do present challenges, the most significant of which relate to international consistency and operational considerations. In normal cyclical downturns, there are clear differences in national economic cycles, with certain regions experiencing material deterioration in economic activity, while other regions are completely unaffected. In such an environment, it will be extremely difficult to balance the need for international consistency while reflecting differences in national economic cycles. With respect to loan loss reserves, the FSB Report stated that earlier recognition of loan losses could have dampened cyclical moves in the current crisis. Under the current accounting requirements of an incurred loss model, a provision for loan losses is recognized only when a loss impairment event or events have taken place that are likely to result in nonpayment of a loan in the future. Earlier identification of credit losses is consistent both with financial statement users' needs for transparency regarding changes in credit trends and with prudential objectives of safety and soundness. To address this issue, the FSB Report set forth recommendations to accounting standard setters and the Basel Committee. Included in the Report was a recommendation to accounting standard setters to reconsider their current loan loss provisioning requirements and related disclosures. The OCC and other Federal banking agencies continue to discuss these difficult issues within the Basel Committee and other international forums.Q.14. Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.14. The OCC has actively participated in various efforts to assess and mitigate possible pro-cyclical effects of current accounting and regulatory capital regimes and I served as a chairperson of the FSB's Working Group on Provisioning discussed in the FSB Report discussed above. Consistent with recommendations in the FSB Report, I have publicly endorsed enhancements to existing provisions of regulatory capital rules and generally accepted accounting principles (GAAP) to address pro-cyclicality concerns.Q.15. 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?A.15. The materials subsequent to the April 2, 2009, G20 Summit offer a constructive basis for a coordinated international response to the current economic crisis. The documents issued by the G20 working groups, especially Working Group 1: Enhancing Sound Regulation and Strengthening Transparency; and Working Group 2: Reinforcing International Cooperation and Promoting Integrity in Financial Markets, will be a particular focus of attention for the OCC and the other Federal banking agencies.Q.16. Do you see any examples or areas where supranational regulation of financial services would be effective?A.16. Issues uniquely related to the activities and operations of internationally active banking organizations compel a higher level of coordination among international supervisors. In fact, the Standards Implementation Group of the Basel Committee is designed to provide international supervisors a forum to discuss such issues and, to the extent possible, harmonize examination activities and supervisory policies related to those institutions.Q.17. How far do you see your agencies pushing for or against such supranational initiatives?A.17. The OCC is supportive of continued efforts to harmonize activities and policies related to the supervision of internationally active banks. The actions of the G20 and its working groups present the opportunity to continue current dialogue with a broader array of jurisdictions. However, we are keenly aware of the need to protect U.S. sovereignty over the supervision of national banks, and will not delegate that responsibility.Q.18. What steps has the OCC taken to promote the use of central counterparties for credit default swap transactions by national banks?A.18. The OCC is an active participant in the Derivatives Infrastructure Project. One of the key accomplishments of this project is working with industry participants in developing a central counterparty solution for credit derivatives. Representatives from the OCC previously testified that credit derivatives risk mitigation is encouraged including the use of a central clearing party. The industry committed in its July 31, 2008, letter to use central clearing for eligible index, single name, and tranche index CDS where practicable. The industry renewed this commitment in October of 2008. Our ongoing supervision efforts continue to track the progress of this commitment in the institutions where the OCC is the primary supervisor. As a result, central clearinghouses have been established and central clearing of index trades began in March of this year. The OCC granted national banks the legal authority to become members of a central clearing house for credit derivatives. The legal approval is also subject to stringent safety and soundness requirements to ensure banks can effectively manage and measure their exposures to central counterparties. The OCC continues to work with market participants and other regulators on increasing the volume and types of credit derivatives cleared via a central counterparty. In a meeting on April 1 at the Federal Reserve Bank of New York, market participants discussed broadening the use of a central clearing party to include a wider range of firms and credit derivative products. Participants agreed to form an industry group to address challenges to achieving these objectives and associated issues surrounding initial margin segregation and portability. The industry will report back to regulators with plans on how to progress.Q.19. What other classes of OTC derivatives are good candidates for central clearing and what steps is the OCC taking to encourage the development and use of central clearing counterparties?A.19. The OCC believes that all types of OTC derivative products, including foreign exchange, interest rate, commodities, and equities, will have some contracts that are appropriate candidates for central clearing. The key to increasing the volume of centrally cleared derivatives is increasing product standardization. Some OTC derivatives products are more amenable to this standardization than others. Over time, a central question for policymakers will be the extent to which the risks of customized OTC derivatives products can be effectively managed off of centralized clearinghouses or exchanges, and whether the benefits exceed the risks. ------ CHRG-111hhrg48867--189 Mr. Price," I would agree. And I think that is almost an impossibility. And I would suggest that community banks, independent community banks, might find themselves out in the cold; that the Federal Government may determine that all those big boys are systemically risky, systemically significant, community banks aren't, and then, therefore, how are community banks going to compete. Mr. Wallison, I would appreciate it if you would just discuss that unequal or unlevel playing field when one defines something as systemically significant. " CHRG-111hhrg55814--168 Secretary Geithner," Yes. We're creating a system modeled on the existing system for banks and thrifts to make sure they could be used for a major bank holding company. " CHRG-111shrg53822--59 Mr. Wallison," I appreciate it very much, Mr. Chairman. I am very pleased to have this opportunity to appear before the Committee. The chairman's letter of invitation asked four questions, and I have attempted to answer them in detail in my prepared testimony. I will try to summarize both the questions and my responses as follows. First, is it desirable or feasible to prevent institutions from becoming ``too big to fail''? I do not believe it is possible to identify in advance those institutions that are ``too big to fail'' because they pose systemic risk. Even if we could do that, the current condition of the heavily regulated banking sector shows that regulation is not an effective way to control growth or risk taking. Only the failure of a large commercial bank is likely to create the kind of systemic breakdown that we fear. Banks are special. Businesses and individuals rely on them for ready cash, necessary to meet payrolls, provide working capital, and pay daily bills. Small banks deposit funds in large banks. If a large bank should fail, that could cause a cascade of losses through the economy, and that is the definition, really, of systemic risk or a systemic breakdown. I doubt, however, that other kinds of financial institutions, insurance companies, securities firms, hedge funds, no matter what their size, can cause a systemic breakdown if they fail. This is because creditors of these firms do not expect to have immediate access to the funds that they have lent. If a large, non-bank financial firm should fail, its creditors suffer its losses over time with no immediate cascade of losses through the economy. The turmoil in the markets after Lehman's bankruptcy was the result of the extreme fragility of the world's financial system at that time and not the result of any losses actually caused by Lehman. The failure of a non-bank financial firm is not much different, in my view, from the failure of a large operating firm like General Motors. If General Motors fails, it will cause many losses throughout our economy, but not even the administration is contending that GM is ``too big to fail.'' The Committee should consider why if GM is not ``too big to fail,'' a large non-bank, financial firm might be; or if GM is ``too big to fail,'' whether we need a government agency that will resolve big operating firms, as some are proposing to resolve big financial firms. Second. Should firms that are ``too big to fail'' be broken up? This would not be good policy. Our large operating companies need large banks and other financial institutions for loans, for insurance, for funds transfers, and for selling their securities. If we broke up large financial institutions on the mere supposition that they might cause a systemic event, we would be depriving our economy of something it needs without getting anything certain in return. Third. What regulatory steps should be taken to address the ``too-big-to-fail'' problem? Since I do not think that non-bank financial institutions can create systemic risk, I would not propose new regulation for them at all. However, regulation of banks can be improved. We should require higher minimum capital levels. Capital should be increased during profitable periods when banks are growing in size. Regulators should develop indicators of risk taking and require banks to publish them regularly. This would assist market discipline. Fourth. How can we improve the current framework for resolving systemically important non-bank financial firms? There is no need to set up a government-run system for resolving non-bank financial institutions the way we resolve banks. They do not pose the risks that banks do. Giving an agency the power to take them over would virtually guarantee more bailouts like AIG with the taxpayers paying the bill. The bankruptcy system is likely to work better with greater certainty and with fewer losses. Within two weeks after its bankruptcy filing, Lehman had sold its investment banking, brokerage and investment advisory businesses to four different buyers. And unlike the $200 billion disaster at AIG, all Lehman's bankruptcy costs are being paid by the shareholders and the creditors of Lehman, not the taxpayers. Because of their special role in the economy, banks must have a special resolution system. I agree with that. But there is no reason to do the same thing for the creditors of non-bank financial institutions. Thank you, Mr. Chairman. Senator Warner. Thank you, Mr. Wallison. Some interesting comments. I am anxious to ask a couple of questions. Mr. Baily? CHRG-111shrg57709--239 PREPARED STATEMENT OF SENATOR SHERROD BROWN Thank you, Mr. Chairman, for holding this hearing on the Administration's plan to curb risky investment activities by banks. I also want to welcome the witnesses and thank them for their participation. Chairman Volcker made the point recently that that the ATM has been the biggest innovation in the financial services industry over the past 20 years. The leading provider of ATM technology, NCR Corporation, started in Dayton, Ohio. I agree with Chairman Volcker that we should support the sorts of financial innovations that have value for working families. Unfortunately, instead of helping working families save and invest, the largest financial institutions ``innovated'' in ways that fueled the financial crisis. Despite the fact that these large, dangerously intertwined institutions recklessly underwrote exotic securities and gambled on toxic assets, they received a multibillion-dollar bailout from American taxpayers. It may have been necessary to prevent a complete financial collapse, but that doesn't make is any less noxious. Americans are disgusted that Wall Street can make or break our economy. So am I. And while the big banks got help, some of the smaller banks have not been so lucky, particularly in Ohio. National City Corp. was a vital part of the Cleveland community from 1845 until 2008. National City experienced severe difficulties caused by its involvement in the subprime market, but the Treasury Department denied its application for TARP funds. Instead, the government gave PNC Bank TARP money to purchase National City. This unfortunate development cost an untold number of jobs in Ohio. In response to this case, I sent a letter to Treasury letting them know of my concern about the TARP program being used to fund bank consolidation, rather than helping to rescue small, ailing banks. Over 1 year later, it appears that my concerns were justified. Large banks are bigger than ever, and they are reaping great benefits from their expansion and consolidation. A study by the Center for Economic and Policy Research found that the ``too big to fail'' banks that carry implicit government guarantees are able to borrow at a lower interest rate than other banks. According to their figures, this implicit ``too big to fail'' guarantee amounts to a government subsidy of $34.1 billion a year to the 18 banks with more than $100 billion in assets. Consolidation is also hurting community banks, thrifts and credit unions. According to the Kansas City Fed, the top four banks raised fees related to deposits by an average of 8 percent in the second quarter last year. To compete with the big banks, smaller banks lowered their fees by an average of 12 percent during the same period. This is the classic story of the big guys running the smaller guys out of town . . . at the expense of free market competition. These consolidations are not only undercutting community banks and their customers, but they are breeding the very environment that threw our financial system into chaos, creating a deep, deep recession. We don't want to bail out another set of ``too big to fail'' banks. We don't want to see risk multiplied a thousand fold by mega banks that have trillions of dollars in assets. We need regulatory reform because we need strict oversight of the major threats to our financial system posed by the size and activity of large, interconnected financial institutions. We need to tackle head-on the ``too big to fail'' problem. As you said in excellent your op-ed in Sunday's New York Times, Chairman Volcker, ``We need to face up to needed structural changes, and place them into law.'' Thank you, Mr. Chairman. I look forward to hearing the witnesses' testimony. ______ CHRG-111hhrg63105--229 Mr. Sprecher," Let me steal the microphone away from Mr. Duffy. I think specifically with credit default swaps, as you may know, we stepped forward at a moment in time when the market had collapsed and people were calling to remove the toxic assets off the books of the banks and built a clearinghouse to do that. And that is why we have 14 large bank members. And the only solution that we could come up with on how to deal with a failed bank is to force the other 13 members to accept a forced allocation of the failed positions amongst them that my company would administer. We want to open that clearinghouse up, but we have to recognize that, particularly in the case of some of these complicated derivatives, the new members coming in have to be in a position to be able to accept an allocation of these derivatives, and then they have to be able to do something with them in a marketplace. And we do intend to open that up and we are working on regimes to get there. And certainly Dodd-Frank is an impetus to speed up that implementation. I think the New York Times article was unfair in that it took the construction of that clearinghouse out of the context in which it was built. " CHRG-111shrg53822--4 INSURANCE CORPORATION Ms. Bair. Good morning, Chairman Dodd, members of the Committee. Thank you for the opportunity to testify on the need to address the issue of systemic risk and the existence of financial firms that are deemed ``too big to fail.'' The financial crisis has taught us that too many financial organizations have grown in both size and complexity to the point that they pose systemic risk to the broader financial system. In a properly functioning market economy, there will be winners and losers. When firms are no longer viable, they should fail. Unfortunately, the actions taken during the recent 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. Taxpayers have a right to question how extensive their exposure should be to such entities. A strong case can be made for creating incentives that reduce the size and complexity of financial institutions. A financial system characterized by a handful of giant institutions with global reach, even with a single systemic regulator, is making a huge bet that they will always make the right decisions at the right time. There are three key elements to addressing the problem of ``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 build-up 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 risk. The third element to address systemic risk is the establishment of a legal mechanism for quick and orderly resolution of these institutions similar to that which we use for the FDIC-insured banks. Over the years we have used this to resolve thousands of failed banks and thrifts. The purpose of the resolution authority should not be to prop up a failed entity indefinitely or to insure our liabilities, but to permit a timely and orderly resolution and the reabsorption 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. For example, our good bank/bad bank model would allow the Government to spin off the healthy parts of an organization while retaining the bad assets that we could work out over time. To be credible, the resolution authority must be exercised by an independent entity with powers similar to those available to the FDIC to resolve banks and clear direction to resolve firms as quickly and inexpensively as possible. To enable the resolution authority to be exercised effectively, there should be a resolution fund paid for by fees or assessments on large, complex financial organizations. To ensure fairness, there should be a clear priority system for stockholders, creditors, and other claimants to distribute the losses when a financial company fails. Finally, separate and apart from establishing a resolution structure to handle systemically important institutions, our ability to resolve non-systemic bank failures would be greatly enhanced if Congress provided the FDIC with the authority to resolve bank and thrift holding companies affiliated with a failed institution. By giving the FDIC authority to resolve a failing 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 currently operate. The choices facing Congress in addressing ``too big to fail'' 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 have seen in decades. 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 systemic risk. Thank you. " FOMC20080625meeting--217 215,VICE CHAIRMAN GEITHNER.," No. May I? You know, we think that the money funds finance about a quarter or a third of the stuff in tri-party. Money funds have a unique type of liquidity risk. So it is possible, if the same set of assets were financed by banks, that because banks have a different liquidity risk the system would be more stable. So you can maybe say, even with the same balance sheets as investment banks and the same mix of illiquid stuff financed through that mechanism, if the banks were the dominant providers of liquidity or it was provided through banks, that the system would be more stable, and the broader protections that we designed over the last century to limit the risk of runs on banks because of the risk to the system might have more power, insulating us from a system where nonbanks are large. I think that's the argument. It would be interesting to know a bit about the politics on the Hill of thinking about that legislative change. It would probably look a little like the Middle East, I suspect. [Laughter] That would be a huge change in the relative return on different types of financial businesses that now would come with that. But it would be worth knowing a bit about the history of that debate in the past and what the probability is that we could get something like that through. " FinancialCrisisReport--431 Bear Stearns Hedge Fund Collapse. The collapse of the Bear Stearns hedge funds in mid-June triggered Goldman’s effort to rebuild its net short position. On June 7, 2007, the Mortgage Department learned that the Bear Stearns hedge funds were seeking quietly to sell some of their subprime portfolio to meet client redemption requests, which Goldman interpreted as a signal of serious financial distress. 1769 After reviewing the hedge funds’ assets, one Goldman employee remarked: “In total these two portfolios add up to roughly $17bil in total exposure after leverage. It goes without saying that if this portfolio were to be released into the market the implications would be pretty severe.” 1770 1769 1770 See 6/7/2007 Goldman email chain, “BSAM Post, ” GS MBS-E-011184213. Id. Some have suggested that the financial problems experienced by the Bear Stearns hedge funds were caused in part by severe markdowns taken by Goldman on assets held in the funds ’ portfolios, and that Goldman caused the funds to collapse. In its final report, the Financial Crisis Inquiry Commission (FCIC) briefly addressed these allegations. See The Financial Crisis Inquiry Report 2010 at 237-40, 244 (hereinafter “Final Report”). Goldman denied the allegations with respect to its April and M ay 2007 marks in filings with the FCIC. See 11/1/2010 letter from Goldman counsel Janet Broecke to FCIC, “FCIC Requests for Documents and Information ” and Appendices A- G, available at www2.goldmansachs.com . The FCIC ’s Final Report was critical of Goldman ’s marks in general as being significantly lower than those of other banks and noted in particular its collateral dispute with AIG. See Final Report at 243-44, 265-71. W ith respect to the Bear Stearns hedge funds, however, the Final Report merely noted that Bear Stearns had disputed marks from Goldman and three other banks and cited the testimony of the funds ’ portfolio manager, Ralph Cioffi, that “a number of factors contributed to the April revision [in the hedge funds ’ values, which ultimately led to the funds ’ collapse], and Goldman ’s marks were one factor. ” Final Report at 240. In addition to the markdowns in April and May, Goldman also marked down certain CDO securities held by the Bear Stearns funds in June 2007, but it appears those June markdowns did not play a significant role in the hedge funds ’ collapse. That month, Goldman marked down their positions in four Goldman CDOs by two points each. See, e.g., 6/8/2007 email from Jonathan Egol to Daniel Sparks, “BSAM mark recap,” GS MBS-E-001920339 (Mr. Egol emailed Mr. Sparks a recap of the Bear Stearns markdowns and stated: “W e lowered the marks on 4 bonds down 2 pts each. ”). Mr. Swenson had urged larger markdowns, but his advice was not followed. On June 7, 2007, Mr. Egol had first marked down the funds ’ holdings in a single Abacus CDO by 2 points, from 89 to 87. Mr. Egol emailed Mr. Sparks a spreadsheet with a cover note: “GS exposure to BSAM [Bear Stearns Asset Management] as of today. ABACUS mark corrected to 87 to handle. ” 6/7/2007 email from Mr. Egol to Mr. Sparks GS MBS-E-003375593. Since Abacus was only one of four Goldman CDOs in which the Bear Stearns funds held positions, Mr. Swenson emailed Mr. Lehman recommending further markdowns: Mr. Swenson: I am on the same page [as] egol we n[e]ed to mark him [Ralph Cioffi, Portfolio Manager of the Bear Stearns funds] CHRG-111shrg56376--122 PREPARED STATEMENT OF JOHN C. DUGAN Comptroller of the Currency, Office of the Comptroller of the Currency August 4, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate this opportunity to discuss the modernization of financial services regulation in the context of the Administration's Proposal for regulatory reform. \1\ The events of the last 2 years--including the unprecedented distress and failure of financial firms, the accumulation of toxic subprime mortgage assets in our financial system, and the steep rise in foreclosures--have exposed gaps and weaknesses in our regulatory framework. The Proposal put forward by the Treasury Department for strengthening that framework is thoughtful and comprehensive, and I support many of its proposed reforms. But I also have significant concerns with two parts of it, i.e., (1) the proposed broad authority of the Federal Reserve, as systemic risk regulator, to override authority of the primary prudential banking supervisor; and (2) the elimination of uniform national consumer protection standards for national banks in connection with establishing the newly proposed Consumer Financial Protection Agency (CFPA), and the transfer of all existing consumer protection examination and enforcement from the Federal banking agencies to the new CFPA. Both concerns relate to the way in which important new authorities would interact with the essential functions of the dedicated prudential banking supervisor.--------------------------------------------------------------------------- \1\ See, U.S. Department of the Treasury, ``Financial Regulatory Reform--A New Foundation: Rebuilding Financial Supervision and Regulation'' (June 2009) (the ``Proposal''), available at www.financialstability.gov/docs/regs/FinalReport.web.pdf. Treasury also has released legislative language to implement most components of the Proposal. That proposed legislation is available at www.treas.gov/initiatives/regulatoryreform.--------------------------------------------------------------------------- My testimony begins with a brief summary of the key parts of the Proposal we generally support. The second section focuses on the topics pertaining to regulatory structure on which the Committee has specifically invited our views; this portion includes a discussion of the Federal Reserve's role and authority. The last section addresses our second area of major concern--uniform national standards and the CFPA.I. Key Provisions Supported by the OCC We believe many of the Administration's proposed reforms will strengthen the financial system and help prevent future market disruptions of the type we witnessed last year, including the following: Establishment of a Financial Stability Oversight Council. This council would consist of the Secretary of the Treasury and all of the Federal financial regulators, and would be supported by a permanent staff. Its general role would be to identify and monitor systemic risk, and it would have strong authority to gather the information necessary for that mission, including from any entity that might pose 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. It also could provide a venue or mechanism for resolving differences of opinions among regulators. Enhanced authority to resolve systemically significant financial firms. The Federal Deposit Insurance Corporation (FDIC) currently has broad authority to resolve a distressed systemically significant depository institution in an orderly manner. No comparable resolution authority exists for large bank holding companies, or for systemically significant financial companies that are not banks, as we learned painfully with the problems of such large financial companies as Bear Stearns, Lehman Brothers, and AIG. The Proposal would extend resolution authority like the FDIC's to such nonbanking companies, while preserving the flexibility to use the FDIC or another regulator as the receiver or conservator, depending on the circumstances. This is a sound approach that would help maximize orderly resolutions of systemically significant firms. Strengthened regulation of systemically significant firms, including requirements for higher capital and stronger liquidity. We support the concept of imposing more stringent prudential standards on systemically significant financial firms to address their heightened risk to the system and to mitigate the competitive advantage they could realize from being designated as systemically significant. But these standards should not displace the standard-setting and supervisory responsibilities of the primary banking supervisor with respect to bank subsidiaries of these companies. And in those instances where the largest asset of the systemically significant firm is a bank--as may often be the case--the primary banking supervisor should have a strong role in helping to craft the new standards for the holding company. Changes in accounting standards that would allow banks to build larger loan loss reserves in good times to absorb more losses in bad times. One of the problems that has impaired banks' ability to absorb increased credit losses while continuing to provide appropriate levels of credit is that their levels of loan loss reserves available to absorb such losses were not as high as they should have been entering the crisis. One reason for this is the currently cramped accounting regime for building loan loss reserves, which is based on the concept that loan loss provisions are permissible only when losses are ``incurred.'' The Proposal calls for accounting standard setters to improve this standard to make it more forward looking so that banks could build bigger loan loss reserves when times are good and losses are low, in recognition of the fact that good times inevitably end, and large loan loss reserves will be needed to absorb increased losses when times turn bad. The OCC strongly supports this part of the Proposal. In fact, I cochaired an international task force under the auspices of the Financial Stability Board to achieve this very objective on a global basis, which we hope will contribute to stronger reserving policy both here and abroad. Enhanced consumer protection. The Proposal calls for enhanced consumer protection standards for consumer financial products through new rules that would be written and implemented by the new Consumer Financial Protection Agency. The OCC supports strong, uniform Federal consumer protection standards. While we generally do not have rulewriting authority in this area, we have consistently applied and enforced the rules written by the Federal Reserve (and others), and, in the absence of our own rulewriting authority, have taken strong enforcement actions to address unfair and deceptive practices by national banks. We believe that an independent agency like the CFPA could appropriately strengthen consumer protections, but we have serious concerns with the CFPA as proposed. We believe the goal of strong consumer protection can be accomplished better through CFPA rules that reflect meaningful input from the Federal banking agencies and are truly uniform, rather than resulting in a patchwork of different rules amended and enforced differently by individual States. We also believe that these rules should continue to be implemented by the Federal banking agencies for banks, under the existing, well- established regulatory and enforcement regime, and by the CFPA and the States for nonbank financial providers, which today are subject to different standards and far less actual oversight than federally regulated depository institutions. This is discussed in greater detail below. Stronger regulation of payments systems, hedge funds, and over-the-counter derivatives, such as credit default swaps. The Proposal calls for significant enhancements in regulation in each of these areas, which we generally support in concept. We will provide more detailed comments about each, as appropriate, once we have had more time to review the implementing legislative language.II. Regulatory Structure Issues1. Proposed Establishment of the National Bank Supervisor and Elimination of the Federal Thrift Charter In proposing to restructure the banking agencies, the Proposal appropriately preserves an agency whose only mission is banking supervision. This new agency, the National Bank Supervisor (NBS), would serve as the primary regulator of federally chartered depository institutions, including the national banks that comprise the dominant businesses of many of the largest financial holding companies. To achieve this goal, the Proposal would effectively merge the Office of Thrift Supervision (OTS) into the OCC. It would eliminate the Federal thrift charter--and also, as I will shortly discuss, the separate treatment of savings and loan holding companies--with all Federal thrifts required to convert to a national bank, a State bank, or a State thrift, over the course of a reasonable transition period. (State thrifts would then be treated as State ``banks'' under Federal law.) We believe this approach to the agency merger is preferable to one that would preserve the Federal thrift charter, with Federal thrift regulation being conducted by a division of the merged agency. With the same deposit insurance fund, same prudential regulator, same holding company regulator, same branching powers, and a narrower charter (a national bank has all the powers of a Federal thrift plus many others), there would no longer be a need for a separate Federal thrift charter. In addition, the approach in the Proposal avoids the considerable practical complexities and costs of administering two separate statutory and regulatory regimes that are largely redundant in many areas, and needlessly different in others. Finally, the legislation implementing this aspect of the Proposal should be unambiguously clear--as we believe is intended--that the new agency is independent from the Treasury Department and the Administration to the same extent that the OCC and OTS are currently independent. \2\--------------------------------------------------------------------------- \2\ For example, current law provides the OCC with important independence from political interference in decision making in matters before the Comptroller, including enforcement proceedings; provides for funding independent of political control; enables the OCC to propose and promulgate regulations without approval by the Treasury; and permits the agency to testify before Congress without the need for the Administration's clearance of the agency's statements.---------------------------------------------------------------------------2. Enhancement of the Federal Reserve's Supervision of Systemically Significant Financial Holding Companies The Federal Reserve Board already has strong authority as consolidated supervisor to identify and address problems at large, systemically significant bank holding companies. In the financial crisis of the last 2 years, the absence of a comparable authority with respect to large securities firms, insurance companies, and Government-sponsored enterprises that were not affiliated with banks proved to be an enormous problem, as a disproportionate share of the financial stress in the markets was created by these institutions. The lack of a consistent and coherent regulatory regime applicable to them by a single regulator helped mask problems in these nonbanking companies until they were massive. And gaps in the regulatory regime constrained the Government's ability to deal with them once they emerged. The Proposal would extend the Federal Reserve's consolidated bank holding company regulation to systemically significant nonbanking companies in the future, which would appropriately address the regulatory gap. However, as discussed below, one aspect of this part of the proposal goes too far, i.e., the new Federal Reserve authority to ``override'' key functions of the primary banking supervisor, which would undermine the authority--and the accountability--of the banking supervisor for the soundness of the banks that anchor systemically significant holding companies.3. Elimination of the Thrift Holding Company and Industrial Loan Company Exceptions to Bank Holding Company Act Regulation Under the law today, companies that own thrifts or industrial loan companies (ILCs) are exempt from regulation under the Bank Holding Company Act. The Proposal would eliminate these exemptions, making these types of firms subject to supervision by the Federal Reserve Board. Thrift holding companies, unlike bank holding companies, are not subject to consolidated regulation; for example, no consolidated capital requirements apply at the holding company level. This difference between bank and thrift holding company regulation created arbitrage opportunities for companies that were able to take on greater risk under a less rigorous regulatory regime. Yet, as we have seen - AIG is the obvious example--large nonbank firms can present similar risks to the system as large banks. This regulatory gap should be closed, and these firms should be subject to the same type of oversight as bank holding companies. Companies controlling ILCs also are not subject to bank holding company regulation, but admittedly, ILCs have not been the source of the same kinds of problems as thrift holding companies. For that reason, it may be appropriate to continue to exempt small ILCs from bank holding company regulation. If this approach were pursued, the exemption should terminate once the ILC exceeds a certain size threshold, however, because the same potential risks can arise as with banks. Alternatively, if the ILC exemption were repealed altogether, appropriate grandfathering of existing ILCs and their parent companies should be considered.4. The Merits of Further Regulatory Consolidation It is clear that the United States has too many bank regulators. We have four Federal bank regulators, 12 Federal Reserve Banks, and 50 State regulators, nearly all of which have some type of overlapping supervisory responsibilities. This system is largely the product of historical evolution, with different agencies created for different legitimate purposes reflecting a much more segmented financial system from the past. No one would design such a system from scratch, and it is fair to say that, at times, it has not been the most efficient way to establish banking policy or supervise banks. Nevertheless, the banking agencies have worked hard over the years to make the system function appropriately despite its complexities. On many occasions, the diversity in perspectives and specialization of roles has provided real value. And from the agencies has been a primary driver of recent problems in the banking system. That said, I recognize the considerable interest in reducing the number of bank regulators. The impulse to simplify is understandable, and it may well be appropriate to streamline our current system. But we ought not approach the task by prejudging the appropriate number of boxes on the organization chart. The better approach is to determine what would be achieved if the number of regulators were reduced. What went wrong in the current crisis that changes in regulatory structure (rather than regulatory standards) will fix? Will accountability be enhanced? Will the change result in greater efficiency and consistency of regulation? Will gaps be closed so that opportunities for regulatory arbitrage in the current system are eliminated? Will overall market regulation be improved? In testimony provided earlier this year, I strongly urged that Congress, in reforming financial services regulation, preserve a robust, independent bank supervisor that is solely dedicated to the prudential oversight of depository institutions. Banks are the anchor of most financial holding companies, including the very largest, and I continue to believe that the benefits of dedicated, strong prudential supervision are significant--indeed, necessary. Dedicated supervision assures there is no confusion about the supervisor's goals and objectives, and no potential conflict with competing objectives. Responsibility is well defined, and so is accountability. Supervision takes a back seat to no other part of the organization, and the result is a strong culture that fosters the development of the type of seasoned supervisors that are needed to confront the many challenges arising from today's banking business. The strength of national banks at the core of many of the largest financial holding companies has been an essential anchor to the ability of those companies to weather recent financial crises--and to absorb distressed securities and thrift companies. While there is arguably an agreement on the need to reduce the number of bank regulators, there is no such consensus on what the right number is or what their roles should be. As I have mentioned, we support reducing the number of Federal banking regulators from four to three by effectively merging the OTS into the OCC, leaving just one Federal regulator for federally chartered banks. There are reasonable arguments for streamlining the regulatory structure even further, but there would be advantages and disadvantages at each step. For example, the number of banking regulators could be further reduced from three to two by creating a single Federal regulator for State-chartered banks, whose Federal supervision is now divided between the Federal Reserve Board and the FDIC, depending on whether the State bank is a member of the Federal Reserve System. Today there is virtually no difference in the regulation applicable to State banks at the Federal level based on membership in the System and thus no real reason to have two different Federal regulators. It would be simpler to have one. Opportunities for regulatory arbitrage--resulting, for example, from differences in the way Federal activities restrictions are administered by one or the other regulator--would be reduced. Policymaking would be streamlined. Fewer decision-makers would have to agree on the implementation of banking policies and restrictions that Congress has required to be carried out on a joint basis. On the other hand, whichever agency loses supervisory authority over State banks also would lose the day-to-day ``window'' into the condition of the banking industry that today informs the conduct of other aspects of its mission. This may present a greater problem for the FDIC, which would have much less engagement with the banking sector during periods with few bank failures, especially if the Federal Reserve retained holding company jurisdiction, an issue I discuss below. Still further consolidation could be achieved by reducing the number of bank regulators to one dedicated prudential supervisor. If this were done, the single Federal supervisor should be structured to be independent from the Treasury Department and headed by a board of directors, with the Chairmen of the FDIC and the Federal Reserve Board serving as board members. This is the simplest, and arguably the most logical, approach. It would afford the most direct accountability--there would be no confusion about which regulator was responsible for the Federal supervision of a bank--and it would end opportunities for regulatory arbitrage. Moreover, it could be done within the framework of the dual banking system by preserving both State and national charters. It would be desirable, however, for the single regulator to maintain separate divisions for the supervision of large and small institutions, given the differences in complexity and types of risk that banks of different sizes present. The disadvantages of such an approach include removing both the Federal Reserve and the FDIC from day-to-day bank supervision (although that concern would be mitigated for the Federal Reserve to the extent it retained holding company regulation). In addition, States may be concerned that the State charter would be significantly less attractive if the same Federal regulator supervised both State and Federal institutions, especially if State-chartered institutions were required to pay for Federal supervision in addition to the assessments charged by the State (although that issue could be addressed separately). Finally, the Committee has asked whether a consolidated prudential bank supervisor also could regulate the holding company. While this could be done, and has significant appeal with respect to small and ``bank-only'' holding companies, there would be significant issues involved with such an approach in the case of the largest companies where the challenges would be the greatest. Little need remains for separate holding company regulation where the bank is small or where it is the holding company's only, or dominant, asset. (The previously significant role of the Federal Reserve, as holding company supervisor, in approving new activities was dramatically reduced by the provisions in the Gramm-Leach-Bliley Act that authorized financial holding companies and specifically identified and approved in advance the types of activities in which they could engage.) For these firms, the holding company regulator's other authorities are not necessary to ensure effective prudential supervision to the extent that they duplicate the Federal prudential supervisor's authority to set standards, examine, and take appropriate enforcement action with respect to the bank. Elimination of a separate holding company regulator thus would eliminate duplication, promote simplicity and accountability, and reduce unnecessary compliance burden for institutions as well. The case is harder and more challenging for the very largest bank holding companies engaged in complex capital markets activities, especially where the company is engaged in many, or predominantly, nonbanking activities, such as securities and insurance. Given its substantial role and direct experience with respect to capital markets, payments systems, the discount window, and international central banking, the Federal Reserve Board provides unique resources and perspective to supervision. Eliminating the Board as holding company regulator would mean losing the direct effect of that expertise. The benefits of the different perspectives of holding company regulator and prudential regulator would be lost. The focus of a dedicated, strong prudential banking supervisor could be significantly diluted by extending its focus to nonbanking activities. It also would take time for the consolidated banking supervisor to acquire and maintain a comparable level of expertise, especially in nonbanking activities.5. Delineation of Responsibilities Between the Systemic Supervisor and Prudential Supervisor If, as under the Administration's Proposal, the Board is the systemic holding company supervisor, then it is essential that clear lines be drawn between the Board's authority and the authority of the prudential banking supervisor. As I will explain, the Proposal goes too far in authorizing the systemic supervisor to override the prudential supervisor's role and authorities. The Proposal would establish the Federal Reserve Board as the systemic supervisor by providing it with enhanced, consolidated authority over a ``Tier 1'' financial holding company--that is, a company that poses significant systemic risk--and all of its subsidiaries. In essence, this structure builds on and expands the current system for supervising bank holding companies, where the Board already has consolidated authority over the company, and the prudential bank supervisor is responsible for direct bank supervision. In practice, many of the companies likely to be designated as Tier 1 financial holding companies will have at their heart very large banks, many of which are national banks. Because of their core role as financial intermediaries, large banks have extensive ties to the ``Federal safety net'' of deposit insurance, the discount window, and the payments system. Accordingly, the responsibility of the prudential bank supervisor must be to ensure that the bank remains a strong anchor within the company as a whole. Indeed, this is our existing responsibility at the OCC, which we take very seriously through our continuous on-site supervision by large teams of resident examiners in all of our largest national banks. As a result, the bank is by far the most intensively regulated part of the largest bank holding companies, which has translated into generally lower levels of losses of banks within the holding company versus other companies owned by that holding company--including those large bank holding companies that have sustained the greatest losses. In the context of regulatory restructuring for systemically significant bank holding companies, preserving the essential role of the prudential supervisor of the bank means that its relationship with the systemic supervisor should be complementary; it should not be subsumed or overtaken by the systemic supervisor. Conflating the two roles undermines the bank supervisor's authority, responsibility, and accountability. Moreover, it would impose major new responsibilities on and further stretch the role of the Board. Parts of the Proposal are consistent with this type of complementary relationship between the Board and the prudential bank supervisor. For example, the Board would be required to rely, as far as possible, on the reports of examination prepared by the prudential bank supervisors. This approach reflects the practical relationship that the OCC has with the Board today, a relationship that works, in part because the lines of authority between the two regulators are appropriately defined. And it has allowed the Board to use and rely on our work to perform its role as supervisor for complex banking organizations that are often involved in many businesses other than banking. It is a model well suited for use in a new regulatory framework where the Board assumes substantial new responsibilities, including potential authority over some Tier 1 companies that do not have bank subsidiaries at all. In one crucial respect, however, the Proposal departs dramatically from that model and is not consistent with its own stated objective of maintaining a robust, responsible, and independent prudential supervisor that will be accountable for its safety and soundness supervision. That is, the Proposal provides the Board with authority to establish, examine, and enforce more stringent standards with respect to the ``functionally regulated'' subsidiaries of Tier 1 financial holding companies--which under the proposal would include bank subsidiaries--in order to mitigate systemic risk posed by those subsidiaries. This open-ended authorization would allow the Board to impose customized requirements on virtually any aspect of the bank's operations at any time, subject only to a requirement for ``consultation'' with the Secretary of the Treasury and the bank's primary Federal or State supervisor. This approach is entirely unnecessary and unwarranted in the case of banks already subject to extensive regulation. It would fundamentally alter the relationship between the Board and the bank supervisor by superseding the bank supervisor's authority over bank subsidiaries of systemically significant companies, and would be yet another measure that concentrates more authority in, and stretches the role of, the Board. In addition, while the Proposal centralizes in the Board more authority over Tier 1 financial holding companies, it does not address the current, significant gap in supervision that exists within bank holding companies. In today's regulatory regime, a bank holding company may engage in a particular banking activity, such as mortgage lending, either through a subsidiary that is a bank or through a subsidiary that is not a bank. If engaged in by the banking subsidiary, the activity is subject to required examination and supervision on a periodic basis by the primary banking supervisor. However, if it is engaged in by a nonbanking subsidiary, it is potentially subject to examination by the Federal Reserve, but regular supervision and examination is not required. As a policy matter, the Federal Reserve had previously elected not to subject such nonbanking subsidiaries to full bank-like examination and supervision on the theory that such activities would inappropriately extend ``the safety net'' of Federal protections from banks to nonbanks. \3\ The result has been the application of uneven standards to bank and nonbank subsidiaries of bank holding companies. For example, in the area of mortgage lending, banks were held to more rigorous underwriting and consumer compliance standards than nonbank affiliates in the same holding company. While the Board has recently indicated its intent to increase examination of nonbank affiliates, it is not clear that such examinations will be required to be as regular or extensive as the examination of the same activities conducted in banks.--------------------------------------------------------------------------- \3\ See, e.g., Chairman Alan Greenspan, ``Insurance Companies and Banks Under the New Regulatory Law'', Remarks Before the Annual Meeting of the American Council of Life Insurance (November 14, 1999) (``The Gramm-Leach-Bliley Act is designed to limit extensions of the safety net, and thus to eliminate the need to impose banklike regulation on nonbank subsidiaries and affiliates of organizations that contain a bank.''), available at www.federalreserve.gov/boarddocs/speeches/1999/19991115.htm.--------------------------------------------------------------------------- I believe that such differential regulation and supervision of the same activity conducted in different subsidiaries of a single bank holding company--whether in terms of safety and soundness or consumer protection--doesn't make sense and is an invitation to regulatory arbitrage. Indeed, leveling the supervision of all subsidiaries of a bank holding company takes on added importance for a ``Tier 1'' financial holding company because, by definition, the firm as a whole presents systemically significant risk. One way to address this problem would be to include in legislative language an explicit direction to the Board to actively supervise nonbanking subsidiaries engaged in banking activities in the same way that a banking subsidiary is supervised by the prudential supervisor, with required regular exams. Of course, adding new required responsibilities for the direct supervision of more companies may serve as a distraction both from the Board's other new assignments under the Proposal as well as the continuation of its existing responsibilities. An alternative approach that may be preferable would be to assign responsibility to the prudential banking supervisor for supervising certain nonbank holding company subsidiaries. In particular, where those subsidiaries are engaged in the same business as is conducted, or could be conducted, by an affiliated bank--mortgage or other consumer lending, for example--the prudential supervisor already has the resources and expertise needed to examine the activity. Affiliated companies would then be made subject to the same standards and examined with the same frequency as the affiliated bank. This approach also would ensure that the placement of an activity in a holding company structure could not be used to arbitrage between different supervisory regimes or approaches.III. The Proposed Consumer Financial Protection Agency and the Elimination of Uniform National Standards for National Banks Today's severe consumer credit problems can be traced to the multiyear policy of easy money and easy credit that led to an asset bubble, with too many people getting loans that could not be repaid when the bubble burst. With respect to these loans--especially mortgages--the core problem was lax underwriting that relied too heavily on rising house prices. Inadequate consumer protections--such as inadequate and ineffective disclosures--contributed to this problem, because in many cases consumers did not understand the significant risks of complex loans that had seductively low initial monthly payments. Both aspects of the problem--lax underwriting and inadequate consumer protections--were especially acute in loans made by nonbank lenders that were not subject to Federal regulation. \4\--------------------------------------------------------------------------- \4\ Some have suggested that the Community Reinvestment Act (CRA) caused the subprime lending crisis. That is simply not true. As the Administration's Proposal expressly recognizes, and as I have testified before, far fewer problem mortgages were made by institutions subject to CRA--that is, federally regulated depository institutions--than were made by mortgage brokers and originators that were not depository institutions. The Treasury Proposal specifically notes that CRA-covered depository institutions made only 6 percent of recent higher-priced mortgages provided to lower-income borrowers or in areas that are the focus of CRA evaluations. Proposal, supra, note 1, at 69-70. Moreover, our experience with the limited portion of subprime loans made by national banks is that they are performing better than nonbank subprime loans. This belies any suggestion that the banking system, and national banks in particular, were any sort of haven for abusive lending practices.--------------------------------------------------------------------------- In terms of changes to financial consumer protection regulation, legislation should be targeted to the two types of fundamental gaps that fueled the current mortgage crisis. The first gap relates to consumer protection rules themselves, which were written under a patchwork of authorities scattered among different agencies; were in some cases not sufficiently robust or timely; and importantly, were not applied to all financial services providers, bank or nonbank, uniformly. The second gap relates to implementation of consumer protection rules, where there was no effective mechanism or framework to ensure that nonbank financial institutions complied with rules to the same extent as regulated banks. That is, the so-called ``shadow banking system'' of nonbank firms, such as finance companies and mortgage brokers, provides products comparable to those provided by banks, but is not subject to comparable oversight. This shadow banking system has been widely recognized as central to the most abusive subprime lending that fueled the mortgage crisis. A new Consumer Financial Protection Agency could be one mechanism to target both the rulewriting gap and the implementation gap. In terms of the rulewriting gap, all existing consumer financial protection authority could be centralized in the CFPA and strengthened as Congress sees fit, and that authority could be applied to all providers of a particular type of financial product with rules that are uniform. In terms of the implementation gap, the CFPA could be focused on supervision and/or enforcement mechanisms that raise consumer protection compliance for nonbank financial providers to a similar level as exists for banks--but without diminishing the existing regime for bank compliance. And in both cases, the CFPA could be structured to recognize legitimate bank safety and soundness concerns that in some cases are inextricably intertwined with consumer protection--as is the case with underwriting standards. Unfortunately, the Proposal's CFPA falls short in addressing these two fundamental consumer protection regulatory gaps. Let me address each in turn.1. Rulewritinga. Lack of Uniform Rules and National Bank Preemption--To address the rulewriting gap, the Proposal's CFPA provides a mechanism for centralized authority and stronger rules that could be applied to all providers of financial products. But the rules would not be uniform; that is, because the Proposal authorizes States to adopt different rules, there could be 50 different standards that apply to providers of a particular product or service, including national banks. A core principle of the Proposal is its recognition that consumers benefit from uniform rules. \5\ Yet this very principle is expressly undermined by the specific grant of authority to States to adopt different rules; by the repeal of uniform standards for national banks; and by the empowerment of individual States, with their very differing points of view, to enforce Federal consumer protection rules--under all Federal statutes--in ways that might vary from State to State. In effect, the resulting patchwork of Federal-plus-differing-State standards would effectively distort and displace the Federal agency's rulemaking, even though the CFPA's rule would be the product of an open public comment process and the behavioral research and evaluative functions that the Proposal highlights.--------------------------------------------------------------------------- \5\ See, e.g., Proposal, supra note 1, at 69 (discussing the proposed CFPA, observing that ``[f]airness, effective competition, and efficient markets require consistent regulatory treatment for similar products,'' and noting that consistent regulation facilitates consumers' comparison shopping); and at 39 (discussing the history of insurance regulation by the States, which ``has led to a lack of uniformity and reduced competition across State and international boundaries, resulting in inefficiency, reduced product innovation, and higher costs to consumers.'').--------------------------------------------------------------------------- In particular, for the first time in the nearly 150-year history of the national banking system, federally chartered banks would be subject to this multiplicity of State operating standards, because the Proposal sweepingly repeals the ability of national banks to conduct any retail banking business under uniform national standards. This is a profound change and, in my view, the rejection of a national standards option is unwise and unjustified, especially as it relates to national banks. Given the CFPA's enhanced authority and mandate to write stronger consumer protection rules, and the thorough and expert processes described as integral to its rulemaking, there should no longer be any issue as to whether sufficiently strong Federal consumer protection standards would be in place and applicable to national banks. In this context there is no need to authorize States to adopt different standards for such banks. Likewise, there is no need to authorize States to enforce Federal rules against national banks--which would inevitably result in differing State interpretations of Federal rules--because Federal regulators already have broad enforcement authority over such institutions and the resources to exercise that authority fully. More fundamentally, we live in an era where the market for financial products and services is often national in scope. Advances in technology, including the Internet and the increased functionality of mobile phones, enable banks to do business with customers in many States. Our population is increasingly mobile, and many people live in one State and work in another--the case for many of us in the Washington, DC, metropolitan area. In this context, regressing to a regulatory regime that fails to recognize the way retail financial services are now provided, and the need for an option for a single set of rules for banks with multistate operations and multistate customers, would discard many of the benefits consumers reap from our modern financial product delivery system. The Proposal's balkanized approach could give rise to significant uncertainty about which sets of standards apply to institutions conducting a multistate business, generating major legal and compliance costs, and major impediments to interstate product delivery. This issue is very real for all banks operating across State lines--not just national banks. Recognizing the importance of preserving uniform interstate standards for all banks operating in multiple States, Congress expressly provided in the ``Riegle-Neal II'' Act enacted in 1997 that State banks operating through interstate branches in multiple States should enjoy the same Federal preemption and ability to operate with uniform standards as national banks. \6\--------------------------------------------------------------------------- \6\ 12 U.S.C. 1831a(j); See, also id. at 1831d (interest rates; parity for State banks).--------------------------------------------------------------------------- Accordingly, repealing the uniform standards option would create fundamental, practical problems for all banks operating across State lines, large or small. For example, there are a number of areas in which complying with different standards set by individual States would require a bank to determine which State's law governs--the law of the State where a person providing a product or service is located, the law of the home State of the bank employing that person, or the law of the State where the customer is located. It is far from clear how a bank could do this based on objective analysis, and any conflicts could result in penalties and litigation in multiple jurisdictions. Consider the following practical examples of the potential for multiple State standards: Different rules regarding allowable terms and conditions of particular products; Different standards for how products may be solicited and sold (including the internal organizational structure of the provider selling the product); Different duties and responsibilities for individuals providing a particular financial product; Different limitations on how individuals offering particular products and services may be compensated; Different standards for counterparty and assignee liability in connection with specified products; Different standards for risk retention (``skin in the game'') by parties in a chain of origination and sale; Different disclosure standards; Different requirements, or permissible rates of interest, for bank products; and Different licensing and product clearance requirements. Taking permissible interest rates as an example, today the maximum permissible interest rate is derived from the bank's home State. Under the proposal, States could claim that the permissible rate should be the rate of the State in which the customer resides, or the rate of the location where the loan is made, or someplace else. States could also have different rules about the types of charges that constitute ``interest'' subject to State limits. And States could have different standards for exerting jurisdiction over interest rates, creating the potential for the laws of two or more States to apply to the same transaction. And even if the bank figures all this out for a particular customer, and for all the product relationships it has with the customer, that could all change if the customer moved. Does that mean the customer would have to open a new account to incorporate the new required terms? Such uncertainties have the real potential to confuse consumers, subject providers to major new potential liabilities, and significantly increase the costs of doing business in ways that will be passed on to consumers. It could also cause product providers to pull back where increased costs erase an already thin profit margin--for example, with ``indirect'' auto lending across State lines--or where they see unacceptable levels of uncertainty and potential risk. Moreover, a bank with multistate operations might well decide that the only sensible way to conduct a national business is to operate to the most stringent standard prevailing in its most significant State market. It should not be the case that a decision by one State legislature about how products should be designed, marketed, or sold should effectively replace a national regulatory standard established by the Federal Government based on thorough research and an open and nationwide public comment process. Finally, subjecting national banks to state laws and state enforcement of Federal laws is a potentially crippling change to the national bank charter and a rejection of core principles that form the bedrock of the dual banking system. For nearly 150 years, national banks have been subject to a uniform set of Federal rules enforced by the OCC, and State banks have been subject to their own States' rules. This dual banking system has worked, as it has allowed an individual State to serve as a ``laboratory'' for new approaches to an issue--without compelling adoption of a particular approach by all States or as a national standard. That is, the dual banking system is built on individual States experimenting with different kinds of laws, including new consumer protection laws, that apply to State banks in a given State, but not to State banks in all States and not to national banks. Some of these individual State laws have proven to be good ideas, while others have not. When Congress has believed that a particular State's experiment is worthwhile, it has enacted that approach to apply throughout the country, not only to all national banks, but to State banks operating in other States that have not yet adopted such laws. As a result of this system, national banks have always operated under an evolving set of Federal rules that are at any one time the same, regardless of the State in which the banks are headquartered, or the number of different States in which they operate. This reliable set of uniform Federal rules is a defining characteristic of the national bank charter, helping banks to provide a broader range of financial products and services at lower cost, which in turn can be passed along to the consumer. The Proposal's CFPA, by needlessly eliminating this defining characteristic, will effectively ``de-nationalize'' the national charter and undermine the dual banking system. What will be the point of a national charter if all banks must operate in every State as if they were chartered in that State? In such circumstances there would be a strong impetus to convert to a State bank regulated by the Federal Reserve in order to obtain the same regulator for the bank and the holding company, while avoiding any additional cost associated with national bank supervision--and that would further concentrate responsibilities in, and stretch the mission of, the Federal Reserve. In short, with many consumer financial products now commoditized and marketed nationally, it is difficult to understand the sense of replacing the existing, long-standing option of enhanced and reliable Federal standards that are uniform, with a balkanized ``system'' of differing State standards that may be adopted under processes very different from the public-comment and research-based rulemaking process that the CFPA would employ as a Federal agency.b. Safety and Soundness Implications of CFPA Rulemaking--The Proposal would vest all consumer protection rulewriting authority in the CFPA, which in turn would not be constrained in any meaningful way by safety and soundness concerns. That presents serious issues because, in critical aspects of bank supervision, such as underwriting standards, consumer protection cannot be separated from safety and soundness. They are both part of comprehensive and effective banking supervision. Despite this integral relationship, the Proposal as drafted would allow the CFPA, in writing rules, to dismiss legitimate safety and soundness concerns raised by a banking supervisor. That is, if a particular CFPA rule conflicts with a safety and soundness standard, the CFPA's views would always prevail, because the legislation provides no mechanism for striking an appropriate balance between consumer protection and safety and soundness objectives. For example, the CFPA could require a lender to offer a standardized mortgage that has simple terms, but also has a low down payment to make it more beneficial to consumers. That type of rule could clearly raise safety and soundness concerns, because lower down payments are correlated with increased defaults on loans--yet a safety and soundness supervisor would have no ability to stop such a rule from being issued. In short, as applied to depository institutions, the CFPA rules need to have meaningful input from banking supervisors--both for safety and soundness purposes and because bank supervisors are intimately familiar with bank operations and can help ensure that rules are crafted to be practical and workable. A workable mechanism needs to be specifically provided to incorporate legitimate operational and safety and soundness concerns of the banking agencies into any final rule that would be applicable to insured depository institutions. Moreover, I do not believe it is sufficient to have only one banking supervisor on the agency's board, as provided under the Proposal; instead, all the banking agencies should be represented, even if that requires expanding the size of the board.2. Implementation: Supervision, Examination, and Enforcement Consumer protection rules are implemented through examination, supervision, and/or enforcement. In this context, the Proposal fails to adequately address the implementation gap I have previously described because it fails to carefully and appropriately target the CFPA's examination, supervision, and enforcement jurisdiction to the literally tens of thousands of nondepository institution financial providers that are either unregulated or very lightly regulated. These are the firms most in need of enhanced consumer protection regulation, and these are the ones that will present the greatest implementation challenges to the CFPA. Yet rather than focus the CFPA's implementation responsibilities on these firms, the Proposal would effectively dilute both the CFPA's and the States' supervisory and enforcement authorities by extending them to already regulated banks. To do this, the Proposal would strip away all consumer compliance examination and supervisory responsibilities--and for all practical purposes enforcement powers as well--from the Federal banking agencies and transfer them to the CFPA. And, although the legislation is unclear about the new agency's responsibilities for receiving and responding to consumer complaints, it would either remove or duplicate the process for receiving and responding to complaints by consumers about their banks. The likely results will be that: (1) nonbank financial providers will not receive the degree of examination, supervision, and enforcement attention required to achieve effective compliance with consumer protection rules; and (2) consumer protection supervision of banks will become less rigorous and less effective. In relative terms, it will be easy for the CFPA to adopt consumer protection rules that apply to all providers of financial products and services. But it will be far harder to craft a workable supervisory and enforcement regime to achieve effective implementation of those rules. In particular, it will be a daunting challenge to implement rules with respect to the wide variety and huge number of unregulated or lightly regulated providers of financial services over which the new CFPA would have jurisdiction, i.e., mortgage brokers; mortgage originators; payday lenders; money service transmitters; check cashers; real estate appraisers; title, credit, and mortgage insurance companies; credit reporting agencies; stored value providers; financial data processing, transmission, and storage firms; debt collection firms; investment advisers not subject to SEC regulation; financial advisors; and credit counseling and tax preparation services, among other types of firms. Likewise, it will be daunting to respond to complaints from consumers about these types of firms. Yet, although the Proposal would give the CFPA broad consumer protection authority over these types of financial product and service providers, it contains no framework or detail for examining them or requiring reports from them--or even knowing who they are. No functions are specified for the CFPA to monitor or examine even the largest of these nonbank firms, much less to supervise and examine them as depository institutions would be when they engaged in the same activities. No provision is even made for registration with the CFPA so that the CFPA could at least know the number and size of firms for which it has supervisory, examination, and enforcement responsibilities. Nor is any means specified for the CFPA to learn this information so that it may equitably assess the costs of its operations--and lacking that, there is a very real concern that assessments will be concentrated on already regulated banks, for which size and operational information is already available. In short, the CFPA has a full-time job ahead to supervise, examine, and take enforcement actions against nonbank firms in order to effect their compliance with CFPA rules. In contrast, achieving effective compliance with such rules by banks is far more straightforward, since an extensive and effective supervisory and enforcement regime is already in place at the Federal banking agencies. It therefore makes compelling sense for the new CFPA to target its scarce implementation resources on the part of the industry that requires the most attention to raise its level of compliance--the shadow banking system--rather than also try to assume supervisory, examination, and enforcement functions with respect to depository institutions. Similarly, State consumer protection resources would be best focused on examining and enforcing consumer protection laws with respect to the nonbank financial firms that are unregulated or lightly regulated--and have been the disproportionate source of financial consumer protection problems. If States targeted their scarce resources in this way, and drew on new examination and enforcement resources of the CFPA that were also targeted in this way, the States could help achieve significantly increased compliance with consumer protection laws by nonbank financial firms. Unfortunately, rather than have this focus, the Proposal's CFPA would stretch the States' enforcement jurisdiction to federally chartered banks, which are already subject to an extensive examination and enforcement regime at the Federal level. We believe this dilution of their resources is unnecessary, and it will only make it more difficult to fill the implementation gap that currently exists in achieving effective compliance of nonbank firms with consumer protection rules. Finally, I firmly believe that, by transferring all consumer protection examination, supervision, and enforcement functions from the Federal banking agencies to the CFPA, the Proposal would create a supervisory system for banks that would be a less effective approach to consumer protection than the integrated approach to banking supervision that exists today. Safety and soundness is not divorced from consumer protection--they are two aspects of comprehensive bank supervision that are complementary. As evidence of this, attached to my testimony are summaries of our actual supervisory experience, drawn from supervisory letters and examination conclusion memoranda, which show the real life linkage between safety and soundness and consumer protection supervision. These summaries demonstrate that the results would be worse for consumers and the prudential supervision of these banks if bank examiners were not allowed to address both safety and soundness and consumer protection issues as part of their integrated supervision. Indeed, we believe that transferring bank examination and supervision authority to the CFPA will not result in more effective supervision of banks--or consumer protection--because the new agency will never have the same presence or knowledge about the institution. Our experience at the OCC has been that effective, integrated safety and soundness and compliance supervision grows from the detailed, core knowledge that our examiners develop and maintain about each bank's organizational structure, culture, business lines, products, services, customer base, and level of risk; this knowledge and expertise is cultivated through regular on-site examinations and contact with our community banks, and close, day-to-day focus on the activities of larger banks. An agency with a narrower focus, like that envisioned for the CFPA, would be less effective than a supervisor with a comprehensive grasp of the broader banking business.Conclusion The OCC appreciates the opportunity to testify on proposed regulatory reform, and we would be pleased to provide additional information as the Committee continues its consideration of this important Proposal. CHRG-111shrg53822--90 TBTF Clearly, we all want a financial and economic system in which those who take risks--whether they are large or small--to bear the full consequences of their actions if they are wrong, just as they are entitled to all of the rewards if they are successful. The policy challenge is how best to ensure this result. One way to prevent non-banking financial institutions from becoming TBTF is to impose limits on their size, measured by assets, indebtedness, counter-party risk exposures, or some combination of these factors. While, as we discuss further below, these measures are useful for establishing whether an institution should be presumptively treated as systemically important and thus subject to heightened regulatory scrutiny, it would be quite extraordinary and unprecedented to actually prevent such institutions from growing above a certain size limit. Putting aside the arbitrary nature of any limit, imposing one would establish perverse, and we believe, undesirable incentives that would undermine economy-wide growth. For one thing, any size limit would punish success, and thus discourage innovation. There are well-managed large financial institutions, such as JP Morgan, TIAA-CREF, Vanguard and Fidelity, to name a few. If the managers and shareholders of each of the institutions had been told in advance that beyond some limit the company could not grow, each of them would have stopped innovating and serving customers' needs well before reaching the limit. Employee morale also clearly would suffer, especially for those employees paid in stock or options, whose value would quite growing and indeed fall as companies reached their limit. These outcomes not only would ill serve consumers, but would discourage future entrepreneurs from reaching for the heights. Second, even though this crisis has demonstrated that the failure of large financial institutions can impose substantial costs on the rest of the financial system economists do not know with any degree of precision at what size these externalities outweigh the benefits of diversification and economies of scale that large institutions may achieve (and further, how these size levels likely vary by activity or industry). Accordingly, by essentially requiring large, growing companies to split themselves up beyond some point, policymakers would be arbitrarily sacrificing these economies. Nonetheless, there are steps short of an absolute size limitation that policymakers should consider to contain future TBTF problems. First, Congress could require regulators to establish a rebuttable presumption against financial institution mergers that result in a new institution above a certain size. Such a standard would provide stronger incentives, if not a requirement, that companies earn their growth organically. For reasons just indicated, we are not certain that economists yet have sufficient evidence to know with any precision at what size level such a presumption should be set, but the harms from limiting mergers beyond a size threshold would be less than imposing an absolute limit on internal growth. If Congress takes this approach, we recommend that it continue to require dual approval for mergers by both the antitrust authorities and the appropriate financial regulator (either the relevant supervisor for the firm, or a new systemic risk regulator, our preference). The reason for this is that while the antitrust enforcement agencies (the Department of Justice and the Federal Trade Commission) have well-defined and supportable numerical standards for assessing whether a merger in any industry poses an unacceptable risk of harming competition, they have no special expertise in making the financial decision with respect to the size at which an institution poses an undue systemic financial risk. This latter decision is more appropriate for the relevant financial regulator to make. A second suggestion about which we have even greater confidence is for Congress to require the appropriate financial regulator(s) to subject systemically important financial institutions to progressively tougher regulatory standards and scrutiny than their smaller counterparts. We provide greater detail below on how this might be done. The basic rationale for this is quite straightforward. Larger financial institutions, if they fail or encounter financial trouble, imperil the entire financial system. This externality must be offset somehow, and a different regulatory regime--one that entails progressively tougher capital and liquidity standards in particular--is the best way we know how to accomplish this. Third, even for large systemically important financial institutions, it is possible to retain at least some market discipline and thus to limit the need for Federal authorities to protect at least some creditors, which is what makes a large and/or highly interconnected financial firm ``too big to fail.'' The way to do this is to require as many SIFIs as possible (large hedge funds may be excepted because their limited partnership interests and/or debt are not publicly traded) to fund a certain minimum percentage of their assets by convertible unsecured long-term debt. Because the debt would be long-term it would not be susceptible to runs (as is true of short-term debt, which in a crisis may not be rolled over). Furthermore, if the debt must be converted to equity upon some pre-defined event--such as a government takeover of the institution (discussed below) or if the capital-to-asset ratio falls below some required minimum level--this would automatically provide an additional cushion of equity when it is most needed, while effectively requiring the debt holders to take a loss, which is essential for market discipline. The details of this arrangement should be left to the appropriate regulators (or the systemic risk regulator), but the development of the concept should be mandated by the Congress.Should SIFIs Be Broken Up? Even if financial institutions are not subjected to a size limit, a number of experts have urged that regulators begin seizing weak banks (and perhaps weak non-bank SIFIs), cleaning them up (by separating them into ``good'' and ``bad'' institutions), and then breaking up the pieces when returning them to private hands (through sale to a single acquirer or public offering). We address below the merits of adopting a bank-like resolution process for non-bank SIFIs. For the numerous practical reasons outlined by our Brookings colleague Doug Elliott, we also urge caution in having regulators seize full control of financial institutions unless it is clear that their capital shortfalls are significant and cannot be remedied through privately raised funds.\7\--------------------------------------------------------------------------- \7\ Elliot's discussions of the difficulties of even temporary nationalizations also appear on the Brookings website.--------------------------------------------------------------------------- However, where regulators lawfully assume control of a troubled important financial institution (bank or non-bank), we are sympathetic with having the FDIC (or any other agency charged with resolution) required to make reasonable efforts to break up the institution when returning it to private hands (through sale or public offering) if it is already deemed to be systemically important or to avoid selling it to another institution when the result will be to create a new systemically important financial institution, provided the resolution authority also has an ``out'' if there is no other reasonable alternative. The rationale for the proposed presumption should be clear: given the costs that taxpayers are already bearing for the failure of certain systemically important institutions in this crisis, why, if it is not necessary, allow more TBTF problems to be created or aggravated by future financial mergers? Congress should recognize, however, that in limiting the sale of troubled financial institutions, it may make some resolutions more expensive than they otherwise be, at least in the short run. Subject to the qualification we next set out, this is an acceptable outcome, in our view, since measures that avoid making the TBTF problem worse have long-run benefits to taxpayers and to society. There must be escape clause, however. The Treasury, the Federal Reserve Board and the appropriate regulator may believe that the functions of the failing (or failed) institution are so intertwined or inseparable, and/or that its purchase by a single entity in a very short period of time--as in the case of Bank of America's acquisition of Merrill Lynch or JP Morgan's purchase of Bear Stearns--is so essential to the health of the overall financial system that disposition of the institution in pieces is impractical or substantially more costly (as measured by the amount of government financing required) than other alternatives. Such a ``systemic risk exception'' should be very narrowly drawn, and conceivably require the approval of all of the regulatory entities just mentioned. We should note, however, that if Congress also creates a bank-like resolution process for non-bank SIFIs, the systemic risk situation we describe truly should be exceedingly rare. Once regulators have the authority to put a non-bank SIFI into receivership and to guarantee against loss such creditors as are necessary to preserve overall financial stability, then regulators should not be forced by the pressure of time to sell the entity in one piece. Of course, it still may be the case that the activities of the institution are sufficiently inseparable that it would be impractical or highly costly for the resolving authority to break up the firm in the disposition process. If that is the case, then the regulators should have the ability to sell off the institution in one piece. One other practical issue must also be addressed. There must be some way for the resolving authority to identify the circumstances under which the resolution of a troubled institution would create or aggravate the TBTF problem. One way to do this is to require an appropriate regulator (a topic we discuss shortly) to designate in advance certain financial institutions as being systemically important (and thus subject to a tougher regulatory scrutiny). Alternatively, the resolution authority could make this determination at the time, in consultation with the Federal Reserve and/or the Treasury, or with the designated systemic risk regulator. In either case, the resolution authority must still be able to determine if a particular sale might create a new systemically important institution.Regulating SIFIs If SIFIs are not to be broken up (outside of temporary government takeover) or subjected to an absolute size constraint, then it is clear that they must be subject to more exacting regulatory scrutiny than other institutions. Otherwise, smaller financial institutions will be disadvantaged and the entire financial system and economy will be put at undue risk. That is perhaps one of the clearest lessons from this current crisis. We recognize, however, that establishing an appropriate regulatory regime for SIFIs is a very challenging assignment, and entails many difficult decisions. We review some of them now. Our overall advice is that because of the complexity of the task, as well as the constantly changing financial environment in which these institutions compete, that Congress avoid writing the details of the new regime into law. Instead, it would be far better, in our view, for Congress to establish the broad outlines of the new system, and then delegate the details to the appropriate regulator(s). First, the regulatory objective must be clear: We suggest that the primary purpose of any new regulatory regime for systemically important financial institutions should be to significantly reduce the sources of systemic risk or to minimize such risk to acceptable levels. The goal should not be to eliminate all systemic risk, since it is unrealistic to expect that result, and an effort to do so could severely dampen constructive innovation and socially useful activity. Second, if SIFIs are to be specially regulated, there must be criteria for identifying them. The Group of Thirty has suggested that the size, leverage and degree of interconnection with the rest of the financial system should be the deciding factors, and we agree.\8\ We also believe that whether an institution is deemed systemically important may depend on both general economic circumstances, as well as the conditions in a specific sector at the time. Some large institutions may not pose systemic risks if they fail if the economy is generally healthy or is experiencing only a modest downturn; but the same institution, threatened with failure, could be deemed systemically important under a different set of general economic or industry-specific conditions. This is just one reason why we counsel against the use of hard and fast numerical standards to determine whether an institution is systemically important. Another reason is that the use of numerical criteria alone could be easily gamed (institutions would do their best either to stay just under or over any threshold, whichever outcome it believes to be to its advantage). Accordingly, the regulator(s) should have some discretion in using these numerical standards, taking into account the general condition of the economy and/or the specific sector in which the institution competes. The ultimate test should be whether the combination of these factors signifies that the failure of the institution poses a significant risk to the stability of the financial system.--------------------------------------------------------------------------- \8\ Group of Thirty. ``Financial Reform: A Framework for Financial Stability'' (Washington D.C., Jan 2009) .--------------------------------------------------------------------------- As we discussed at the outset of our testimony, application of this test should result in some banks, insurers, clearinghouses and/or exchanges, and hedge funds as being systemically important (certain formerly independent investment banks that have since converted to bank holding companies or that are no longer operating as independent institutions also would have qualified, and conceivably could do so again). We doubt whether venture capital firms would qualify. Clearly, to the extent possible, the list of SIFIs should be compiled in advance, since otherwise there would no method of specially regulating them (some institutions that may be deemed systemically important only in the context of particular economy-wide or sector-specific conditions cannot be identified in advance, or may be so identified only when such conditions are present). A natural question then arises: should this list be made public? As a practical matter, we do not think one could avoid making it public. At a minimum, it would be apparent from the capital and liquidity positions reported in the firms' financial statements that the relevant institutions had been deemed by regulators to be systemically important. Meanwhile, the presence of more intensive regulatory oversight, coupled with a mandatory long-term debt requirement, both not applicable to smaller institutions, would counter the concern that public announcement of the firms on the list would somehow weaken market discipline or give the institutions access to lower cost funds than they might otherwise have. Institutions designated as systemically important should have some right to challenge, as well as the right to petition for removal of that status, if the situation warrants. For example, a hedge fund initially highly leveraged should be able to have its SIFI designation removed if the fund substantially reduces its size, leverage and counter-party risk. As this discussion implies, the process of designating or identifying institutions as systemically important must be a dynamic one, and will depend on the evolution of the financial service industry, the firms within in, and the future course of the economy. It is to be expected that some firms will be added to the list, while others are dropped, over time. In particular, regulators must be vigilant to include new variations of the ostensibly off-balance sheet structured investment vehicles (SIVs), which technically may have complied with existing accounting rules regarding consolidation, but which functionally always were the creations and obligations of their bank sponsors. Regulators should take a functional approach toward such entities in the future for purposes of determining whether an institution is systemically important. If the firm's affiliates or partners in any way could require rescue by other institutions, then that prospect should be considered when assessing the size, leverage, and financial interconnection of the firm. Third, the nature of regulation should depend on the activity of the institutions. For financial intermediaries, such as banks and insurance companies, and clearinghouses or exchanges, which are considered to be systemically important, the main regulatory tools should be higher capital, liquidity and risk management standards than those that apply to smaller institutions. It is to be expected that these standards will differ by type of institution. Furthermore, the appropriate regulator(s) should consider making these standards progressively higher as the size of the SIFI increases, to reflect the likely increasing bailout risk that SIFIs pose to the rest of the financial system as they grow. Several more details about these standards also deserve mention. Capital standards, for SIFIs and other financial institutions, should be made less pro-cyclical, or even counter-cyclical. Another lesson from this crisis is that financial regulation should not unduly constrain lending in bad times and fail to curb it in booms. The way to learn this lesson, however, is not to leave too much discretion to regulators in raising or lowering capital (and possibly liquidity) standards in response to changes in economic conditions. If regulators have too much discretion about when to adjust capital standards, they may succumb to heavy pressures to relax them in bad times, and not to raise them when times are good. To avoid this problem, Congress should require the regulators to set in advance a clear set of standards for good times and bad (or, at a minimum, to specify a range for those standards, as the Group of Thirty has suggested). With respect to their oversight of an institution's risk management procedures, regulators must be more aggressive in the future in testing the reasonableness of the assumptions that are built into the risk models used by complex financial institutions. In addition, regulators should consider the structure of the executive compensation systems of SIFIs under their watch, paying particular attention to the degree to which compensation is tied to long-run, rather than short-run, performance of the institution. In the normal course of their supervisory activities, regulators should use their powers of persuasion, but should also have a ``club in the closet''--the authority to issue cease and desist orders--if necessary. For private investment vehicles, primarily or possibly only hedge funds, the appropriate regulatory regime is likely to differ from publicly traded financial intermediaries. Here, we would expect that the appropriate regulator, at a minimum, would have the authority to collect on a regular basis information about the size of the fund, its leverage, its exposure to specific counter-parties, and its trading strategies so that the supervisor can at least be alert to potential systemic risks from the simultaneous actions of many funds. We would expect that most of this information, with the exception of fund size and perhaps its leverage, would be confidential, to preserve the trade secrets of the funds. We would not expect the regulator to have authority to dictate counter-party exposures or trading strategies. However, where the authorities see that particular funds are excessively leveraged, or when considered in the aggregate their trading strategies may create excessive risks, the appropriate regulator should have the obligation to transmit that information to the banking regulators or the systemic risk regulator, which in turn should have the ability to constrain lending to particular funds or a set of funds. Fourth, ideally a single regulator should oversee and actively supervise all systemically important financial institutions (bank and non-bank). Splitting up this authority among the various functional regulators--such as the three bank regulators, the SEC (for securities firms), the CFTC, a merged SEC/CFTC or another relevant body (for derivatives clearinghouses), and a new Federal insurance regulator--runs a significant risk of regulatory duplication of effort, inconsistent rules, and possibly after-the-fact finger-pointing in the event of a future financial crisis. Likewise, vesting authority for systemic risk oversight in a committee of regulators--for example, the President's Working Group on Financial Markets--risks indecision and delay. The various functional regulators should be consulted by the systemic risk regulator. In addition, the systemic risk regulator should have automatic and regular access to information collected by the functional regulators. But, in our view, systemic risks are best overseen by a single agency.\9\--------------------------------------------------------------------------- \9\ We are aware that the Committee has not asked for views about which regulator should have this authority, but if asked, we would suggest either a single new Federal financial solvency regulator, or the Federal Reserve. For further details, see Testimony of Robert E. Litan before the Senate Committee on Homeland Security, March 4, 2009.--------------------------------------------------------------------------- If a single systemic risk regulator is designated, a question that must be considered is whether it, or the appropriate functional regulator, should actively supervise systemically important institutions. There are merits to either approach. However, on balance, we believe that the systemic risk regulator should have primary supervisory authority over SIFIs. There is much day-to-day learning that can come from regular supervision that could be useful to the systemic risk regulator in a crisis, when there is no room for delay or error. In addition to overseeing or at least setting supervisory standards for SIFIs, the systemic risk regulator should be required to issue regular (annual or perhaps more frequent, or as the occasion arises) reports outlining the nature and severity of any systemic risks in the financial system. Such reports would put a spotlight on, among other things, rapidly growing areas of finance, since rapid growth in particular asset classes tends to be associated (but not always) with future problems. These reports should be of use to both other regulators and the Congress in heading off potential future problems. A legitimate objection to early warnings is that policymakers will ignore them. In particular, the case can be made that had warnings about the housing market overheating been issued by the Fed and/or other financial regulators during the past decade, few would have paid attention. Moreover, the political forces behind the growth of subprime mortgages--the banks, the once independent investment banks, mortgage brokers, and everyone else who was making money off subprime originations and securitizations--could well have stopped any counter-measures dead in their tracks. This recounting of history might or might not be right. But the answer should not matter. The world has changed with this crisis. For the foreseeable future, perhaps for several decades or as long as those who have lived and suffered through recent events are still alive and have an important voice in policymaking, the vivid memories of these events and their consequences will give a future systemic risk regulator (and all other regulators) much more authority when warning the Congress and the public of future asset bubbles or sources of undue systemic risk. Fifth, Congress should assign regulatory responsibilities for overseeing derivatives that are currently traded ``over-the-counter'' rather than on exchanges. As has been much discussed, regulators already are moving to authorize the creation of clearinghouses for credit default swaps, which should reduce the systemic risks associated with standardized CDS. But these clearinghouses must still be regulated for capital adequacy and liquidity, either by specific functional regulators or by the systemic risk regulator. Yet even well-capitalized and supervised central clearinghouses for CDS and possibly other derivatives will not reduce systemic risks posed by customized derivatives whose trades are not easily cleared by a central party (which cannot efficiently gather and process as much information about the risks of non-payment as the parties themselves). Congress should enable an appropriate regulator to set minimum capital and/or collateral rules for sellers of these contracts. At a minimum, more detailed reporting to the regulator by the participants in these customized markets should be required. Finally, while there are legitimate concerns about the efficacy of financial regulation, we believe that these should not deter policymakers from implementing and then overseeing a special regulatory system for systemically important financial institutions. We recognize, of course, that financial regulators did not adequately control the risks that led to the current crisis. But that does not mean that we should simply give up on doing something about the TBTF problem. We should remember that U.S. bank regulators in fact were able to contain risk taking for roughly the 15 year period following the last banking crisis of the late 1980s and early 1990s, and financial regulators are already learning from their mistakes this time around. Furthermore, we take some comfort from the fact that Canadian bank regulators have prevented that country's banks from running into the trouble that our banks have experienced, by applying sensible underwriting and capital standards. So, regulation, when properly practiced, can prevent undue risk-taking.\10\--------------------------------------------------------------------------- \10\ For a guide to how the Canadians have done it, see Pietro Nivola, ``Know Thy Neighbor: What Canada Can Tell Us About Financial Regulation,'' March 2009, at www.brookings.edu.--------------------------------------------------------------------------- Further, under the regulatory system we recommend, regulators would not be the only source of discipline against excessive risk-taking by SIFIs. They would be assisted by holders of long-term uninsured, convertible debt, who would have their money at risk and thus incentives to monitor and control risk-taking by the institutions. In short, regulators, working hand in hand with market participants under the right set of rules, can do better than simply waiting for the next disasters to occur and cleaning up after them. The costs of cleaning up after this crisis--which eventually could run into the trillions of dollars--as well as the damage caused by the crisis itself should be stark reminders that we can and must do better to prevent future crises or at least contain their costs if they occur.Improving Resolution of Non-Bank SIFIs The Committee is surely aware of the many calls for extending the failure resolution procedure for banks to non-banks determined to be systemically important (either before or after the fact). The basic idea, known as ``prompt corrective action'' or ``PCA'', is to authorize (or direct) a relevant agency (the FDIC in the case of banks) to assume control over a weakly capitalized institution before it is insolvent, and then either to liquidate it or, after cleaning up its balance sheet (by separating out the bad assets), return it to private ownership (through sale to another firm or a public offering). Such takeovers are meant to be a last resort, only if prior regulatory restrictions and/or directives to raise private capital, have failed. Many have argued that had something like this system been in place for the various non-banks that have failed in this crisis--Bear Stearns, Lehman, and AIG--the resolutions would have been more orderly and achieved at less cost to taxpayers.\11\--------------------------------------------------------------------------- \11\ Lehman was not rescued and thus all its losses have fallen on its shareholders and creditors. We won't know for some time the full cost of JP Morgan's rescue of Bear Stearns, which was aided by loans from the Federal Reserve, or certainly the much larger final cost of the Fed's takeover of AIG.--------------------------------------------------------------------------- We agree with this view. By definition, troubled systemically important financial institutions cannot be resolved in bankruptcy without threatening the stability of the financial system. The bankruptcy process stays payment of unsecured creditors, while inducing secured creditors to seize and then possibly sell their collateral. Either or both outcomes could lead to a wider panic, which is why a bank-like restructuring process--which puts the troubled bank into receivership, allowing the FDIC to transfer the institution's liabilities to an acquirer or to a ``bridge bank''--is necessary for non-bank SIFIs. Congress must resolve a number of complex issues, however, in creating an effective resolution process for these non-bank institutions. First, the law should provide some procedure for identifying the systemically important institutions that are eligible for this special resolution mechanism in lieu of a normal bankruptcy. This can be done either by allowing the appropriate regulator (we would prefer this be a single systemic risk regulator) to designate specific institutions in advance as SIFIs and therefore subject to a special resolution process if they get into financial trouble, or on ad hoc basis, as the appropriate regulator(s) deem appropriate. Secretary Geithner, for example, has proposed that the Secretary of Treasury could make this designation, upon the positive recommendation of the Federal Reserve Board and the appropriate regulator, in consultation with the President. We favor a combination of these approaches: institutions subject to special regulation as SIFIs automatically would be covered by the special non-bank resolution process, while the Treasury Secretary under the procedure outlined by Secretary Geithner would have the ability to use the special resolution process for other troubled institutions deemed systemically important given unusual circumstances that may be present at a particular time. Second, there must be clear and effective criteria for placing a financially weak non-bank SIFIs into the special resolution process, ideally before it is insolvent. In principle, bank regulators have this authority under FDICIA, but in practice, regulators tend to arrive too late--after banks are well under water (one recent, notable example is the failure of IndyMac, which is going to cost the FDIC several billion dollars). There is really only one way to address this problem, for banks and non-bank SIFIs alike, and that is to raise the minimum capital-to-asset threshold that can trigger regulatory takeover of a weak bank or non-bank SIFI (if, by some chance, there is still some positive equity after an early resolution, it can and should be returned to the shareholders, as is the case for early bank resolutions, at least in principle). Since the appropriate threshold is likely to differ by type of institution, this reform is probably best handled by delegating the job to the appropriate regulator: the banking regulators for banks and Treasury and/or the FDIC for non-bank SIFIs (or the systemic risk regulator, if one is established). The capital-to-asset trigger also should be coordinated with any new counter-cyclical capital regulatory regime that may be established for banks and other financial institutions. In particular, once the new standards are phased in, they should not be so low in recessions as to render ineffective any capital-to-asset trigger designed to facilitate sufficiently early interventions by regulators to avoid or at least minimize losses to taxpayers. Third, the resolution mechanism must have a well-defined procedure for handling uninsured creditor claims. Unlike a bank that has insured liabilities, the creditors of a non-bank are likely to be uninsured (unless they have bought reliable credit default protection, or they have some limited protection through other means: through state guaranty funds for insurance policy holders or through SPIC for brokerage accounts). In a normal bankruptcy, creditors are paid in order of seniority and whether their borrowings are backed by specific collateral. Market discipline requires that creditors not be paid in full if there are insufficient corporate assets to repay them. However, what makes a non-bank systemically important is that the failure to protect at least short-term creditors can trigger creditor runs on other, similar institutions and/or unacceptable losses throughout the financial system. There are several ways to handle this problem. One approach would require all SIFIs, bank and non-bank, to file a resolution plan with their regulator, spelling out the procedures for ``haircutting'' specific classes of creditors if the regulator assumes control of the institution. Another approach is to have the regulators spell out those procedures including minimum haircuts that each class of creditors would be expected to receive if the regulators assume control of the institution. A third idea is to address the issue on a case by case basis--for example, by dividing the institution into a ``good'' and ``bad'' entity, and require shareholders and creditors to bear losses associated with the ``bad'' one. Of course, to be truly effective in preserving market discipline, regulators actually must imposes losses under any of these approaches on unsecured creditors, which as recent events have demonstrated, can be difficult, if not impossible, to do. In particular, when overall economic conditions are dire, as they have been throughout the current crisis, regulators will feel much pressure to protect one or more classes of creditors in full, regardless of what any pre-filed or mandated resolution plan may say (or what the allocation of losses may be as a result of splitting the institution in two). Thus, in the banking context, FDICIA enables regulators to guarantee all deposits, included unsecured debt, of banks when it is deemed necessary to prevent systemic risk. This ``systemic risk exception'' to the general rule that only insured deposits are covered may be invoked, however, only with the concurrence of \2/3\ of the members of the Federal Reserve Board, \2/3\ of the members of the FDIC Board, and the Secretary of the Treasury, in consultation with the President. Even then, the Comptroller General must make a report after the fact assessing whether the intervention was appropriate. A similar systemic risk exception (with the perhaps the same or a similar approval procedure) should also be established for debt issued by troubled non-bank SIFIs (Secretary Geithner has suggested that government assistance be provided when approved by the Treasury and the FDIC, in consultation with the Federal Reserve and the appropriate regulatory authority). Fourth, the resolution process should be overseen by a specific agency. The Treasury has proposed that the FDIC handle this responsibility, as has the current FDIC Chair. Given the FDIC's expertise with resolving bank failures, expanding its authority to cover suitable non-banks makes sense. Fifth, the non-bank resolution process must have a funding mechanism. This is relatively easy, as these things go, for banks, which are covered by an explicit deposit insurance system that is funded by all members of the banking industry. Of special relevance to the TBTF issue, if the Federal Government guarantees uninsured deposits and other creditors of any banks under the ``systemic risk exception'', all other banks must be assessed for the cost, although the FDIC can borrow from the Treasury to finance its initial outlays if its reserves are insufficient (under current law, the FDIC's borrowing limit is $30 billion, but in light of the current crisis, the agency is requesting that this limit be raised to $500 billion). It is difficult to structure an assessment structure for the costs of rescuing the creditors of non-bank SIFIs, however. For one thing, who should pay? Just the other members of the industry in which the failed SIFI is active (such as other hedge funds or insurers, as the case may be), all non-bank SIFIs, or even all non-banks? Under any of these options, what would be the assessment base, and should the contribution rate differ by industry sector? And should any assessment be collected in advance, after the fact, or both? Merely asking these questions should make clear how difficult it can be to design an acceptable industry-based assessment system. We realize that on grounds of equity, it would be appropriate only to assess other SIFIs, assuming they are specifically identified. But this approach may not raise sufficient funds to cover the costs involved. We note that the costs of the AIG rescue alone, for example, are approaching $200 billion. A similar amount has been put aside for the conservatorships of Fannie Mae and Freddie Mac. Congress could broaden the assessment base to include all non-bank institutions (to cover the costs only of providing financial assistance to non-bank SIFIs). This may not appear equitable on the surface, but if the institution receiving government funds is truly systemically important then even smaller institutions do benefit when the government steps in to prevent creditor losses at a SIFI from damaging the rest of the financial system. Indeed, if an institution is truly systemic, then everyone presumably benefits from not having the financial system meltdown, which is why it is advisable in our view for Congress to give the FDIC and/or the Treasury an appropriation up to some sizable limit--say $250 billion--that could be tapped, if necessary for future non-bank SIFI resolutions. Congress may also want to instruct the FDIC and/or the Treasury to use this appropriation only as a resort, and turn to assessments on some class of institutions first. We have no objection to such an approach, but for reasons just noted, there is no perfect way to do that. In any event, as with bank resolutions under the systemic risk exception, the Comptroller General should be required to report to Congress on all non-bank resolutions, too: whether government-provided financial assistance was appropriate, and whether the resolution was completed at least cost. However the Congress decides these issues, it should do so promptly, without waiting to reach agreement on a more a comprehensive financial reform bill. The country clearly would be best served if a new resolution process were in place before another large non-banking firm approaches insolvency before this recession is over.Concluding Observations We would like to close with perhaps the obvious observation that addressing the TBTF problem is not simple. Further, as we have noted, it is unreasonable to expect any new policy framework to prevent all future bailouts, and future bubbles. Perfection is not possible in this or any other endeavor, and suggestions for policy improvements should not be judged against such a harsh and unrealistic standard. The challenge before the Congress instead is to significantly improve the odds that future bailouts of large financial institutions will be unnecessary, without at the same time materially dampening the innovative spirit that has driven our financial system and our economy. We believe that goal can be accomplished, but it will take time. Congress will write new laws, but will have to place considerable faith in regulators to carry them out. In turn, regulators will make mistakes, they will learn, and they will make mid-course corrections. This Committee is certainly well aware that regulation can never fully keep up with market developments. Private actors always find ways around rules; economists call this regulatory arbitrage, in which the regulatory ``cats'' are constantly trying to keep the private ``mice: from doing damage to the financial system.'' This crisis has exposed the unwelcome truth that over the past several years, some of the private sector mice grew so large and so dangerous that they threatened the welfare of our entire financial system. It is now time to beef up the regulatory cats, to arm them with the right rules, and to assist them with constructive market discipline so that the game of regulatory arbitrage will be kept in check, while the financial system continues to do what it is supposed to do: channel savings efficiently toward constructive social purposes. Thank you and we look forward to addressing your questions. ______ fcic_final_report_full--487 In addition, Roubini and Parisi-Capone estimated that U.S. commercial and investment banks suffered a further mark-to-market loss of $225 billion on unsecuritized subprime and Alt-A mortgages. 57 They also estimated that mark-to- market losses for financial institutions outside the U.S. would be about 40 percent of U.S. losses, so there was likely to be a major effect on banks and other financial institutions around the world—depending, of course, on their capital position at the time the PMBS market stopped functioning. I am not aware of any data showing the mark-to-market effect of the collapse of the PMBS market on other U.S. financial institutions, but it can be assumed that they also suffered similar losses in proportion to their holdings of PMBS. Losses of this magnitude would certainly be enough—when combined with other losses on securities and loans not related to mortgages—to call into question the stability of a large number of banks, investment banks and other financial institutions in the U.S. and around the world. However, there was one other factor that exacerbated the adverse effect of the loss of a market for PMBS. Although accounting rules did not require all PMBS to be written down, investors and counterparties did not know which financial institutions were holding the weakest assets and how much of their assets would have to be written down over time. Whatever that amount, it would reduce their capital positions at a time when investors and counterparties were anxious about their stability. This was the balance sheet effect that was the third element of Chairman Bair’s summary. To summarize, then, the following are the steps through which the government’s housing policies transmitted losses—through PMBS—to the largest financial institutions: (i) the 19 million NTMs acquired or guaranteed by the Agencies were major contributors to the growth of the bubble and its extension in time; (ii) the growth of the bubble suppressed the losses that would ordinarily have brought the development of NTM-backed PMBS to a halt; (ii) competition for NTMs drove subprime lenders further out the risk curve to find high-yielding mortgages to securitize, especially when these loans did not appear to be producing losses commensurate with their risk; (iv) when the bubble finally burst, the unprecedented number of delinquencies and defaults among all NTMs—the great majority of which were held or guaranteed by the Agencies—caused investors to 56 Timothy F. Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” Remarks at the Economic Club of New York, June 9, 2008, available at http://www.ny.frb.org/newsevents/speeches/2008/ tfg080609.html. 57 Nouriel Roubini and Elisa Parisi-Carbone, “Total $3.6 Trillion Projected Loan and Securities Losses,” p.7. flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS; and (v) mark-to-market accounting required these institutions to write down the value of the PMBS they held, as well as their other mortgage-related assets, reducing their capital positions and raising further questions about their stability and solvency. fcic_final_report_full--96 The Boom and Bust  6 fcic_final_report_full--50 Then, beginning in , the Federal Reserve accommodated a series of requests from the banks to undertake activities forbidden under Glass-Steagall and its modifi- cations. The new rules permitted nonbank subsidiaries of bank holding companies to engage in “bank-ineligible” activities, including selling or holding certain kinds of se- curities that were not permissible for national banks to invest in or underwrite. At first, the Fed strictly limited these bank-ineligible securities activities to no more than  of the assets or revenue of any subsidiary. Over time, however, the Fed re- laxed these restrictions. By , bank-ineligible securities could represent up to  of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi- nated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.  Meanwhile, the OCC, the regulator of banks with national charters, was expand- ing the permissible activities of national banks to include those that were “function- ally equivalent to, or a logical outgrowth of, a recognized bank power.”  Among these new activities were underwriting as well as trading bets and hedges, known as derivatives, on the prices of certain assets. Between  and , the OCC broad- ened the derivatives in which banks might deal to include those related to debt secu- rities (), interest and currency exchange rates (), stock indices (), precious metals such as gold and silver (), and equity stocks (). Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that fi- nancial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management. Likewise, finan- cial markets would exert strong and effective discipline through analysts, credit rat- ing agencies, and investors. Greenspan argued that the urgent question about government regulation was whether it strengthened or weakened private regulation. Testifying before Congress in , he framed the issue this way: financial “modern- ization” was needed to “remove outdated restrictions that serve no useful purpose, that decrease economic efficiency, and that . . . limit choices and options for the con- sumer of financial services.” Removing the barriers “would permit banking organiza- tions to compete more effectively in their natural markets. The result would be a more efficient financial system providing better services to the public.”  During the s and early s, banks and thrifts expanded into higher-risk loans with higher interest payments. They made loans to oil and gas producers, fi- nanced leveraged buyouts of corporations, and funded developers of residential and commercial real estate. The largest commercial banks advanced money to companies and governments in “emerging markets,” such as countries in Asia and Latin Amer- ica. Those markets offered potentially higher profits, but were much riskier than the banks’ traditional lending. The consequences appeared almost immediately—espe- cially in the real estate markets, with a bubble and massive overbuilding in residential and commercial sectors in certain regions. For example, house prices rose  per year in Texas from  to .  In California, prices rose  annually from  to .  The bubble burst first in Texas in  and , but the trouble rapidly spread across the Southeast to the mid-Atlantic states and New England, then swept back across the country to California and Arizona. Before the crisis ended, house prices had declined nationally by . from July  to February   —the first such fall since the Depression—driven by steep drops in regional markets.  In the s, with the mortgages in their portfolios paying considerably less than current interest rates, spiraling defaults on the thrifts’ residential and commercial real estate loans, and losses on energy-related, leveraged-buyout, and overseas loans, the indus- try was shattered.  fcic_final_report_full--225 CDOs; pushing ratings out the door with insufficient review; failing to adequately disclose its rating process for mortgage-backed securities and CDOs; and allowing conflicts of interest to affect rating decisions.  So matters stood in , when the machine that had been humming so smoothly and so lucratively slipped a gear, and then another, and another—and then seized up entirely. COMMISSION CONCLUSIONS ON CHAPTER 10 The Commission concludes that the credit rating agencies abysmally failed in their central mission to provide quality ratings on securities for the benefit of in- vestors. They did not heed many warning signs indicating significant problems in the housing and mortgage sector. Moody’s, the Commission’s case study in this area, continued issuing ratings on mortgage-related securities, using its outdated analytical models, rather than making the necessary adjustments. The business model under which firms issuing securities paid for their ratings seriously under- mined the quality and integrity of those ratings; the rating agencies placed market share and profit considerations above the quality and integrity of their ratings. Despite the leveling off and subsequent decline of the housing market begin- ning in , securitization of collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs continued unabated, greatly expanding the expo- sure to losses when the housing market collapsed and exacerbating the impact of the collapse on the financial system and the economy. During this period, speculators fueled the market for synthetic CDOs to bet on the future of the housing market. CDO managers of these synthetic products had potential conflicts in trying to serve the interests of customers who were bet- ting mortgage borrowers would continue to make their payments and of cus- tomers who were betting the housing market would collapse. There were also potential conflicts for underwriters of mortgage-related secu- rities to the extent they shorted the products for their own accounts outside of their roles as market makers. CHRG-110shrg46629--47 Chairman Bernanke," It is not our expertise to directly say that this deal is a good deal and that deal is a bad deal. What we try to do is make sure that the banks and the investment banks themselves have good controls, have good models, have good approaches, have good risk management so that they can make what we believe to be, in general, appropriate decisions about these instruments. Senator Reed. Let me shift gears again, Mr. Chairman, to try to cover a lot of ground. We have witnessed all a booming housing market until very recently. As your predecessor, Chairman Greenspan, opined in many homes their increasing equity valuation was an ATM that they could go to without leaving the house. Current estimates are that equity withdrawals are down precipitously, 70 percent from 2005. What is your view of the macroeconomic effect as people can no longer essentially use their equity as a quick source of cash? " CHRG-111hhrg48867--109 Mr. Wallison," I am saying the opposite. I am saying that if we were to create a systemic regulator--a systemic risk regulator that has the power to bail out U.S. banks, you would in effect always be bailing out foreign banks, because all banks, especially at the international level, are interconnected. " CHRG-111hhrg55809--59 Mr. Bernanke," We are actually looking very carefully at this question because it is very important for policy going forward, and I think we need to keep an open mind. Having said that, I think that the very strong way you stated it is probably an overstatement. I think there are a lot of reasons to think that there were other factors involved in the housing boom and bust besides monetary policy. And I would say secondly that a strong, well-regulated financial system should not have been crashed by an increase and decrease in house prices. I think the failures of regulation, supervision and oversight allowed this to become as big a deal as it was. So I think that is a very high priority right now. " CHRG-111hhrg53244--133 Mr. Bernanke," I don't think that Glass-Steagall, if it had been enforced, would have prevented the crisis. We saw plenty of situations where a commercial bank on its own or an investment bank on its own got into significant problems without cross-effects between those two categories. On the other hand, I think that we do need to be looking at the complexity and scale of these firms and asking whether they pose a risk to the overall system? And if that risk is too great, is there reason or scope to limit certain activities? And I think that might be something we should look at. But I think the investment banking versus commercial banking distinction probably would not have been that helpful in this particular crisis. " CHRG-111hhrg52261--135 Chairwoman Velazquez," Mr. MacPhee and Mr. Hampel, addressing systemic risk will be an essential element of the reform proposal. As you noted in your testimony, community banks are smaller and are much less interconnected than larger international institutions. Even so, community banks can still transmit risk into the financial system. In light of this, should community banks or all credit unions be subject to systemic regulation? " fcic_final_report_full--241 The International Monetary Fund’s Global Financial Stability Report published in October  examined where the declining assets were held and estimated how se- vere the write-downs would be. All told, the IMF calculated that roughly  trillion in mortgage assets were held throughout the financial system. Of these, . trillion were GSE mortgage–backed securities; the IMF expected losses of  billion, but in- vestors holding these securities would lose no money, because of the GSEs’ guaran- tee. Another . trillion in mortgage assets were estimated to be prime and nonprime mortgages held largely by the banks and the GSEs. These were expected to suffer as much as  billion in write-downs due to declines in market value. The remaining . trillion in assets were estimated to be mortgage-backed securities and CDOs. Write-downs on those assets were expected to be  billion. And, even more troubling, more than one-half of these losses were expected to be borne by the investment banks, commercial banks, and thrifts. The rest of the write-downs from non-agency mortgage–backed securities were shared among institutions such as in- surance companies, pension funds, the GSEs, and hedge funds. The October report also expected another  billion in write-downs on commercial mortgage–backed securities, CLOs, leveraged loans, and other loans and securities—with more than half coming from commercial mortgage–backed securities. Again, the commercial banks and thrifts and investment banks were expected to bear much of the brunt.  Furthermore, when the crisis began, uncertainty (suggested by the sizable revi- sions in the IMF estimates) and leverage would promote contagion. Investors would realize they did not know as much as they wanted to know about the mortgage assets that banks, investment banks, and other firms held or to which they were exposed. To an extent not understood by many before the crisis, financial institutions had lever- aged themselves with commercial paper, with derivatives, and in the short-term repo markets, in part by using mortgage-backed securities and CDOs as collateral. Lenders would question the value of the assets that those companies had posted as collateral at the same time that they were questioning the value of those companies’ balance sheets. Even the highest-rated tranches of mortgage-backed securities were downgraded, and large write-downs were recorded on financial institutions’ balance sheets based on declines in market value. However, although this could not be known in , at the end of  most of the triple-A tranches of mortgage-backed securities have avoided actual losses in cash flow through  and may avoid significant realized losses going forward. Overall, for  to  vintage tranches of mortgage-backed securities origi- nally rated triple-A, despite the mass downgrades, only about  of Alt-A and  of subprime securities had been “materially impaired”—meaning that losses were im- fcic_final_report_full--167 The CSE program was based on the bank supervision model, but the SEC did not try to do exactly what bank examiners did.  For one thing, unlike supervisors of large banks, the SEC never assigned on-site examiners under the CSE program; by comparison, the OCC alone assigned more than  examiners full-time at Citibank. According to Erik Sirri, the SEC’s former director of trading and markets, the CSE program was intended to focus mainly on liquidity because, unlike a commercial bank, a securities firm traditionally had no access to a lender of last resort.  (Of course, that would change during the crisis.) The investment banks were subject to annual examinations, during which staff reviewed the firms’ systems and records and verified that the firms had instituted control processes. The CSE program was troubled from the start. The SEC conducted an exam for each investment bank when it entered the program. The result of Bear Stearns’s en- trance exam, in , showed several deficiencies. For example, examiners were con- cerned that there were no firmwide VaR limits and that contingency funding plans relied on overly optimistic stress scenarios.  In addition, the SEC was aware of the firm’s concentration of mortgage securities and its high leverage. Nonetheless, the SEC did not ask Bear to change its asset balance, decrease its leverage, or increase its cash liquidity pool—all actions well within its prerogative, according to SEC officials.  Then, because the CSE program was preoccupied with its own staff reor- ganization, Bear did not have its next annual exam, during which the SEC was sup- posed to be on-site. The SEC did meet monthly with all CSE firms, including Bear,  and it did conduct occasional targeted examinations across firms. In , the SEC worried that Bear was too reliant on unsecured commercial paper funding, and Bear reduced its exposure to unsecured commercial paper and increased its reliance on se- cured repo lending.  Unfortunately, tens of billions of dollars of that repo lending was overnight funding that could disappear with no warning. Ironically, in the sec- ond week of March , when the firm went into its four-day death spiral, the SEC was on-site conducting its first CSE exam since Bear’s entrance exam more than two years earlier.  Leverage at the investment banks increased from  to , growth that some critics have blamed on the SEC’s change in the net capital rules. Goldschmid told the FCIC that the increase was owed to “a wild capital time and the firms being irrespon- sible.”  In fact, leverage had been higher at the five investment banks in the late s, then dropped before increasing over the life of the CSE program—a history that suggests that the program was not solely responsible for the changes.  In , Sirri noted that under the CSE program the investment banks’ net capital levels “re- mained relatively stable . . . and, in some cases, increased significantly” over the pro- gram.  Still, Goldschmid, who left the SEC in , argued that the SEC had the power to do more to rein in the investment banks. He insisted, “There was much more than enough moral suasion and kind of practical power that was involved. . . . The SEC has the practical ability to do a lot if it uses its power.”  CHRG-111shrg55278--49 Chairman Dodd," Thank you, Mike, very much. Good point. Senator Merkley. Senator Merkley. Thank you very much, Mr. Chair. One of the components of the President's plan is the Consumer Financial Protection Agency. There hasn't been a lot of discussion of that this morning, so Chair Bair, can you give us a sense of your insights on the role of this potential institution and whether it is an appropriate one to create? Ms. Bair. We support the creation of the agency--an agency that is focused exclusively on consumer protection in financial services that can apply standards across the board for both banks and nonbanks and make sure they are the same standards. We think that would help the banking sector because one of the things that drove the rapid decline in mortgage origination standards was inadequate regulation and supervision outside the banking sector. Most of these very high-risk mortgages were done outside of the traditional banking sector, but as competitive pressure drew market share from banks and thrifts, which also lowered their standards in kind. So I think making sure there are even standards across the board is very important. Where we think the proposal could be strengthened is on its enforcement focus. We strongly recommend that the examination and enforcement component for banks be left with the bank regulators. I say that as a bank regulator but also as an insurer of all institutions with, ultimately, taxpayer exposure with the deposit insurance guarantee. There is a reason why we focus on prudential regulation of banks, as well, and a lot of it is because of FDIC insurance, which is a taxpayer backstop. There are important synergies you can get between prudential and consumer supervision. We typically cross-train our examiners. We can send in teams of both safety and soundness and consumer compliance. A prime example of where joint safety and soundness and compliance examination can be beneficial can be seen in cases where mortgages that were abusive to consumers were also found to be unsafe and unsound. And frequently, we will find where there is a consumer compliance problem that can flag a more fundamental problem with risk management at the institution. We think strongly that the rule writing should be for both banks and nonbanks. We are fine with that. But the examination and enforcement mechanism of a newly formed consumer protection agency should focus outside of the banking sector where you really don't have much examination and enforcement activity at all with the mortgage brokers or payday lenders. There are a lot of abuses outside the banking system that we think could and should be addressed by this agency. But, we really think their focus should be on creating more robust enforcement mechanisms for the nonbank sector. I don't understand why moving all the examiners from the bank regulators to this new agency and then making them responsible for both banks and nonbanks is going to work. I don't think it will. It would be highly disruptive to the FDIC. That is, about 21 percent of our examiners being pulled out of the FDIC. I assume it is a similar percentage for the other regulators. We think we do a good job on examination and enforcement. We have never had the ability to write rules, so that doesn't really change things for us. So we would ask you to consider that change in the Administration's proposal, but we do support the agency. Senator Merkley. Somewhat related to this, the systemic risk conversation is partly about institutions and it is partly about practices. By practices, I would mention things such as prepayment penalties in mortgage, regulatory arbitrage, whether there is a fundamental conflict of interest in the rating system in which the entity that you are rating is paying for that rating, and the issue of the amounts of leverage that were established in the system under Cox's supervision of the SEC. I am trying to sort out, how does one decide when you have a consumer issue that would be driven by the Consumer Financial Protection Agency? When is it an issue that the systemic risk regulators would take on? And when would it be an issue that the regular bank regulators would take on, and how would it get worked out in terms of how to proceed? Ms. Bair. Well, I think it does go both ways. What we have suggested in my written testimony, is that bank regulators should be represented on the board of the new consumer agency. Again, as an insurer as well as supervisor, we think the FDIC would have a unique perspective that should be represented. We also would be happy to have the head of these two agencies serve on our board because there are synergies and interconnectedness between prudential supervision and safety and soundness, and I think those need to be dealt with and that would be one way to deal with them. There has always been a separation between rule writing and enforcement for the consumer laws, at least for banks. The Federal Reserve Board has had that authority for federally insured banks. The FDIC and the OCC have never had the ability to write rules. We have just had the examination enforcement component. Senator Merkley. I want to get in one last question before I run out of time. Paul Volcker had a report that came out in January--I think it was called the ``Group of 30 Report''--that addressed the issue of proprietary trading by banks and essentially using the capital assets of the bank, should banks freely engage in purchasing assets regardless of the risk, and does that create systemic risk, and they had recommendations for constraints on proprietary trading. I open it up to all three of you. Do you have any thoughts about--this hasn't gotten a lot of attention and I am curious of your thinking. Ms. Bair. This probably doesn't surprise you, but as the insurer of banks we would strongly prefer that the proprietary trading occur outside the bank, in an affiliate. If it does occur in a bank holding company that includes an insured depositor institution, that is a risk factor that should be considered in setting assessments if the Congress decides to approve an assessment system for larger institutions. Ms. Schapiro. I would just add that I think proprietary trading with either taxpayers' money in the event of a supported institution or a customer's money does absolutely create risks that we need to be sensitive to. On the broker-dealer side, you are not permitted to proprietary trade with customer funds, and most of that activity takes place outside the regulated broker-dealer. " CHRG-111shrg57923--43 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System February 12, 2010 Chairman Bayh, Ranking Member Corker, and other members of the Committee, thank you for inviting me to testify today. I also want to thank all of you for taking the time to explore a subject that is easily overlooked in the public debate around financial reform, but that will be central to ensuring a more stable financial system in the future. The recent financial crisis revealed important gaps in data collection and systematic analysis of institutions and markets. Remedies to fill those gaps are critical for monitoring systemic risk and for enhanced supervision of systemically important financial institutions, which are in turn necessary to decrease the chances of such a serious crisis occurring in the future. The Federal Reserve believes that the goals of agency action and legislative change should be (1) to ensure that supervisory agencies have access to high-quality and timely data that are organized and standardized so as to enhance their regulatory missions, and (2) to make such data available in appropriately usable form to other government agencies and private analysts so that they can conduct their own analyses and raise their own concerns about financial trends and developments. In my testimony this morning I will first review the data collection and analysis activities of the Federal Reserve that are relevant to systemic risk monitoring and explain why we believe additional data should be collected by regulatory authorities with responsibility for financial stability. Next I will set forth some principles that we believe should guide efforts to achieve the two goals I have just noted. Finally, I will describe current impediments to these goals and suggest some factors for the Congress to consider as it evaluates potential legislation to improve the monitoring and containment of systemic risk.The Federal Reserve and Macro-Prudential Supervision The Federal Reserve has considerable experience in data collection and reporting in connection with its regulation and supervision of financial institutions, monetary policy deliberations, and lender-of-last-resort responsibilities. The Federal Reserve has made large investments in quantitative and qualitative analysis of the U.S. economy, financial markets, and financial institutions. The Federal Reserve also has recently initiated some new data collection and analytical efforts as it has responded to the crisis and in anticipation of new financial and economic developments. For supervision of the largest institutions, new quantitative efforts have been started to better measure counterparty credit risk and interconnectedness, market risk sensitivities, and funding and liquidity. The focus of these efforts is not only on risks to individual firms, but also on concentrations of risk that may arise through common exposures or sensitivity to common shocks. For example, additional loan-level data on bank exposures to syndicated corporate loans are now being collected in a systematic manner that will allow for more timely and consistent measurement of individual bank and systemic exposures to these sectors. In addition, detailed data obtained from firms' risk-management systems allow supervisors to examine concentration risk and interconnectedness. Specifically, supervisors are aggregating, where possible, the banks' largest exposures to other banks, nonbank financial institutions, and corporate borrowers, which could be used to reveal large exposures to individual borrowers that the banks have in common or to assess the credit impact of a failure of a large bank on other large banks. Additional time and experience with these data will allow us to assess the approach's ability to signal adverse events, and together they will be a critical input to designing a more robust and consistent reporting system. Furthermore, we are collecting data on banks' trading and securitization risk exposures as part of an ongoing, internationally coordinated effort to improve regulatory capital standards in these areas. Moreover, analysis of liquidity risk now incorporates more explicitly the possibility of marketwide shocks to liquidity. This effort also is an example of the importance of context and the need to understand the firms' internal risk models and risk-management systems in designing data collection requirements. Data that only capture a set of positions would not be sufficient since positions would not incorporate behavioral assumptions about firms, based on information about firms' business models and practices. The Federal Reserve's responsibilities for monetary policy are also relevant for systemic risk monitoring. Systemic risk involves the potential for financial crises to result in substantial adverse effects on economic activity. As the nation's central bank, the Federal Reserve assesses and forecasts the U.S. and global economies using a wide variety of data and analytical tools, some based on specific sectors and others on large-scale models. In the wake of the crisis, research has been expanded to better understand the channels from the financial sector to the real economy. For example, building on lessons from the recent crisis, the Federal Reserve added questions to the Survey of Professional Forecasters to elicit from private-sector forecasters their subjective probabilities of forecasts of key macroeconomic variables, which provides to us, and to the public, better assessments of the likelihood of severe macroeconomic outcomes. The Federal Reserve has made substantial investments in data and analytical staff for financial market monitoring. Each day, the Trading Desk at the Federal Reserve Bank of New York analyzes and internally distributes reports on market developments, focusing on those markets where prices and volumes are changing rapidly, where news or policy is having a major effect, or where there are special policy concerns. Those analyses begin with quantitative data, supplemented with information obtained through conversations with market participants and reviews of other analyses available in the market. Over the past few years, the Desk has worked closely with our research staff in developing new quantitative tools and new data sources. This ongoing monitoring requires continual evaluation of new data sources and analytical tools to develop new data as new markets and practices develop. For example, information on market volumes and prices can be collected from new trading platforms and brokers, data on instruments such as credit default swaps, or CDS, are provided by vendors or market participants, and fresh insights are gained from new methods of extracting information from options data. In some cases, publication of data by the private sector may be mandated by legislation (such as, potentially, trade data from over-the-counter derivatives trade repositories); in other cases, the Federal Reserve or other government agencies or regulators require or encourage the gathering and publication of data. Our experiences with supervision, monetary policy, and financial market monitoring suggest that market data gathering and market oversight responsibilities must continuously inform one another. In addition, efforts to identify stresses in the system are not a matter of running a single model or focusing on a single risk. Rather, it is the assembly of many types of analysis in a systematic fashion. The Supervisory Capital Assessment Program (SCAP) for large financial institutions--popularly known as the ``stress test'' when it was conducted early last year--illustrates the importance of combining analysis by credit experts, forecasts and scenario design by macroeconomists, and hands-on judgments by supervisors in assessing the financial condition and potential vulnerabilities of large financial institutions. While considerable steps have been made in the wake of the financial crisis, the Federal Reserve intends to do a good deal more. The Federal Reserve also will continue to strengthen and expand its supervisory capabilities with a macroprudential approach by drawing on its considerable data reporting, gathering, and analytical capabilities across many disciplines. In the areas in which we are collecting data through the supervisory process on measures of interlinkages and common exposures among the largest financial firms we supervise, we are developing new analytical tools that may lead us to change our information requests from supervised firms. The Federal Reserve is exploring how to develop analytically sophisticated measures of leverage and better measures of maturity transformation from information that we can collect from the supervised firms in the supervisory process and from other available data and analysis. We envision developing a robust set of key indicators of emerging risk concentrations and market stresses that would both supplement existing supervisory techniques and assist in the early identification of early trends that may have systemic significance and bear further inquiry. This kind of approach will require data that are produced more frequently than the often quarterly data gathered in regulatory reports, although not necessarily real-time or intraday, and reported soon after the fact, without the current, often long, reporting lags. These efforts will need to actively seek international cooperation as financial firms increasingly operate globally.The Potential Benefits of Additional Data Improved data are essential for monitoring systemic risk and for implementing a macroprudential approach to supervision. The financial crisis highlighted the existence of interlinkages across financial institutions and between financial institutions and markets. Credit risks were amplified by leverage and the high degree of maturity transformation, especially outside of traditional commercial banking institutions. Moreover, supervision traditionally has tended to focus on the validity of regulated firms' private risk-management systems, which did not easily allow comparisons and aggregation across firms. One key feature of the recent crisis was the heavy reliance on short-term sources of funds to purchase long-term assets, which led to a poor match between the maturity structure of the firms' assets and liabilities. Such maturity transformation is inherently fragile and leaves institutions and entire markets susceptible to runs. Indeed, a regulatory, supervisory, and insurance framework was created during the Great Depression to counter this problem at depository institutions. However, in recent years a significant amount of maturity transformation took place outside the traditional banking system--in the so-called shadow banking system--through the use of commercial paper, repurchase agreements, and other instruments. Our ability to monitor the size and extent of maturity transformation has been hampered by the lack of high-quality and consistent data on these activities. Better data on the sources and uses of maturity transformation outside of supervised banking organizations would greatly aid macroprudential supervision and systemic risk regulation. Another feature of the recent crisis was the extensive use of leverage, often in conjunction with maturity transformation. The consequences of this combination were dramatic. When doubts arose about the quality of the assets on shadow banking system balance sheets, a classic adverse feedback loop ensued in which lenders were increasingly unwilling to roll over the short-term debt that was used as funding. Liquidity-constrained institutions were forced to sell assets at increasingly distressed prices, which accelerated margin calls for leveraged actors and amplified mark-to-market losses for all holders of the assets, including regulated firms. Here, too, government regulators and supervisors had insufficient data to determine the degree and location of leverage in the financial system. More generally, the crisis revealed that regulators, supervisors, and market participants could not fully measure the extent to which financial institutions and markets were linked. A critical lesson from this crisis is that supervisors and investors need to be able to more quickly evaluate the potential effects, for example, of the possible failure of a specific institution on other large firms through counterparty credit channels; financial markets; payment, clearing, and settlement arrangements; and reliance on common sources of short-term funding. A better system of data collection and aggregation would have manifold benefits, particularly if the data are shared appropriately among financial regulators and with a systemic risk council if one is created. It would enable regulators and a council to assess and compare risks across firms, markets, and products. It would improve risk management by firms themselves by requiring standardized and efficient collection of relevant financial information. It also would enhance the ability of the government to wind down systemically important firms in a prompt and orderly fashion by providing policymakers a clearer view of the potential impacts of different resolution options on the broader financial system. Additional benefits would result from making data public to the degree consistent with protecting firm-specific proprietary and supervisory information. Investors and analysts would have a more complete picture of individual firms' strengths and vulnerabilities, thereby contributing to better market discipline. Other government agencies, academics, and additional interested parties would be able to conduct their own analyses of financial system developments and identify possible emerging stresses and risks in financial markets. One area in which better information is particularly important is the web of connections among financial institutions though channels such as interbank lending, securities lending, repurchase agreements, and derivatives contracts. Regulators also need more and better data on the links among institutions through third-party sponsors, liquidity providers, credit-support providers, and market makers. Knowledge of such network linkages is a necessary first step to improve analysis of how shocks to institutions and markets can propagate through the financial system.Principles for Developing a System of Effective Data and Analytical Tools Moving from the recognition of the need for more data to an efficient data system is not an easy task. Data collection entails costs in collection, organization, and utilization for government agencies, reporting market participants, and other interested parties. Tradeoffs may need to be faced where, for example, a particular type of information would be very costly to collect and would have only limited benefits. The Internet and other applications of information technologies have made us all too aware of the potential for information overload, a circumstance in which relevant information is theoretically available, but the time and expense of retrieving it or transforming it into a usable form make it unhelpful in practical terms. Collection of more data just for its own sake also can raise systemic costs associated with moral hazard if investors view data collection from certain firms, products, and markets as suggesting implicit support. It is thus particularly worth emphasizing the importance of having data available readily and in a form that is appropriate for the uses to which it will be put. With these considerations in mind, we have derived a number of guiding principles for a system of new data and analytical tools for effectively supervising large institutions and monitoring systemic risk. First, the priorities for new data efforts should be determined by the nature of regulatory and supervisory missions. In particular, the data need to be sufficiently timely and to cover a sufficient range of financial institutions, markets, instruments, and transactions to support effective systemic risk monitoring and macroprudential supervision, as well as traditional safety-and-soundness regulation. The events of the past few years have painfully demonstrated that regulators, financial institutions, and investors lacked ready access to data that would have allowed them to fully assess the value of complex securities, understand counterparty risks, or identify concentrations of exposures. The data needed for systemic risk monitoring and supervision are not necessarily ``real-time'' market data--information about trades and transactions that can be reported at high frequency when the events occur--but certainly data would need to be ``timely.'' What is considered to be ``timely'' will depend on its purpose, and decisions about how timely the data should be should not ignore the costs of collecting and making the data usable. For many supervisory needs, real-time data would be impractical to collect and analyze in a meaningful way and unnecessary. For example, while supervisors may indeed need to be able to quickly value the balance sheets of systemically important financial institutions, very frequent updates as transactions occur and market prices change could lead to more volatility in values than fundamental conditions would indicate and would be extraordinarily expensive to provide and maintain. Certainly, real-time data could be needed for regulators responsible for monitoring market functioning, and daily data would be helpful to measure end-of-day payment settlements and risk positions among the largest firms. But for supervising market participants, real-time market data could require enormous investments by regulators, institutions, and investors in order to be usable while yielding little net benefit. As policymakers consider redesign of a system of data collection, the goal should be data that are timely and best suited to the mission at hand. A second principle is that data collection be user-driven. That is, data on particular markets and institutions should be collected whenever possible by the regulators who ultimately are responsible for the safety and soundness of the institutions or for the functioning of those markets. Regulators with supervisory responsibilities for particular financial firms and markets are more likely to understand the relevance of particular forms of standardized data for risk management and supervisory oversight. For example, supervisors regularly evaluate the ability of individual firms' own risk measures, such as internal ratings for loans, and of liquidity and counterparty credit risks, to signal potential problems. As a result, these supervisors have the expertise needed to develop new reporting requirements that would be standardized across firms and could be aggregated. Third, greater standardization of data than exists today is required. Standardized reporting to regulators in a way that allows aggregation for effective monitoring and analysis is imperative. In addition, the data collection effort itself should encourage the use of common reporting systems across institutions, markets, and investors, which would generally enhance efficiency and transparency. Even seemingly simple changes, such as requiring the use of a standardized unique identifier for institutions (or instruments), would make surveillance and reporting substantially more efficient. Fourth, the data collected and the associated reporting standards and protocols should enable better risk management by the institutions themselves and foster greater market discipline by investors. Currently, because the underlying data in firms' risk-management systems are incomplete or are maintained in nonstandardized proprietary formats, compiling industry-wide data on counterparty credit risk or common exposures is a challenge for both firms and supervisors. Further, institutions and investors cannot easily construct fairly basic measures of common risks across firms because they may not disclose sufficient information. In some cases, such as disclosure of characteristics of underlying mortgages in a securitized pool, more complete and interoperable data collection systems could enhance market discipline by allowing investors to better assess the risks of the securities without compromising proprietary information of the lending institution. Fifth, data collection must be nimble, flexible, and statistically coherent. With the rapid pace of financial innovation, a risky new asset class can grow from a minor issue to a significant threat faster than government agencies have traditionally been able to revise reporting requirements. For example, collateralized debt obligations based on asset-backed securities grew from a specialized niche product to the largest source of funding for asset-backed securities in just a few years. Regulators, then, should have the authority to collect information promptly when needed, even when such collections would require responses from a broad range of institutions or markets, some of which may not be regulated or supervised. In addition, processes for information collection must meet high standards for reliability, coherence, and representativeness. Sixth, data collection and aggregation by regulatory agencies must be accompanied by a process for making the data available to as great a degree as possible to fellow regulators, other government entities, and the public. There will, of course, be a need to protect proprietary and supervisory information, particularly where specific firm-based data are at issue. But the presumption should be in favor of making information widely available. Finally, any data collection and analysis effort must be attentive to its international dimensions and must seek appropriate participation from regulators in other nations, especially those with major financial centers. Financial activities and risk exposures are increasingly globalized. A system without a common detailed taxonomy for securities and counterparties and comparable requirements for reporting across countries would make assembling a meaningful picture of the exposures of global institutions very difficult. Efforts to improve data collection are already under way in the European Union, by the Bank of England and the Financial Services Authority, and the European Central Bank, which has expressed support for developing a unified international system of taxonomy and reporting. The Financial Stability Board, at the request of the G-20, is initiating an international effort to develop a common reporting template and a process to share information on common exposures and linkages between systemically important global financial institutions.Barriers to Effective Data Collection for Analysis Legislation will be needed to improve the ability of regulatory agencies to collect the necessary data to support effective supervision and systemic risk monitoring. Restrictions designed to balance the costs and benefits of data collection and analysis have not kept pace with rapid changes in the financial system. The financial system is likely to continue to change rapidly, and both regulators and market participants need the capacity to keep pace. Regulators have been hampered by a lack of authority to collect and analyze information from unregulated entities. But the recent financial crisis illustrated that substantial risks from leverage and maturity transformation were outside of regulated financial firms. In addition, much of the Federal Reserve's collection of data is based on voluntary participation. For example, survey data on lending terms and standards at commercial banks, lending by finance companies, and transactions in the commercial paper market rely on the cooperation of the surveyed entities. Moreover, as we have suggested, the data collection authority of financial regulators over the firms they supervise should be expanded to encompass macroprudential considerations. The ability of regulators to collect information should similarly be expanded to include the ability to gather market data necessary for monitoring systemic risks. Doing so would better enable regulators to monitor and assess potential systemic risks arising directly from the firms or markets under their supervision or from the interaction of these firms or markets with other components of the financial system. The Paperwork Reduction Act also can at times impede timely and robust data collection. The act generally requires that public notice be provided, and approval of the Office of Management and Budget (OMB) be obtained, before any information requirement is applied to more than nine entities. Over the years, the act's requirement for OMB approval for information collection activity involving more than nine entities has discouraged agencies from undertaking many initiatives and can delay the collection of important information in a financial crisis. For example, even a series of informal meetings with more than nine entities designed to learn about emerging developments in markets may be subject to the requirements of the act. While the principle of minimizing the burdens imposed on private parties is an important one, the Congress should consider amending the act to allow the financial supervisory agencies to obtain the data necessary for financial stability in a timely manner when needed. One proposed action would be to increase the number of entities from which information can be collected without triggering the act; another would be to permit special data requests of the systemically important institutions could be conducted more quickly and flexibly. The global nature of capital markets seriously limits the extent to which one country acting alone can organize information on financial markets. Many large institutions have foreign subsidiaries that take financial positions in coordination with the parent. Accordingly, strong cooperative arrangements among domestic and foreign authorities, supported by an appropriate statutory framework, are needed to enable appropriate sharing of information among relevant authorities. Strong cooperation will not be a panacea, however, as legal and other restrictions on data sharing differ from one jurisdiction to the next, and it is unlikely that all such restrictions can be overcome. But cooperation and legislation to facilitate sharing with foreign authorities appears to be the best available strategy. Significant practical barriers also exist that can, at times, limit the quality of data collection and analysis available to support effective supervision and regulation, which include barriers to sharing data that arise from policies designed to protect privacy. For example, some private-sector databases and bank's loan books include firms' tax identification (ID) numbers as identifiers. Mapping those ID numbers into various characteristics, such as broad geographic location or taxable income measures, can be important for effective analysis and can be done in a way that does not threaten privacy. However, as a practical matter, a firm may have multiple ID numbers or they may have changed, but the Internal Revenue Service usually cannot share the information needed to validate a match between the firm and the ID number, even under arrangements designed to protect the confidentiality of the taxpayer information obtained. In addition, a significant amount of financial information is collected by private-sector vendors seeking to profit from the sale of data. These vendors have invested in expertise and in the quality of data in order to meet the needs of their customers, and the Federal Reserve is a purchaser of some of these data. However, vendors often place strong limitations on the sharing of such data with anyone, including among Federal agencies, and on the manner in which such data may be used. They also create systems with private identifiers for securities and firms or proprietary formats that do not make it easy to link with other systems. Surely it is important that voluntary contributors of data be able to protect their interests, and that the investments and intellectual property of firms be protected. But the net effect has been a noncompatible web of data that is much less useful, and much more expensive, to both the private and the public sector, than it might otherwise be. Protecting privacy and private-sector property rights clearly are important policy objectives; they are important considerations in the Federal Reserve's current data collection and safeguarding. Protecting the economy from systemic risk and promoting the safety and soundness of financial institutions also are important public objectives. The key issue is whether the current set of rules appropriately balances these interests. In light of the importance of the various interests involved, the Congress should consider initiating a process through which the parties of interest may exchange views and develop potential policy options for the Congress's consideration.Organization Structure for Data Collection and Developing Analytical Tools In addition to balancing the costs and benefits of enhanced data and analytical tools, the Congress must determine the appropriate organizational form for data collection and development of analytical tools. Budget costs, production efficiencies, and the costs of separating data collection and analysis from decisionmaking are important considerations. Any proposed form of organization should facilitate effective data sharing. It also should increase the availability of data, including aggregated supervisory data as appropriate, to market participants and experts so that they can serve the useful role of providing independent perspectives on risks in the financial system. The current arrangement, in which different agencies collect and analyze data, cooperating in cases where a consensus exists among them, can certainly be improved. The most desirable feature of collection and analysis under the existing setup is that it satisfies the principle that data collection and analysis should serve the end users, the regulatory agencies. Each of the existing agencies collects some data from entities it regulates or supervises, using its expertise to decide what to collect under its existing authorities and how to analyze it. Moreover, the agencies seek to achieve cost efficiencies and to reduce burdens on the private sector by cooperating in some data collection. An example is the Consolidated Reports of Condition and Income, or Call Reports, collected by the bank regulatory agencies from both national and state-chartered commercial banks. The content of the reporting forms is coordinated by the Federal Financial Institutions Examination Council, which includes representatives of both state and Federal bank regulatory agencies. A standalone independent data collection and analysis agency might be more nimble than the current setup because it would not have to reach consensus with other agencies. It might also have the advantage of fostering an overall assessment of financial data needs for all governmental purposes. However, there would also be some substantial disadvantages to running comprehensive financial data collection through a separate independent agency established for this purpose. A new agency would entail additional budget costs because the agency would likely need to replicate many of the activities of the regulatory agencies in order to determine what data are needed. More importantly, because it would not be involved directly in supervision or market monitoring, such an agency would be hampered in its ability to understand the types of information needed to effectively monitor systemic risks and conduct macroprudential supervision. Data collection and analysis are not done in a vacuum; an agency's duties will inevitably reflect the priorities, experience, and interests of the collecting entity. Even regular arms-length consultations among agencies might not be effective, because detailed appreciation of the regulatory context within which financial activities that generate data and risks is needed. The separation of data collection and regulation could also dilute accountability if supervisors did not have authority to shape the form and scope of reporting requirements by regulated entities in accordance with supervisory needs. An alternative organizational approach would be available if the Congress creates a council of financial regulators to monitor systemic risks and help coordinate responses to emerging threats, such as that contemplated in a number of legislative proposals. Under this approach, the supervisory and regulatory agencies would maintain most data collection and analysis, with some enhanced authority along the lines I have suggested. Coordination would be committed to the council, which could also have authority to establish information collection requirements beyond those conducted by its member agencies when necessary to monitor systemic risk. This approach might achieve the benefits of the current arrangement and the proposed independent agency, while avoiding their drawbacks. The council would be directed to seek to resolve conflicts among the agencies in a way that would preserve nimbleness, and it could recommend that an agency develop new types of data, but it would leave the details of data collection and analysis to the agencies that are closest to the relevant firms and markets. And while this council of financial supervisors could act independently if needed to collect information necessary to monitor the potential buildup of systemic risk, it would benefit directly from the knowledge and experience of the financial supervisors and regulators represented on the council. The council could also have access to the data collected by all its agencies and, depending on the staffing decisions, could either coordinate or conduct systemic risk analyses.Conclusion Let me close by thanking you once again for your attention to the important topic of ensuring the availability of the information necessary to monitor emergent systemic risks and establish effective macroprudential supervisory oversight. As you know, these tasks will not be easy. However, without a well-designed infrastructure of useful and timely data and improved analytical tools--which would be expected to continue to evolve over time--these tasks will only be more difficult. We look forward to continued discussion of these issues and to a development of a shared agenda for improving our information sources. I would be happy to answer any questions you might have. ______ CHRG-111hhrg52261--143 Mr. Roberts," We are--again, with a dual banking system, we are a State-chartered bank that happens also to be a member of the Federal Reserve System. We are regulated by the Commonwealth of Virginia and we are also regulated by the Federal Reserve. " CHRG-110shrg46629--30 Chairman Bernanke," Capital standards, I am sorry. Capital standards, thank you. The system we have now, Basel I, was designed 20 years ago for a very different kind of banking world. Banks are far more obligated. They use much more off balance sheets types of operations. The existing Basel I Accord, as the GAO study that just came agrees, and as the international banking community strongly agrees, is not safe for the largest and most sophisticated international banking organizations. And so it is not a question of going to lower capital standards. It is a question of finding a new system that will provide capital on a risk-adjusted basis that will match the capital against the risk, and therefore make these banks safer not less safe. So we take a backseat to nobody in the importance of making sure that these banks are safe and sound. That is our primary objective. And we believe that making this change to Basel II will increase, not decrease, the safety of these banks. In addition, of course, in any change from one system to another there is going to be a period of uncertainty as we work through the new methods and so on. And so we have been very careful to include a wide variety of protections including, as you know, the leverage ratio, prompt corrective action, the transition floors, Pillar II, a wide variety of things that will make sure that we have the control that we need to begin to see any unsafe drops in capital, we can make the changes to ensure that the banks are operating safely and soundly. So, I would just very strongly urge you to consider that Basel II is not about lowering capital, it is about making banks safer. Senator Shelby. But some banks believe it is about lowering capital. There has been a lot of stuff written about it. At the end of the day they said it would free up their capital, in other words lower the capital. That is some of our concerns. " CHRG-111shrg53176--126 Mr. Chanos," Thank you. Good afternoon, Mr. Chairman, Senator Shelby, and Members of the Committee. My name is Jim Chanos. I am here today testifying as Chairman of the Coalition of Private Investment Companies. I thank you for the opportunity to testify on this important subject today. The damage done by the collapse of global equity credit and asset-backed markets has been staggering in scope. The plain truth is that there is not a single market participant, from banker to dealer to end user and investor, that does not have to absorb some degree of responsibility for the difficulties we are confronting today. And while there is plenty of blame to spread around, there is little doubt that the root cause of the financial collapse lay at the large global diversified investment and commercial banks, insurance companies, and government-sponsored enterprises under direct regulatory scrutiny. Notably, hedge funds and investors have generally absorbed the painful losses of the past year without any government cushion or taxpayer assistance. While hedge funds and other types of private investment companies were not the primary catalyst for our current situation, it is also true that these private pools of capital should not be exempt from the regulatory modernization and improvement that will be developed based on lessons learned from the financial calamities of the past 20 months. CPIC believes that there are a few key principles that should be followed in establishing a regulatory regime for monitoring systemic risk. First, regulatory authority should be based upon activities and not actors. The same activities should be treated similarly, regardless of where it takes place. Proprietary trading at a major bank should not receive less scrutiny than the trading activity of a hedge fund. Second, the system should be geared to size, meaning overall size or relative importance in a given market and complexity. Third, all companies performing systemically important functions, such as credit rating agencies and others, should be included in this regime. Fourth, accuracy of required disclosures to shareholders and counterparties should be considered systemically significant. Fifth, the regulatory regime should be able to follow activities at systemically important entities regardless of the affiliated business unit in which the entity conducts these activities. Sixth and finally, the regulatory regime itself should be clear and unambiguous about the criteria that brings an entity under the new oversight regime. Increasing the financial regulation of hedge funds and other private investment companies carries both risks and benefits. I would like to chat about that for a few seconds. Relying on the fact of direct regulation in lieu of one's own due diligence will undermine those parts of the private sector that continue to work well and thus hamper the goal of restoring market strength and confidence. While it is clear that a regulator should have the ability to examine the activities of significant pools of capital to help mitigate against activities that would disrupt the markets, simply trying to wedge hedge funds and other private investment funds into the Investment Company Act or Investment Advisers Act is not likely to achieve that goal. If direct regulation is deemed necessary, Congress should consider a stand-alone statutory authority for the SEC or other regulator that permits the Commission to focus on market-wide issues that are relevant to managers of institutional funds while not undermining essential investor due diligence. Perhaps the most important role that hedge funds play is as investors in our financial system. To that end, CPIC believes that maximum attention should be paid to maintaining and increasing the transparency and accuracy of financial reporting to shareholders, counterparties, and the market as a whole. Undermining accounting standards may provide an illusion of temporary relief, but will ultimately result in less market transparency and a much longer recovery. Private investment companies play important roles in the market sufficiency and liquidity. They help provide price discovery, but they also play the role of financial detectives. Government actions that discourage investors from being skeptical, from being able to hear from differing opinions, or to review negative research ultimately harms the market. Indeed, some say that if Madoff Securities had been a public entity, short sellers would have blown a market whistle long ago. Honesty and fair dealing are at the foundation of investor confidence our markets have enjoyed for so many years. A sustainable economic recovery will not occur until investors can again feel certain that their interests come first and foremost with the companies, asset managers, and others with whom they invest their money and until they believe that regulators are effectively safeguarding them against fraud. CPIC is committed to working diligently with this Committee and other policymakers to achieve that difficult but necessary goal. Thank you very much. Senator Reed. Thank you very much. Ms. Roper. STATEMENT OF BARBARA ROPER, DIRECTOR OF INVESTOR PROTECTION, CHRG-111shrg51303--96 Chairman Dodd," Thank you very much. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. This is an area that I share Chairman Bernanke's comments about being angry. I am angrier than hell at what AIG has been able to get away with, and I am angry that regulators who, in my mind, should have seen the regulatory arbitrage that was taking place didn't bring it to the Congress's attention and say, hey, this is a gap that should be closed. The reason we have regulators is for them to be on the beat, not to be asleep at the switch. We keep hearing that AIG has systemic risk. Well, even systemic risk has to be quantifiable. So my question is, after having given them another $30 billion to supposedly stop them from collapse, the fourth bailout that they have had, there are those who are asking when is the fifth and how much. So you must all, I assume, if we are doing our jobs here, thinking about best and worst case scenarios, and so what is the quantifiable risk here, particularly in your minds, in the worst case scenario, what are AIG's assets really worth, or do you even know? " CHRG-110hhrg44900--58 Mr. Bernanke," I would like to. Thank you. First of all, I agree absolutely that market discipline is the heart of our system. Avoiding the moral hazard, having strong market discipline makes the system work better, and an example would be the counterparty discipline between the banks, investment banks, and the hedge funds, has protected the banks and the banks and the investment banks from any losses from hedge funds. There have been no material losses to banks or investment banks because of failing hedge funds, and because the banks have been doing due diligence, and that's what we want to see. Now in my view, our action to address the Bear Stearns situation was necessary, given the financial conditions at the time, but it's absolutely correct, as President Lacker has pointed out, it does raise moral hazard concerns going forward, and then the question is how do you address those. In my remarks today, I listed three possible approaches or complementary approaches. The first is supervisory oversight of those institutions to make sure that they are in fact doing what they need to do to be safe and sound, are not taking advantage of the implicit backstop. So since we have gone into the investment banks, they have all raised their liquidity, not reduced it. So that is one way to ensure that the moral hazard is minimized. Second, as Secretary Paulson mentioned, if we can strengthen our infrastructure sufficiently so that it could absorb the failure of a large firm--we felt it wasn't able to do so in March. But if it were clearer that the system could withstand the failure of a firm of Bear Stearns' size, then we would be much more comfortable letting it happen, because we would think the system would be preserved. And finally, I think that, as has happened in the commercial banking world, we do have stronger resolution procedures that would allow us to intervene in an early stage perhaps and to try to create an orderly process that doesn't create the market externalities at the same time it would avoid moral hazard because the equity holders, the management and subordinate debt holders would all be subjected to losses in that process. " CHRG-111shrg54533--91 PREPARED STATEMENT OF TIMOTHY GEITHNER Secretary, Department of the Treasury June 18, 2009 Financial Regulatory Reform: A New FoundationIntroduction Over the past 2 years we have faced the most severe financial crisis since the Great Depression. Americans across the Nation are struggling with unemployment, failing businesses, falling home prices, and declining savings. These challenges have forced the government to take extraordinary measures to revive our financial system so that people can access loans to buy a car or home, pay for a child's education, or finance a business. The roots of this crisis go back decades. Years without a serious economic recession bred complacency among financial intermediaries and investors. Financial challenges such as the near-failure of Long-Term Capital Management and the Asian Financial Crisis had minimal impact on economic growth in the U.S., which bred exaggerated expectations about the resilience of our financial markets and firms. Rising asset prices, particularly in housing, hid weak credit underwriting standards and masked the growing leverage throughout the system. At some of our most sophisticated financial firms, risk management systems did not keep pace with the complexity of new financial products. The lack of transparency and standards in markets for securitized loans helped to weaken underwriting standards. Market discipline broke down as investors relied excessively on credit rating agencies. Compensation practices throughout the financial services industry rewarded short-term profits at the expense of long-term value. Households saw significant increases in access to credit, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations that they did not understand and could not afford. While this crisis had many causes, it is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of our financial system. Gaps and weaknesses in the supervision and regulation of financial firms presented challenges to our government's ability to monitor, prevent, or address risks as they built up in the system. No regulator saw its job as protecting the economy and financial system as a whole. Existing approaches to bank holding company regulation focused on protecting the subsidiary bank, not on comprehensive regulation of the whole firm. Investment banks were permitted to opt for a different regime under a different regulator, and in doing so, escaped adequate constraints on leverage. Other firms, such as AIG, owned insured depositories, but escaped the strictures of serious holding company regulation because the depositories that they owned were technically not ``banks'' under relevant law. We must act now to restore confidence in the integrity of our financial system. The lasting economic damage to ordinary families and businesses is a constant reminder of the urgent need to act to reform our financial regulatory system and put our economy on track to a sustainable recovery. We must build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation, and that is able to adapt and evolve with changes in the financial market. In the following pages, we propose reforms to meet five key objectives: 1. Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose: A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation. New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks. Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms. A new National Bank Supervisor to supervise all federally chartered banks. Elimination of the Federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve. The registration of advisers of hedge funds and other private pools of capital with the SEC. 2. Establish comprehensive supervision of financial markets. Our major financial markets must be strong enough to withstand both systemwide stress and the failure of one or more large institutions. We propose: Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans. Comprehensive regulation of all over-the-counter derivatives. New authority for the Federal Reserve to oversee payment, clearing, and settlement systems. 3. Protect consumers and investors from financial abuse. To rebuild trust in our markets, we need strong and consistent regulation and supervision of consumer financial services and investment markets. We should base this oversight not on speculation or abstract models, but on actual data about how people make financial decisions. We must promote transparency, simplicity, fairness, accountability, and access. We propose: A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices. Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services. A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank. 4. Provide the government with the tools it needs to manage financial crises. We need to be sure that the government has the tools it needs to manage crises, if and when they arise, so that we are not left with untenable choices between bailouts and financial collapse. We propose: A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects. Revisions to the Federal Reserve's emergency lending authority to improve accountability. 5. Raise international regulatory standards and improve international cooperation. The challenges we face are not just American challenges, they are global challenges. So, as we work to set high regulatory standards here in the United States, we must ask the world to do the same. We propose: International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools. In addition to substantive reforms of the authorities and practices of regulation and supervision, the proposals contained in this report entail a significant restructuring of our regulatory system. We propose the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal Federal financial regulators as members. We also propose the creation of two new agencies. We propose the creation of the Consumer Financial Protection Agency, which will be an independent entity dedicated to consumer protection in credit, savings, and payments markets. We also propose the creation of the National Bank Supervisor, which will be a single agency with separate status in Treasury with responsibility for federally chartered depository institutions. To promote national coordination in the insurance sector, we propose the creation of an Office of National Insurance within Treasury. Under our proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of State-chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though we propose to harmonize the statutory and regulatory frameworks for futures and securities. The proposals contained in this report do not represent the complete set of potentially desirable reforms in financial regulation. More can and should be done in the future. We focus here on what is essential: to address the causes of the current crisis, to create a more stable financial system that is fair for consumers, and to help prevent and contain potential crises in the future. (For a detailed list of recommendations, please see Summary of Recommendations following the Introduction.) These proposals are the product of broad-ranging individual consultations with members of the President's Working Group on Financial Markets, Members of Congress, academics, consumer and investor advocates, community-based organizations, the business community, and industry and market participants.I. Promote Robust Supervision and Regulation of Financial Firms In the years leading up to the current financial crisis, risks built up dangerously in our financial system. Rising asset prices, particularly in housing, concealed a sharp deterioration of underwriting standards for loans. The Nation's largest financial firms, already highly leveraged, became increasingly dependent on unstable sources of short-term funding. In many cases, weaknesses in firms' risk-management systems left them unaware of the aggregate risk exposures on and off their balance sheets. A credit boom accompanied a housing bubble. Taking access to short-term credit for granted, firms did not plan for the potential demands on their liquidity during a crisis. When asset prices started to fall and market liquidity froze, firms were forced to pull back from lending, limiting credit for households and businesses. Our supervisory framework was not equipped to handle a crisis of this magnitude. To be sure, most of the largest, most interconnected, and most highly leveraged financial firms in the country were subject to some form of supervision and regulation by a Federal Government agency. But those forms of supervision and regulation proved inadequate and inconsistent. First, capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times. Regulators did not require firms to plan for a scenario in which the availability of liquidity was sharply curtailed. Second, on a systemic basis, regulators did not take into account the harm that large, interconnected, and highly leveraged institutions could inflict on the financial system and on the economy if they failed. Third, the responsibility for supervising the consolidated operations of large financial firms was split among various Federal agencies. Fragmentation of supervisory responsibility and loopholes in the legal definition of a ``bank'' allowed owners of banks and other insured depository institutions to shop for the regulator of their choice. Fourth, investment banks operated with insufficient government oversight. Money market mutual funds were vulnerable to runs. Hedge funds and other private pools of capital operated completely outside of the supervisory framework. To create a new foundation for the regulation of financial institutions, we will promote more robust and consistent regulatory standards for all financial institutions. Similar financial institutions should face the same supervisory and regulatory standards, with no gaps, loopholes, or opportunities for arbitrage. We propose the creation of a Financial Services Oversight Council, chaired by Treasury, to help fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities. This Council would include the heads of the principal Federal financial regulators and would maintain a permanent staff at Treasury. We propose an evolution in the Federal Reserve's current supervisory authority for BHCs to create a single point of accountability for the consolidated supervision of all companies that own a bank. All large, interconnected firms whose failure could threaten the stability of the system should be subject to consolidated supervision by the Federal Reserve, regardless of whether they own an insured depository institution. These firms should not be able to escape oversight of their risky activities by manipulating their legal structure. Under our proposals, the largest, most interconnected, and highly leveraged institutions would face stricter prudential regulation than other regulated firms, including higher capital requirements and more robust consolidated supervision. In effect, our proposals would compel these firms to internalize the costs they could impose on society in the event of failure.II. Establish Comprehensive Regulation of Financial Markets The current financial crisis occurred after a long and remarkable period of growth and innovation in our financial markets. New financial instruments allowed credit risks to be spread widely, enabling investors to diversify their portfolios in new ways and enabling banks to shed exposures that had once stayed on their balance sheets. Through securitization, mortgages and other loans could be aggregated with similar loans and sold in tranches to a large and diverse pool of new investors with different risk preferences. Through credit derivatives, banks could transfer much of their credit exposure to third parties without selling the underlying loans. This distribution of risk was widely perceived to reduce systemic risk, to promote efficiency, and to contribute to a better allocation of resources. However, instead of appropriately distributing risks, this process often concentrated risk in opaque and complex ways. Innovations occurred too rapidly for many financial institutions' risk management systems; for the market infrastructure, which consists of payment, clearing, and settlement systems; and for the Nation's financial supervisors. Securitization, by breaking down the traditional relationship between borrowers and lenders, created conflicts of interest that market discipline failed to correct. Loan originators failed to require sufficient documentation of income and ability to pay. Securitizers failed to set high standards for the loans they were willing to buy, encouraging underwriting standards to decline. Investors were overly reliant on credit rating agencies. Credit ratings often failed to accurately describe the risk of rated products. In each case, lack of transparency prevented market participants from understanding the full nature of the risks they were taking. The build-up of risk in the over-the-counter (OTC) derivatives markets, which were thought to disperse risk to those most able to bear it, became a major source of contagion through the financial sector during the crisis. We propose to bring the markets for all OTC derivatives and asset-backed securities into a coherent and coordinated regulatory framework that requires transparency and improves market discipline. Our proposal would impose record-keeping and reporting requirements on all OTC derivatives. We also propose to strengthen the prudential regulation of all dealers in the OTC derivative markets and to reduce systemic risk in these markets by requiring all standardized OTC derivative transactions to be executed in regulated and transparent venues and cleared through regulated central counterparties. We propose to enhance the Federal Reserve's authority over market infrastructure to reduce the potential for contagion among financial firms and markets. Finally, we propose to harmonize the statutory and regulatory regimes for futures and securities. While differences exist between securities and futures markets, many differences in regulation between the markets may no longer be justified. In particular, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.III. Protect Consumers and Investors From Financial Abuse Prior to the current financial crisis, a number of Federal and State regulations were in place to protect consumers against fraud and to promote understanding of financial products like credit cards and mortgages. But as abusive practices spread, particularly in the market for subprime and nontraditional mortgages, our regulatory framework proved inadequate in important ways. Multiple agencies have authority over consumer protection in financial products, but for historical reasons, the supervisory framework for enforcing those regulations had significant gaps and weaknesses. Banking regulators at the State and Federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission but limited tools and jurisdiction. Most critically in the run-up to the financial crisis, mortgage companies and other firms outside of the purview of bank regulation exploited that lack of clear accountability by selling mortgages and other products that were overly complicated and unsuited to borrowers' financial situation. Banks and thrifts followed suit, with disastrous results for consumers and the financial system. This year, Congress, the Administration, and financial regulators have taken significant measures to address some of the most obvious inadequacies in our consumer protection framework. But these steps have focused on just two, albeit very important, product markets--credit cards and mortgages. We need comprehensive reform. For that reason, we propose the creation of a single regulatory agency, a Consumer Financial Protection Agency (CFPA), with the authority and accountability to make sure that consumer protection regulations are written fairly and enforced vigorously. The CFPA should reduce gaps in Federal supervision and enforcement; improve coordination with the States; set higher standards for financial intermediaries; and promote consistent regulation of similar products. Consumer protection is a critical foundation for our financial system. It gives the public confidence that financial markets are fair and enables policy makers and regulators to maintain stability in regulation. Stable regulation, in turn, promotes growth, efficiency, and innovation over the long term. We propose legislative, regulatory, and administrative reforms to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products and services. We also propose new authorities and resources for the Federal Trade Commission to protect consumers in a wide range of areas. Finally, we propose new authorities for the Securities and Exchange Commission to protect investors, improve disclosure, raise standards, and increase enforcement.IV. Provide the Government With the Tools It Needs To Manage Financial Crises Over the past 2 years, the financial system has been threatened by the failure or near failure of some of the largest and most interconnected financial firms. Our current system already has strong procedures and expertise for handling the failure of banks, but when a bank holding company or other nonbank financial firm is in severe distress, there are currently only two options: obtain outside capital or file for bankruptcy. During most economic climates, these are suitable options that will not impact greater financial stability. However, in stressed conditions it may prove difficult for distressed institutions to raise sufficient private capital. Thus, if a large, interconnected bank holding company or other nonbank financial firm nears failure during a financial crisis, there are only two untenable options: obtain emergency funding from the U.S. Government as in the case of AIG, or file for bankruptcy as in the case of Lehman Brothers. Neither of these options is acceptable for managing the resolution of the firm efficiently and effectively in a manner that limits the systemic risk with the least cost to the taxpayer. We propose a new authority, modeled on the existing authority of the FDIC, that should allow the government to address the potential failure of a bank holding company or other nonbank financial firm when the stability of the financial system is at risk. In order to improve accountability in the use of other crisis tools, we also propose that the Federal Reserve Board receive prior written approval from the Secretary of the Treasury for emergency lending under its ``unusual and exigent circumstances'' authority.V. Raise International Regulatory Standards and Improve International Cooperation As we have witnessed during this crisis, financial stress can spread easily and quickly across national boundaries. Yet, regulation is still set largely in a national context. Without consistent supervision and regulation, financial institutions will tend to move their activities to jurisdictions with looser standards, creating a race to the bottom and intensifying systemic risk for the entire global financial system. The United States is playing a strong leadership role in efforts to coordinate international financial policy through the G20, the Financial Stability Board, and the Basel Committee on Banking Supervision. We will use our leadership position in the international community to promote initiatives compatible with the domestic regulatory reforms described in this report. We will focus on reaching international consensus on four core issues: regulatory capital standards; oversight of global financial markets; supervision of internationally active financial firms; and crisis prevention and management. At the April 2009 London Summit, the G20 leaders issued an eight-part declaration outlining a comprehensive plan for financial regulatory reform. The domestic regulatory reform initiatives outlined in this report are consistent with the international commitments the United States has undertaken as part of the G20 process, and we propose stronger regulatory standards in a number of areas. CHRG-111shrg52619--202 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM SCOTT M. POLAKOFFQ.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. 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? 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. A change in the structure of the regulatory system alone will not achieve success. While Congress should focus on ensuring that all participants in the financial markets are subject to the same set of regulations, the regulatory agencies must adapt using the lessons learned from the financial crisis to improve regulatory oversight. OTS conducts internal failed bank reviews for thrifts that fail and has identified numerous lessons learned from recent financial institution failures. The agency has revised its policies and procedures to correct gaps in regulatory oversight. OTS has also been proactive in improving the timeliness of formal and informal enforcement action.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. OTS believes that the best way to improve the regulatory oversight of financial activities is to ensure that all entities that provide specific financial services are subject to the same level of regulatory requirements and scrutiny. For example, there is no justification for mortgage brokers not to be bound by the same laws and rules as banks. A market where unregulated or under-regulated entities can compete alongside regulated entities offering complex loans or other financial products to consumers provides a disincentive to protect the consumer. Any regulatory restructure effort must ensure that all entities engaging in financial services are subject to the same laws and regulations. In addition, the business models of community banks versus that of commercial banks are fundamentally different. Maintaining and strengthening a federal regulatory structure that provides oversight of these two types of business models is essential. Under this structure, the regulatory agencies will need to continue to coordinate regulatory oversight to ensure they apply consistent standards for common products and services.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. While undesirable, failures are inevitable in a dynamic and competitive market. The housing downturn and resulting economic strain highlights that even traditionally lower-risk lending activities can become higher-risk when products evolve and there is insufficient regulatory oversight covering the entire market. There is no way to predict with absolute certainty how economic factors will combine to cause stress. For example, in late 2007, financial institutions faced severe erosion of liquidity due to secondary markets not functioning. This problem compounded for financial institutions engaged in mortgage banking who found they could not sell loans from their warehouse, nor could they rely on secondary sources of liquidity to support the influx of loans on their balance sheets. While the ideal goal of the regulatory structure is to limit and prevent failures, it also serves as a safety net to manage failures with no losses to insured depositors and minimal cost to the deposit insurance fund.Q.4. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.4. Hedge funds are unregulated entities that are considered impermissible investments for thrifts. As such, OTS has no direct knowledge of hedge fund failures or how they have specifically contributed to systemic risk. Anecdotally, however, we understand that many of these entities were highly exposed to sub-prime loans through their investment in private label securities backed by subprime or Alt-A loan collateral, and they were working with higher levels of leverage than were commercial banks and savings institutions. As defaults on these loans began to rise, the value of those securities fell, losses mounted and capital levels declined. As this occurred, margin calls increased and creditors began cutting these firms off or stopped rolling over lines of credit. Faced with greater collateral requirements, creditors demanding lower levels of leverage, eroding capital, and dimming prospects on their investments, these firms often perceived the sale of these unwanted assets as the best option. The glut of these securities coming to the market and the lack of private sector buyers likely further depressed prices.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. The problem was not a lack of identifying risk areas, but in understanding and predicting the severity of the economic downturn and its resulting impact on entire asset classes, regardless of risk. The magnitude and severity of the economic downturn was unprecedented. The confluence of events leading to the financial crisis extends beyond signals that bank examiners alone could identify or correct. OTS believes it is important for Congress to establish a systemic risk regulator that will work with the federal bank regulatory agencies to identify systemic risks and how they affect individual regulated entities. There is evidence in reports of examination and other supervisory documents that examiners identified several of the problems we are facing, particularly the concentrations of assets. There was no way to predict how rapidly the market would reverse and housing prices would decline. The agency has taken steps to improve its regulatory oversight through the lessons learned during this economic cycle. For its part, OTS has strengthened its regulatory oversight, including the timeliness of enforcement actions and monitoring practices to ensure timely corrective action.Q.6. There have been many thrifts that failed under the watch of the OTS this year. While not all thrift or bank failures can or should be stopped, the regulators need to be vigilant and aware of the risks within these financial institutions. Given the convergence within the financial services industries, and that many financial institutions offer many similar products, what is distinct about thrifts? Other than holding a certain proportion of mortgages on their balance sheets, do they not look a lot like other financial institutions?A.6. In recent years, financial institutions of all types have begun offering many of the same products and services to consumers and other customers. It is hard for customers to distinguish one type of financial institution from another. This is especially true of insured depository institutions. Despite the similarities, savings associations have statutory limitations on the assets they may have or in the activities in which they may engage. They still must have 65 percent of their assets in housing related loans, as defined. As a result, savings associations are not permitted to diversify to the same extent as are national banks or state chartered banks. Within the confines of the statute, savings associations have begun to engage in more small business and commercial real estate lending in order to diversify their activities, particularly in times of stress in the mortgage market. Savings associations are the insured depositories that touch the consumer. They are local community banks providing services that families and communities need and value. Many of the institutions supervised by the OTS are in the mutual form of ownership and are small. While many savings associations offer a variety of lending and deposit products and they are competitors in communities nationwide, they generally are retail, customer driven community banks. ------ CHRG-111shrg56376--233 PREPARED STATEMENT OF RICHARD S. CARNELL Associate Professor, Fordham University School of Law September 29, 2009 Mr. Chairman, Senator Shelby, Members of the Committee: You hold these hearings in response to an extraordinary financial debacle, costly and far-reaching: a debacle that has caused worldwide pain and will saddle our children with an oversized public debt. ``And yet,'' to echo President Franklin D. Roosevelt's inaugural address, ``our distress comes from no failure of substance. We are stricken by no plague of locusts. . . . Plenty is at our doorstep.'' Our financial system got into extraordinary trouble--trouble not seen since the Great Depression--during a time of record profits and great prosperity. This disaster had many causes, including irrational exuberance, poorly understood financial innovation, loose fiscal and monetary policy, market flaws, regulatory gaps, and the complacency that comes with a long economic boom. But our focus here is on banking, where the debacle was above all a regulatory failure. Banking is one of our most heavily regulated industries. Bank regulators had ample powers to constrain and correct unsound banking practices. Had regulators adequately used those powers, they could have made banking a bulwark for our financial system instead of a source of weakness. In banking, as in the system as a whole, we have witnessed the greatest regulatory failure in history. Our fragmented bank regulatory structure contributed to the debacle by impairing regulators' ability and incentive to take timely preventive action. Reform of that structure is long overdue. In my testimony today, I will: 1. Note how regulatory fragmentation has grave defects, arose by happenstance, and persists not on its merits but through special-interest politics and bureaucratic obduracy; 2. Recommend that Congress unify banking supervision in a new independent agency; and 3. Reinforce the case for reform by explaining how regulatory fragmentation helps give regulators an unhealthy set of incentives--incentives that hinder efforts to protect bank soundness, the Federal deposit insurance fund, and the taxpayers.I. Fragmentation Impedes Effective SupervisionFragmentation Is Dysfunctional Our fragmented bank regulatory structure is needlessly complex, needlessly expensive, and imposes needless compliance costs on banks. It ``requires too many banking organizations to deal with too many regulators, each of which has overlapping, and too often maddeningly different, regulations and interpretations,'' according to Federal Reserve Governor John LaWare. It engenders infighting and impedes prudent regulatory action. FDIC Chairman William Seidman deplored the stubbornness too often evident in interagency negotiations: ``There is no power on earth that can make them agree--not the President, not the Pope, not anybody. The only power that can make them agree is the Congress of the United States by changing the structure so that the present setup does not continue.'' The current structure promotes unsound laxity by setting up interagency competition for bank clientele. It also blunts regulators' accountability with a tangled web of overlapping jurisdictions and responsibilities. Comptroller Eugene Ludwig remarked that ``it is never entirely clear which agency is responsible for problems created by a faulty, or overly burdensome, or late regulation. That means that the Congress, the public, and depository institutions themselves can never be certain which agency to contact to address problems created by a particular regulation.'' Senator William Proxmire, longtime Chairman of this Committee, called this structure ``the most bizarre and tangled financial regulatory system in the world.'' Treasury Secretary Lloyd Bentsen branded it ``a spider's web of overlapping jurisdictions that represents a drag on our economy, a headache for our financial services industry, and a source of friction within our Government.'' Chairman Seidman derided it as ``complex, inefficient, outmoded, and archaic.'' The Federal Reserve Board declared it ``a crazy quilt of conflicting powers and jurisdictions, of overlapping authorities, and gaps in authority'' (and that was in 1938, when the system was simpler than now). Federal Reserve Vice Chairman J.L. Robertson went further: The nub of the problem . . . is the simple fact that we are looking for, talking about, and relying upon a system where no system exists. . . . Our present arrangement is a happenstance and not a system. In origin, function, and effect, it is an amalgam of coincidence and inadvertence. Opponents of reform portray a unified supervisory agency as ominous and unnatural. Yet although the Federal Government regulates a wide array of financial institutions, no other type of institution has competing Federal regulators. Not mutual funds, exchange-traded funds, or other regulated investment companies. Not securities broker-dealers. Not investment advisers. Not futures dealers. Not Government-sponsored enterprises. Not credit unions. Not pension funds. Not any other financial institution. A single Federal regulator is the norm; competition among Federal regulators is an aberration of banking. Nor do we see competition among Federal regulators when we look beyond financial services--and for good reason. Senator Proxmire observed: Imagine for a moment that we had seven separate and distinct Federal agencies for regulating airline safety. Imagine further the public outcry that would arise following a series of spectacular air crashes while the seven regulators bickered among themselves on who was to blame and what was the best way to prevent future crashes. There is no doubt in my mind that the public would demand and get a single regulator. There is a growing consensus among experts that our divided regulatory system is a major part of the problem. There are many reasons for consolidating financial regulations, but most of them boil down to getting better performance.Fragmentation Is the Product of Happenstance Two forces long shaped American banking policy: distrust of banks, particularly large banks; and crises that necessitated a stronger banking system. Our fragmented regulatory structure reflects the interplay between these forces. As FDIC Chairman Irvine H. Sprague noted, this structure ``had to be created piecemeal, and each piece had to be wrested from an economic crisis serious enough to muster the support for enactment.'' Distrust of banking ran deep from the beginning of the Republic. John Adams, sober and pro-business, declared that ``banks have done more injury to the religion, morality, tranquility, prosperity, and even wealth of the Nation than they have done or ever will do good.'' Thomas Jefferson asserted that states ``may exclude [bankers] from our territory, as we do persons afflicted with disease.'' Andrew Jackson won reelection pledging to destroy the Nation's central bank, which he likened to a malicious monster. This powerful, longstanding distrust of banking shaped U.S. law in ways that, until recent decades, kept U.S. banks smaller and weaker (relative to the size of our economy) than their counterparts in other developed countries. Yet banking proved too useful to ignore or suppress. To cope with financial emergencies, Congress acted to strengthen the banking system. It created: National banks to finance the Civil War and the OCC to supervise national banks; The Federal Reserve in response to the Panic of 1907; The FDIC, its thrift-institution counterpart, and the Federal thrift charter to help stabilize the financial system during the Great Depression; and The Office of Thrift Supervision in response to the thrift debacle of the 1980s.These and other ad hoc actions gave us a hodgepodge of bank regulatory agencies unparalleled in the world. Each agency, charter type, and regulatory subcategory developed a political constituency resistant to reform. The Bank Holding Company Act, another product of happenstance, exacerbated this complexity. It ultimately gave most banking organizations of any size a second Federal regulator: the Federal Reserve Board. As enacted in 1956, the Act sought to prevent ``undue concentration of economic power'' by limiting banks' use of holding companies to enter additional businesses and expand across State lines. The Act reflected a confluence of three disparate forces: populist suspicion of bigness in banking; special-interest politics; and the Federal Reserve Board's desire to bolster its jurisdiction. Representative Wright Patman, populist chairman of the House Banking Committee, sought to prevent increased concentration in banking and the broader economy. Small banks sought to keep large banks from expanding into new products and territory. A variety of other firms sought to keep banks out of their businesses. The Fed gained both expanded jurisdiction and a respite from Chairman Patman's attempts to curtail its independence in monetary policy. \1\ The Act originally applied only to companies owning two or more banks. But in 1970 Congress extended the Act to companies owning a single bank.--------------------------------------------------------------------------- \1\ Mark J. Roe, ``Strong Managers, Weak Owners: The Political Roots of American Corporate Finance'', 99-100 (1994).---------------------------------------------------------------------------Special-Interest Politics Perpetuate Fragmentation Regulatory fragmentation leaves individual agencies smaller, weaker, and more vulnerable to pressure than a unified agency would be. It can also undercut their objectivity. Fragmentation played a pivotal role in the thrift debacle. Specialized thrift regulators balked at taking strong, timely action against insolvent thrifts. Regulators identified with the industry and feared that stern action would sharply shrink the industry and jeopardize their agencies' reason for being. In seeking to help thrifts survive, the regulators multiplied the ultimate losses to the deposit insurance fund and the taxpayers. For example, they granted sick thrifts new lending and investment powers for which the thrifts lacked the requisite competence (e.g., real estate development and commercial real estate lending). By contrast, bank regulators who also regulated thrifts took firmer, more appropriate action (e.g., limiting troubled institutions' growth and closing deeply insolvent institutions). These policies bore fruit in lower deposit insurance losses. State-chartered thrifts regulated by State banking commissioners were less likely to fail--and caused smaller insurance losses--than thrifts with a specialized, thrift-only regulator. Likewise, thrifts regulated by the FDIC fared far better than those regulated by the thrift-only Federal Home Loan Bank Board.II. Unifying Federal Bank Supervision Fragmentation problems have a straightforward, common-sense solution: unifying Federal bank regulation. Treasury Secretary Lloyd Bentsen offered that solution here in this room 15 years ago. As Assistant Secretary of the Treasury for Financial Institutions, I worked with him in preparing that proposal. He made a cogent case then, and I'll draw on it in my testimony now. Secretary Bentsen proposed that we unify the supervision of banks, thrifts, and their parent companies in a new independent agency, the Federal Banking Commission. The agency would have a five-member board, with one member representing the Treasury, one member representing the Federal Reserve, and three independent members appointed by the President and confirmed by the Senate. The President would designate and the Senate confirm one of the independent members to head the agency. The commission would assume all the existing bank regulatory responsibilities of the Comptroller of the Currency, Federal Reserve Board, FDIC, and Office of Thrift Supervision. The Federal Reserve would retain all its other responsibilities, including monetary policy, the discount window, and the payment system. The FDIC would retain all its powers and responsibilities as deposit insurer, including its power to conduct special examinations, terminate insurance, and take back-up enforcement action. The three agencies' primary responsibilities would correspond to the agencies' core functions: bank supervision, central banking, and deposit insurance. This structure would promote clarity, efficiency, accountability, and timely action. It would also help the new agency maintain its independence from special-interest pressure. The agency would be larger and more prominent than its regulatory predecessors and would supervise a broader range of banking organizations. It would thus be less beholden to a particular industry clientele--and more able to carry out appropriate preventive and corrective action. Moreover, a unified agency could do a better job of supervising integrated banking organizations--corporate families in which banks extensively interact with their bank and nonbank affiliates. The agency would look at the whole organization, not just some parts. Secretary Bentsen put the point this way: Under today's bank regulatory system, any one regulator may see only a limited piece of a dynamic, integrated banking organization, when a larger perspective is crucial both for effective supervision of the particular organization and for an understanding of broader industry conditions and trends.Having the same agency oversee banks and their affiliates both simplifies compliance and makes supervision more effective. We have no need for a separate holding company regulator. Under the Bentsen proposal, the Fed and FDIC would have full access to supervisory information about depository institutions and their affiliates. Their examiners could participate regularly in examinations conducted by the commission and maintain their expertise in sizing up banks. As members of a Federal Banking Commission-led team, Fed and FDIC examiners could scrutinize the full spectrum of FDIC-insured depository institutions, including national banks. The two agencies would have all the information, access, and experience needed to carry out their responsibilities. The Treasury consulted closely with the FDIC in developing its 1994 reform proposal. The FDIC supported regulatory consolidation in testimony before this Committee on March 2, 1994. It stressed that in the context of consolidation it had five basic needs. First, to remain independent. Second, to retain authority to set insurance premiums and determine its own budget. Third, to have ``timely access'' to information needed to ``understand and stay abreast of the changing nature of the risks facing the banking industry . . . and to conduct corrective resolution and liquidation activities.'' Fourth, to retain power to grant and terminate insurance, assure prompt corrective action, and take back-up enforcement action. Fifth, to retain its authority to resolve failed and failing banks. A regulatory unification proposal can readily meet all five of those needs. Indeed, Secretary Bentsen's proposal dealt with most of them in a manner satisfactory to the FDIC. The Treasury and FDIC did disagree about FDIC membership on the Federal Banking Commission. The FDIC regarded membership as an important assurance of obtaining timely information. The Treasury proposal did not provide for an FDIC seat, partly out of concern that it would entail expanding the commission to seven members. Now as then, I believe that the agency's board should include an FDIC representative. The Federal Reserve and FDIC complain that they cannot properly do their jobs unless they remain the primary Federal regulator of some fraction of the banking industry. These complaints ignore the sort of safeguards in Secretary Bentsen's proposal. They also exaggerate the significance of the two agencies' current supervisory responsibilities. FDIC-supervised banks hold only 17 percent of all FDIC-insured institutions' aggregate assets; Fed-supervised banks, only 13 percent. Nor does the Fed's bank holding jurisdiction fundamentally alter the picture: the Fed as holding company regulator neither examines nor supervises other FDIC-insured institutions. The Fed and FDIC, in carrying out their core responsibilities, already rely primarily on supervisory information provided by others. Thus it strains credulity to suggest that the FDIC cannot properly carry out its insurance and receivership functions unless it remains the primary Federal regulator of State nonmember banks. These banks, currently numbering 5,040, average $460 million in total assets. How many community banks must the FDIC supervise to remain abreast of industry trends and remember how to resolve a community bank? Likewise, the Fed cannot plausibly maintain that its ability to conduct monetary policy, operate the discount window, and gauge systemic risk appreciably depends on remaining the primary Federal regulator of 860 State member banks (only 10 percent of FDIC-insured institutions), particularly when those banks average less than $2 billion in total assets. Moreover, according to the most recent Federal Reserve Flow of Funds accounts, the entire commercial banking industry (including U.S.-chartered commercial banks, foreign banks' U.S. offices, and bank holding companies) holds only some 18 percent of our Nation's credit-market assets. In sum, the two agencies' objections to reform ring false. They are akin to saying, ``I can't do my job right without being the supreme Federal regulator for some portion of the banking industry, small though that portion may be. Nothing else will do.'' Nor do regulatory checks and balances depend on perpetuating our multiregulator jumble. ``Regulatory power is not restrained by creating additional agencies to perform duplicate functions,'' Secretary Bentsen rightly declared. A unified banking supervisor would face more meaningful constraints from ``congressional oversight, the courts, the press, and market pressures.'' Its decision making would also, under my recommendations, include the insights, expertise, and constant participation of the Federal Reserve Board and FDIC.III. Regulatory Fragmentation Promotes Unsound Laxity Most debate about banking regulation pays little heed to bank regulators' incentives. That's a serious mistake, all the more so given the recent debacle. As noted at the outset, regulators had ample powers to keep banks safe but failed to do so. This failure partly involved imperfect foresight (an ailment common to us all). But it also reflected an unhealthy set of incentives--incentives that tend to promote unsound laxity. These incentives discouraged regulators from taking adequate steps to protect bank soundness, the Federal deposit insurance fund, and the taxpayers. Economists refer to such incentives as ``perverse'' because they work against the very goals of banking regulation. These incentives represent the regulatory counterpart of moral hazard. Just as moral hazard encourages financial institutions to take excessive risks, these incentives discourage regulators from taking adequate precautions. To improve regulation, we need to give regulators a better set of incentives--incentives more compatible with protecting the FDIC and the taxpayers. Several key factors create perverse incentives for bank regulators. First, we have difficulty telling good regulation from bad--until it's too late. Second, lax regulation is more popular than stringent regulation--until it's too late. Third, regulators' reputations suffer less from what goes wrong on their watch than from what comes to light on their watch. This is the upshot: Bank Soundness Regulation Has No Political Constituency--Until It's Too Late. To make the incentive problem more concrete, put yourself in the position of a regulator who, during a long economic boom and a possible real estate bubble, sees a need to raise capital standards. The increase will have short-term, readily identifiable consequences. To comply with the new standards, banks may need to constrain their lending and reduce their dividends. Prospective borrowers will complain. Banks' return on equity will decline because banks will need more equity per dollar of deposits. Hence bankers will complain. You'll feel immediate political pain. Yet the benefits of higher capital standards, although very real, will occur over the long run and be less obvious than the costs. Raising capital levels will help protect the taxpayers, but the taxpayers won't know it. Moreover, in pressing weaker banks to shape up and in limiting the flow of credit to real estate, you may get blamed for causing problems that already existed. From the standpoint of your own self-interest, you're better off not raising capital standards. You can leave office popular. By the time banks get into trouble, you'll have a new job and your successor will have to shoulder the problem. Similar incentives encourage too-big-to-fail treatment. Bailouts confer immediate, readily identifiable benefits. By contrast, the costs of intervention (such as increased moral hazard and potential for future instability) are long-term, diffuse, and less obvious. But you can leave those problems for another day and another regulator. You risk criticism whether or not you intervene. But on balance you run a greater risk of destroying your reputation if you let market discipline take its course. Unwarranted intervention may singe your career; a seemingly culpable failure to intervene will incinerate it. Bank regulators need better incentives far more than they need new regulatory powers. Creating a unified regulator will make for a healthier set of incentives.Conclusion Now is the right time to fix the bank regulatory structure: now, while we're still keenly aware of the financial debacle; now, while special-interest pressure and bureaucratic turf struggles are less respectable than usual. Reform should promote efficiency, sharpen accountability, and help regulators withstand special-interest pressure. Speaking from this table in 1994, Secretary Bentsen underscored the risk of relying on ``a dilapidated regulatory system that is ill-designed to prevent future banking crises and ill-equipped to cope with crises when they occur.'' He observed, in words eerily applicable to the present, that our country had ``just emerged from its worst financial crisis since the Great Depression,'' a crisis that our cumbersome bank regulatory system ``did not adequately anticipate or help resolve.'' He also issued this warning, which we would yet do well to heed: ``If we fail to fix [the system] now, the next financial crisis we face will again reveal its flaws. And who suffers then? Our banking industry, our economy, and, potentially, the taxpayers. You have the chance to help prevent that result.'' PREPARED STATEMENT OF RICHARD J. HILLMAN Managing Director, Financial Markets and Community Investment Team, Government Accountability Office September 29, 2009" CHRG-111shrg52619--183 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOHN C. DUGANQ.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 financial crisis has highlighted significant regulatory gaps in the oversight of our financial system. Large nonbank financial institutions like AIG, Fannie Mae and Freddie Mac, Bear Steams, and Lehman were subject to varying degrees and different kinds of government oversight. No one regulator had access to risk information from these nonbank firms in the same way that the Federal Reserve has with respect to bank holding companies. The result was that the risk these firms presented to the financial system as a whole could not be managed or controlled before their problems reached crisis proportions. Assigning to one agency the oversight of systemic risk throughout the financial system could address certain of these regulatory gaps. For example, such an approach would fix accountability, centralize data collection, and facilitate a unified approach to identifying and addressing large risks across the system. However, a single systemic regulator approach also would face challenges due to the diverse nature of the firms that could be labeled systemically significant. Key issues would include the type of authority that should be provided to the regulator; the types of financial firms that should be subject to its jurisdiction; and the nature of the new regulator's interaction with existing prudential supervisors. It would be important, for example, for the systemic regulatory function to build on existing prudential supervisory schemes, adding a systemic point of view, rather than replacing or duplicating regulation and supervisory oversight that already exists. How this would be done would need to be evaluated in light of other restructuring goals, including providing clear expectations for financial institutions and clear responsibilities and accountability for regulators; avoiding new regulatory inefficiencies; and considering the consequences of an undue concentration of responsibilities in a single regulator. Moreover, the contours of new systemic authority may need to vary depending on the nature of the systemically significant entity. For example, prudential regulation of banks involves extensive requirements with respect to risk reporting, capital, activities limits, risk management, and enforcement. The systemic supervisor might not need to impose all such requirements on all types of systemically important firms. The ability to obtain risk information would be critical for all such firms, but it might not be necessary, for example, to impose the full array of prudential standards, such as capital requirements or activities limits on all types of systemically important firms, e.g., hedge funds (assuming they were subject to the new regulator's jurisdiction). Conversely, firms like banks that are already subject to extensive prudential supervision would not need the same level of oversight as firms that are not--and if the systemic overseer were the Federal Reserve Board, very little new authority would be required with respect to banking companies, given the Board's current authority over bank holding companies.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. A number of options for regulatory reform have been put forward, including those mentioned in this question. Each raises many detailed issues. The Treasury Blueprint offers a thoughtful approach to the realities of financial services regulation in the 21st century. In particular, the Blueprint's recommendation to establish a new federal charter for systemically significant payment and settlement systems and authorizing the Federal Reserve Board to supervise them is appropriate given the Board's extensive experience with payment system regulation. The Group of 30 Report compares and analyzes the financial regulatory approaches of seventeen jurisdictions--including the United Kingdom, the United States and Australia--in order to illustrate the implications of the four principal models of supervisory oversight. The Group of 30 Report then sets forth 18 proposals for banks and nonbanks. For all countries, the Report recommends that bank supervision be consolidated under one prudential regulator. Under the proposals, banks that are deemed systemically important would face restrictions on high-risk proprietary activities. The report also calls for raising the level at which banks are considered to be well-capitalized, Proposals for nonbanks include regulatory oversight and the production or regular reports on leverage and performance. For banks and nonbanks alike, the Report calls for a more refined analysis of liquidity in stressed markets and more robust contingency planning. The Financial Services Authority model is one in which all supervision is consolidated in one agency. As debate on these and other proposals continues, the OCC believes two fundamental points are essential. First, it is important to preserve the Federal Reserve Board's role as a holding company supervisor. Second, it is equally if not more important to preserve the role of a dedicated, front-line prudential supervisor for our nation's banks. The Financial Services Authority model raises the fundamental problem that consolidating all supervision in a new, single independent agency would take bank supervisory functions away from the Federal Reserve Board. As the central bank and closest agency we have to a systemic risk regulator, the Board needs the window it has into banking organizations that it derives from its role as bank holding company supervisor. Moreover, given its substantial role and direct experience with respect to capital markets, payments systems, the discount window, and international supervision, the Board provides unique resources and perspective to bank holding company supervision. Second, and perhaps more important, is preserving the very real benefit of having an agency whose sole mission is bank supervision. The benefits of dedicated supervision are significant. Where it occurs, there is no confusion about the supervisor's goals and objectives, and no potential conflict with competing objectives. Responsibility is well defined, and so is accountability. Supervision does not take a back seat to any other part of the organization, and the result is a strong culture that fosters the development of the type of seasoned supervisors that are needed to confront the many challenges arising from today's banking business.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? 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? 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.3. There a number of ways ``too big to fail'' can be defined, including the size of an institution, assets under management, interrelationships or interconnections with other significant economic entities, or global reach. Likewise, ``failure'' could have several definitions, including bankruptcy. But whatever definition of these terms Congress may choose, it is important that there be an orderly process for resolving systemically significant firms. U.S. law has long provided a unique and well developed framework for resolving distressed and failing banks that is distinct from the federal bankruptcy regime. Since 1991, this unique framework, contained in the Federal Deposit Insurance Act, has also provided a mechanism to address the problems that can arise with the potential failure of a systemically significant bank--including, if necessary to protect financial stability, the ability to use the bank deposit insurance fund to prevent uninsured depositors, creditors, and other stakeholders of the bank from sustaining loss. No comparable framework exists for resolving most systemically significant financial firms that are not banks, including systemically significant holding companies of banks. Such firms must therefore use the normal bankruptcy process unless they can obtain some form of extraordinary government assistance to avoid the systemic risk that might ensue from failure or the lack of a timely and orderly resolution. While the bankruptcy process may be appropriate for resolution of certain types of firms, it may take too long to provide certainty in the resolution of a systemically significant firm, and it provides no source of funding for those situations where substantial resources are needed to accomplish an orderly solution. This gap needs to be addressed with an explicit statutory regime for facilitating the resolution of systemically important nonbank companies as well as banks. This new statutory regime should provide tools that are similar to those currently available for resolving banks, including the ability to require certain actions to stabilize a firm; access to a significant funding source if needed to facilitate orderly dispositions, such as a significant line of credit from the Treasury; the ability to wind down a firm if necessary; and the flexibility to guarantee liabilities and provide open institution assistance if needed to avoid serious risk to the financial system. In addition, there should be clear criteria for determining which institutions would be subject to this resolution regime, and how to handle the foreign operations of such institutions. ------ CHRG-111shrg53822--92 PREPARED STATEMENT OF RAGHURAM G. RAJAN Eric J. Gleacher Distinguished Service Professor of Finance, University of Chicago, Booth School of Business May 6, 2009Too Systemic to fail: Consequences, Causes, and Potential Remedies\1\--------------------------------------------------------------------------- \1\ The opinions expressed in this piece are mine alone, but I have benefited immensely from past discussions and work with Douglas Diamond, Anil Kashyap, and Jeremy Stein, as well as members of the Squam Lake Group (see http://www.cfr.org/project/1404/squam_lake_working_group_on_financial_regulation.html).--------------------------------------------------------------------------- Perhaps the single biggest distortion to the free enterprise system is when a number of private institutions are deemed by political and regulatory authorities as too systemic to fail. Resources are trapped in corporate structures that have repeatedly proven their incompetence, and further resources are sucked in from the taxpayer as these institutions destroy value. Indeed, these institutions can play a game of chicken with the authorities by refusing to take adequate precautions against failure, such as raising equity, confident in the knowledge the authorities will come to the rescue when needed. The consequences are observationally identical to those in a system of crony capitalism. Indeed, it is hard for the authorities to refute allegations of crony capitalism--after all, the difference is only one of intent for the authorities in a free enterprise system do not want to bail out systemically important institutions, but are nevertheless forced to, while in crony capitalism, they do so willingly. More problematic, corrupt officials can hid behind the doctrine of systemic importance to bail out favored institutions. Regardless of whether such corruption takes place, the collateral damage to public faith in the system of private enterprise is enormous, especially as the public senses two sets of rules, one for the systemically important, and another for the rest of us. As important as the economic and political damage created in bad times, is the damage created in good times because these institutions have an unfair competitive advantage. Some institutions may undertake businesses they have no competence in, get paid for guarantees they have no ability to honor, or issue enormous amounts of debt cheaply only because customers and investors see the taxpayer standing behind them. Other institutions may deliberately create complexities, fragilities, and interconnections so as to become hard to fail. In many ways, therefore, I believe the central focus of any new regulatory effort should be on how to prevent institutions from becoming too systemic to fail.Is it only too ``big'' to fail? Note that I have avoided saying ``too big to fail.'' This is because there are entities that are very large but have transparent, simple structures that allow them to be failed easily--for example, a firm running a family of regulated mutual funds. By contrast, there are relatively small entities--the mortgage insurers or Bear Stearns are examples--whose distress caused substantial stress to buildup through the system. This means a number of factors other than size may cause an institution to be systemically important including (i) the institution's centrality to a market (mortgage insurers, exchanges) (ii) the extent to which systemic institutions are exposed to the institution (AIG) (iii) the extent to which the institution's business and liabilities are intertwined, or are in foreign jurisdictions where U.S. bankruptcy stay does not apply, so that the act of failing the institution will impose substantial losses on its assets, and (iv) the extent to which the institution's business interacts in complex ways with the financial system so that the authorities are uncertain about the systemic consequences of failure and do not want to take the risk of finding out. This last point takes us to the role of regulators and politicians in creating an environment where institutions are deemed too systemic to fail. For the authorities, there is little immediate benefit to failing a systemically important institution. If events spin out of control, the downside risks to one's career, as well as short-term risks to the economy, loom far bigger for the authorities than any long term benefit of asserting market discipline and preventing moral hazard. Moreover, the public is likely to want to assign blame for a recognized failure, while a bailout can largely be hidden from public eye. Finally, the budgetary implications of recognizing failure can be significant, while the budgetary implications of bailouts can be postponed into the future. For all these reasons, it will be the brave or foolhardy regulator who tries to fail a systemically important institution, and give the experience of the events surrounding the Lehman bankruptcy, I do not see this happening over the foreseeable future. If the authorities are likely to bail out systemically--or even near-systemically important institutions--the solution to the problem of institutions becoming ``too systemically important to fail'' has to be found elsewhere than in stiffening the backbone of regulators or limiting their discretion.\2\ There are three obvious possibilities: 1) prevent institutions from becoming systemically important; 2) keep them from failing by creating additional private sector buffers; 3) when they do become truly distressed, make it easier for the authorities to fail them. Let me discuss each of these in turn.--------------------------------------------------------------------------- \2\ For example, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in many ways was meant to ensure regulators took prompt corrective action, by reducing their leeway to forbear. However, FDICIA was focused on the problem of relatively small thrifts, not ``too-big-to-fail'' institutions.---------------------------------------------------------------------------Preventing Institutions From Becoming Systemically Important Many current regulatory proposals focus on preventing institutions from becoming systemically important. These include preventing institutions from expanding beyond a certain size or limiting the activities of depository institutions (through a modern version of the 1933 Glass-Steagall Act). I worry that these proposals may be very costly, and may still not achieve their intent. Here is why. Clearly, casual empiricism would suggest that some institutions have become too big to manage. If in addition they are likely to impose costs on the system because they are ``too big to fail,'' it seems obvious they should be constrained from growing, and indeed should be forced to break up.\3\ Similarly, it seems obvious that the peripheral risky activities of banks should be constrained or even banned if there are underlying core safe activities than need to be protected.--------------------------------------------------------------------------- \3\ The academic literature lends support to such a view for banks because it finds few economies of scale for banks beyond a certain size.---------------------------------------------------------------------------Economic Concerns More careful thought would, however, suggest serious concerns about such proposals. First, consider the economic concerns. Some institutions get large, not through opportunistic and unwise acquisitions, but through organic growth based on superior efficiency. A crude size limit, applied across the board, would prevent the economy from realizing the benefits of the growth of such institutions. Furthermore, size can imply greater diversification, which can reduce risk. The optimal size can vary across activities and over time. Is a trillion dollar institution permissible if it is a mutual fund holding assets? What if it is an insurance company? What if it is an insurance company owning a small thrift? Finally, size itself is hard to define. Do we mean assets, liabilities, gross derivatives positions, net derivatives positions, transactions, or profitability? Each of these could be a reasonable metric, yet vastly different entities would hit against the size limit depending on the metric we choose. Given all these difficulties, any legislation on size limits will have to give regulators substantial discretion. That creates its own problems which I will discuss shortly. Similar issues arise with activity limits. What activities would be prohibited? Many of the activities that were prohibited to commercial banks under Glass-Steagall were peripheral to this crisis. And activities that did get banks into trouble, such as holding sub-prime mortgage-backed securities, would have been permissible under Glass Steagall.\4\ Some suggest banning banks from proprietary trading (trading for their own account). But how would regulators distinguish (illegitimate) proprietary trading from legitimate risk-reducing hedging?--------------------------------------------------------------------------- \4\ Banks like Citibank have found sufficient ways to get into trouble in recent decades even when Glass Steagall was in force.---------------------------------------------------------------------------Regulatory Concerns Regulating size limits would be a nightmare. Not only would the regulator have to be endowed with substantial amounts of discretion because of the complexities associated with size regulation, the regulated would constantly attempt to influence regulators to rule in their favor. While I have faith in regulators, I would not want them to be subject to the temptations of the license-permit Raj of the kind that flourished in India. Indeed, even without such temptations, regulators are influenced by the regulated--one of the deficiencies uncovered by this crisis is that banks were allowed under Basel II to set their levels of capital based on their own flawed models. Moreover, the regulated would be strongly tempted to arbitrage draconian regulations. In India, strict labor laws kicked in once firms reached 100 employees in size. Not surprisingly, there were a large number of firms with common ownership that had 99 employees--every time a firm was to exceed 100 employees, it broke up into two firms. Similarly, would size limits lead to firms shifting activity into commonly owned and managed, but separately capitalized, entities as soon as they approach the limits? Will we get virtual firms that are as tightly knit together as current firms, but are less transparent to the regulator? I fear the answer could well be yes. Similar problems may arise with banning activities. The common belief is that there are a fixed set of risky possibilities so if enough are prohibited to banks, they will undertake safe activities only--what one might call the ``lump of risk'' fallacy. The truth is that banks make money only by taking risks and managing them carefully. If enough old risky activities are banned, banks will find new creative ways of taking on risk, with the difference that these will likely be hidden from the regulator. And because they are hidden, they are less likely to be managed carefully.Political Concerns Finally, the presumption is that the political support for heavy regulation will continue into the future. Yet, as the business cycle turns, as memories of this crisis fade, and as the costs associated with implementing the regulation come to the fore without visible benefits, there will be less support for the regulation. Profitable banks will lobby hard to weaken the legislation, and they will likely be successful. And all this will happen when we face the most danger from too-systemic-to-fail entities. If there is one lesson we take away from this crisis, it should be this--regulation that the regulated perceive as extremely costly is unlikely to be effective, and is likely to be most weakened at the point of maximum danger to the system. I would suggest that rather than focusing on regulations to limit size or activities, we focus on creating private sector buffers and making institutions easier to fail. Let us turn to these now.Adding Additional Private Sector Buffers. One proposal making the rounds is to require higher levels of capital for systemically important institutions. The problem though is that capital is costlier than other forms of financing. In boom times, the market requires very low levels of capital from financial intermediaries, in part because euphoria makes losses seem remote. So when regulated financial intermediaries are forced to hold more costly capital than the market requires, they have an incentive to shift activity to unregulated intermediaries, as did banks in setting up SIVs and conduits during the current crisis. If systemically important institutions are required to hold substantially more capital, their incentive to undertake this arbitrage is even stronger. Even if regulators are strengthened to detect and prevent this shift in activity, banks can subvert capital requirements by taking on risk the regulators do not see, or do not penalize adequately with capital requirements. So while increased capital for systemically important entities can be beneficial, I do not believe it is a panacea.\5\ An additional, and perhaps more effective, buffer is to ask systemically important institutions to arrange for capital to be infused when the institution or the system is in trouble. Because these ``contingent capital'' arrangements will be contracted in good times when the chances of a downturn seem remote, they will be relatively cheap (compared to raising new capital in the midst of a recession) and thus easier to enforce. Also, because the infusion is seen as an unlikely possibility, firms cannot go out and increase their risks, using the future capital as backing. Finally, because the infusions come in bad times when capital is really needed, they protect the system and the taxpayer in the right contingencies.--------------------------------------------------------------------------- \5\ See the comprehensive discussion of capital requirements in the Squam Lake Group's proposal http://www.cfr.org/publication/19001/reforming_capital_requirements_for_financial_institutions.html.--------------------------------------------------------------------------- Put differently, additional capital is like keeping buckets full of water ready to douse a potential fire. As the years go by and the fire does not appear, the temptation is to use up the water. By contrast, contingent capital is like installing sprinklers. There is no water to use up, but when the fire threatens, the sprinklers will turn on.Contingent Debt Conversions One version of contingent capital is for banks to issue debt which would automatically convert to equity when two conditions are met; first, the system is in crisis, either based on an assessment by regulators or based on objective indicators such as aggregate bank losses (this could be cruder, but because it is automatic, it will eliminate the pressure that would otherwise come on regulators), and second, the bank's capital ratio falls below a certain value.\6\ The first condition ensures that banks that do badly because of their own errors, and not when the system is in trouble, don't get to avoid the disciplinary effects of debt. The second condition rewards well-capitalized banks by allowing them to avoid the forced conversion (the number of shares the debt converts to will be set at a level so as dilute the value of old equity substantially), while also giving banks that anticipate losses an incentive to raise new equity well in time.--------------------------------------------------------------------------- \6\ This describes work done by the Squam Lake Group, and a more comprehensive treatment is available at http://www.cfr.org/publication/19002.---------------------------------------------------------------------------Capital Insurance Another version of contingent capital is to require that systemically important levered financial institutions buy fully collateralized insurance policies (from unlevered institutions, foreigners, or the government) that will infuse capital into these institutions when the system is in trouble.\7\--------------------------------------------------------------------------- \7\ This is based on a paper I wrote with Anil Kashyap and Jeremy Stein, which is available at http://www.kc.frb.org/publicat/sympos/2008/KashyapRajanStein.03.12.09.pdf--------------------------------------------------------------------------- Here is one way it could operate. Megabank would issue capital insurance bonds, say to sovereign wealth funds or private equity. It would invest the proceeds in Treasury bonds, which would then be placed in a custodial account in State Street Bank. Every quarter, Megabank would pay a pre-agreed insurance premium (contracted at the time the capital insurance bond is issued) which, together with the interest accumulated on the Treasury bonds held in the custodial account, would be paid to the sovereign fund. If the aggregate losses of the banking system exceed a certain pre-specified amount, Megabank would start getting a payout from the custodial account to bolster its capital. The sovereign wealth fund will now face losses on the principal it has invested, but on average, it will have been compensated by the insurance premium.Clearly, both the convertible debt proposal and the capital insurance proposal will have to be implemented with care. For instance, it would be silly for any systemically important institution to buy these instruments, and they should be deterred from doing so. At the same time, some obvious objections can be answered easily. For instance, some critics worry whether there will be a market for these bonds that fall in value when the whole economy is in distress. The answer is there are already securities that have these characteristics and are widely traded. Moreover, a bank in Canada has actually issued securities of this sort.Making Institutions Easier to Fail. Let us now turn to the other possible remedy--making systemically important institutions easier to fail. There are currently a number of problems in failing systemically important institutions. Let me list them and suggest obvious remedies. (i) Regulators do not have resolution authority over non-bank financial firms or bank holding companies, and ordinary bankruptcy court would take too long--the financial business would evaporate while the institution is in bankruptcy court. This leaves piece-meal liquidation, with attendant loss in value, as the only alternative to a bailout. Regulators need resolution authority of the kind the FDIC has for banks. (ii) Regulators do not have full information on the holders of a systemically important institution's liabilities. They have difficulty figuring out whom the first round of losses would hit, let alone where the second round (as institutions hit by the first round fail) would fall. While in principle they could allow the institution to fail, and ensure the first and second round failures are limited by providing capital where necessary, they do not have the ability to do so at present. Furthermore, because the market too does not know where the exposures are, the failure of a large institution could lead to panic. More information about exposures needs to be gathered, and the authorities need the ability to act on this information (including offering routine warnings to levered regulated entities that have high exposure to any institution), as well as the ability to disseminate it widely if they have to fail an institution. (iii) The foreign operations of institutions are especially problematic since there is no common comprehensive resolution framework for all of a multi-national bank's operations. Failing a bank in the United States could lead to a run on a branch in a foreign country, or a seizure of local assets by a foreign authority in order to protect liability holders within that country. These actions could erode the value of the bank's international operations substantially, resulting in losses that have to be borne by U.S. taxpayers, and making authorities more reluctant to fail the bank. A comprehensive international resolution framework needs to be negotiated with high priority. (iv) The operations of some systemically important institutions are linked to their liabilities in ways that are calculated to trigger large losses if the bank is failed. For instance, if a bank is on one side of swap transactions and it fails, the counterparties on the other side need to be paid the transactions costs incurred in setting up new substitute swap contracts. Even if the market is calm, these seemingly small transactions costs multiplied by a few trillion dollars in gross outstanding contracts can amount to a large number, in the many billions of dollars. If we add to this the higher transactions costs when the market is in turmoil, the costs can be very high. Regulators have to work with the industry to reduce the extent to which business losses are triggered when the institution's debt is forced to bear losses. These cross- default clauses essentially are poison-pills that make large institutions too costly to fail. (v) Finally, the implicit assumption that some of these institutions will not be failed causes market participants to treat their liabilities as backed by the full faith and credit of the government. These liabilities then become the core of strategies that rely indeed on their being fully backed. Any hint that belief in the backing is unwarranted can cause these strategies to implode, making the authorities averse to changing beliefs.\8\ Regulators have to convince the market that no institution is too systemically important to fail. --------------------------------------------------------------------------- \8\ Mohamed El Erian of Pimco phrases this as a situation where what the market thinks of as constant parameters become variables, resulting in heightened risk aversion. One example of this is the failure of Lehman, which resulted in the Reserve Primary money market fund ``breaking the buck''. The strategy of money market funds investing in the debt of systemically important-but-weak banks in order to obtain higher yields imploded, causing a run on money market funds. The problem is that none of this can be achieved if the financial institutions are working at cross-purposes to the regulator--all will be for naught if even while the regulator is working with international authorities to devise a comprehensive resolution scheme, the financial institution is adding on layers of complexity in its international operations. Therefore I end with one last suggestion: Require systemically important financial institutions to develop a plan that would enable them to be resolved quickly--eventually over a weekend. Such a ``shelf bankruptcy'' plan would require institutions to track, and document, their exposures much more carefully and in a timely manner, probably through much better use of technology. The plan will need to be stress tested by regulators periodically and supported by enabling legislation--such as one facilitating an orderly transfer of the institution's swap books to pre-committed partners. And regulators will need to be ready to do their part, including paying off insured depositors quickly where necessary. Not only will the need to develop a plan give these institutions the incentive to work with regulators to reduce unnecessary complexity and improve management, it may indeed force management to think the unthinkable during booms, thus helping avoid the costly busts. Most important, it will convey to the market the message that the authorities are serious about allowing the systemically important to fail. When we emerge from this crisis, this will be the most important message to convey.RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM SHEILA C. BAIRQ.1. Mr. Wallison testified that, ``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 AlG 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. Taylor's view, then, is that AlG 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.'' Do you agree or disagree with the above statement? Why, or why not?A.1. Professor Taylor argues that the data on the LIBOR-OIS spread indicate that the market had a stronger reaction to the testimony by Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson of September 23, 2008, on the government policy intervention that would become known as the TARP program than to the bankruptcy of Lehman Brothers on September 15. Professor Taylor's interpretation does not acknowledge that the events of the period happened so rapidly and in such short order that it is difficult to disentangle the effects of specific news and market events. Other evidence suggests that reserves held by banks jumped dramatically immediately after Lehman entered bankruptcy (Federal Reserve Statistical Release H-3), indicating that banks preferred the security of a deposit at the Federal Reserve over the risk-and-return profile offered by an interbank loan. Following the Lehman Brothers bankruptcy filing, Primary Reserve--a large institutional money market fund--suffered losses on unsecured commercial paper it had bought from Lehman. The fund ``broke the buck'' on September 16. This ``failure'' instigated a run and subsequent collapse of the commercial paper market. The events of the week may have had compound effect on the market's perception of risk. For example, it is unclear whether AIG would have deteriorated as fast if Lehman had not entered bankruptcy. Indeed, TARP may not have even been proposed without the failure of Lehman. It also took time for markets to understand the size of the Lehman bankruptcy losses--which were larger than anticipated--and to use this new information to reassess the worthiness of all surviving counterparties. In the FDIC's view, uncertainty about government action and interventions has been a source of systemic risk. As outlined in my testimony, the FDIC recommends a legal mechanism for the orderly resolution of systemically important institutions that is similar to what exists for FDIC-insured banks. The purpose of the resolution authority should not be to prop up a failed entity, 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. Imposing losses on shareholders and other creditors will restore market discipline. A new legal mechanism also will permit continuity in key financial operations and reduce uncertainty. Such authority can preserve valuable business lines using an industry-paid fund when debtor-in-possession financing is unavailable because of market-wide liquidity shocks or strategic behavior by potential lenders who also are potential fire sale acquirers of key assets and businesses of the failing institution. Under a new resolution process, uninsured creditor claims could be liquefied much more quickly than can be done in a normal bankruptcy.Q.2. Do you believe that if Basel II had been completely implemented in the United States that the trouble in the banking sector would have been much worse? Some commentators have suggested that the stress tests conducted on banks by the Federal Government have replaced Basel II as the nation's new capital standards. Do you believe that is an accurate description? Is that good, bad, or indifferent for the health of the U.S.-banking system?A.2. Throughout the course of its development, the advanced approaches of Basel II were widely expected to result in lower bank capital requirements. The results of U.S. capital impact studies, the experiences of large investment banks that increased their financial leverage during 2006 and 2007 under the Securities and Exchange Commission's version of the advanced approaches, and recent evidence from the European implementation of Basel II all demonstrated that the advanced approaches lowered bank regulatory capital requirements significantly. Throughout the interagency Basel II discussions, the record shows that the FDIC took the position that capital levels needed to be strengthened for the U.S. Basel II banks. If the advanced approaches of Basel II had been fully in place and relied upon in the United States, the FDIC believes that large banks would have entered the crisis period with significantly less capital, and would therefore have been even more vulnerable to the stresses they have experienced. Supervisors have long encouraged banks to hold more capital than their regulatory minimums, and we view the stress tests as being squarely within that tradition. While stress testing is an important part of sound risk management practice, it is not expected to replace prudential regulatory minimum capital requirements. In many respects, the advanced approaches of Basel II do not constitute transparent regulatory minimum requirements, in that they depend for their operation on considerable bank and supervisory judgment. The FDIC supported the implementation of the advanced approaches only subject to considerable safeguards, including the retention of the leverage ratio and a regulatory commitment that the banking agencies would conduct a study after 2010 to identify whether the new approaches have material weaknesses, and if so, that the agencies would connect those weaknesses.Q.3. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.3. For a new resolution process to work efficiently, market expectations must adjust and investors must assume that the government will use the new resolution scheme instead of providing government support. It is not simply a matter of political will, but of having the necessary tools ready so that a resolution can be credibly implemented. A systemic resolution authority could step between a failing firm and the market to ensure that critical functions are maintained while an orderly unwinding takes place. The government could guarantee or provide financing for the unwinding if private financing is unavailable. Assets could be liquidated in an orderly manner rather than having collateral immediately dumped on the market. This would avoid the likelihood of a fire sale of assets, which depresses market prices and potentially weakens other firms as they face write-downs of their assets at below ``normal'' market prices.Q.4. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.4. The FDIC supports the idea of providing incentives to financial firms that would cause them to internalize into their decisionmaking process the potential external costs that are imposed on society when large and complex financial firms become troubled. While fewer firms may choose to become large and complex as a result, there would be no prohibition on growing or adding complex activities. Large and complex financial firms 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. Capital and regulatory requirements could increase as firms become larger so that firms must operate more efficiently if they become large. In addition, restrictions on leverage and the imposition of risk-based premiums on institutions and their activities should provide incentives for financial firms to limit growth and complexity that raise systemic concerns. To address pro-cyclicality, capital standards should provide for higher capital buffers that increase during expansions and are drawn down during contractions. In addition, large and complex financial firms could be subject to higher Prompt Corrective Action 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.Q.5. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.5. 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 immediately upon a bankruptcy filing. In addition, since the termination right is immediate, and the bankruptcy process does not provide for a right of a trustee or debtor to transfer the contracts before termination, the bankruptcy filing leads to a rapid, uncontrolled liquidation of the derivatives positions. During normal market conditions, the ability of counterparties to terminate and net their exposures to bankrupt entities prevents additional losses flowing through the system and serves to improve market stability. However, when stability is most needed during a crisis, these inflexible termination and netting rights can increase contagion. Without any option of a bridge bank or similar type of temporary continuity option, there is really no practical way to limit the potential contagion absent a pre-packaged transaction or arrangements by private parties. While this sometimes happens, and did to some degree in Lehman's bankruptcy, it raises significant questions about continuity and comparative fairness for creditors. 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. The failure of Lehman and the instability and bail-out of AIG led investors and counterparties to pull back from the market, increase collateral requirements on other market participants, and dramatically de-leverage the system. In the case of Lehman, the bankruptcy filing triggered the right of counterparties to demand an immediate close-out and netting of their contracts and to sell their pledged collateral. The immediate seizing and liquidation of the firm's assets left less value for the firm's other creditors. In the case of AIG, the counterparties to its financial contracts demanded more collateral as AIG's credit rating dropped. Eventually, AIG realized it would run out of collateral and was forced to turn to the government to prevent a default in this market. Had AIG entered bankruptcy, the run on its collateral could have translated into a fire sale of assets by its counterparties. In the case of a bank failure, by contrast, the FDIC has 24 hours after becoming receiver to decide whether to pass the contracts to a bridge bank, sell them to another party, or leave them in the receivership. If the contracts are passed to a bridge bank or sold, they are not considered to be in default and they remain in force. Only if the financial contracts are left in the receivership are they subject to immediate close-out and netting.Q.6. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward--senior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.'' With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.6. Bankruptcy is designed to facilitate the smooth restructuring or liquidation of a firm. It is an effective insolvency process for most companies. However, it was not designed to protect the stability of the financial system. Large complex financial institutions play an important role in the financial intermediary function, and the uncertainties of the bankruptcy process can create `runs' similar to depositor runs of the past in financial firms that depend for their liquidity on market confidence. Putting a bank holding company or other non-bank financial entity through the normal corporate bankruptcy process may create instability as was noted in the previous answer. In the resolution scheme for bank holding companies and other non-bank financial firms, the FDIC is proposing to establish a clear set of claims priorities just as in the bank resolution system. Under the bank resolution system, there is no uncertainty and creditors know the priority of their claims. 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. A stay that prevents creditors from accessing their funds destroys financial relationships. 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. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM GARY STERNQ.1. Mr. Wallison testified that, ``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. 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.'' Do you agree or disagree with the above statement? Why, or why not?A.1. Members of the Board of Governors of the Federal Reserve System have addressed the factors that contributed to the market dislocation in mid-September 2008. See, for example, the testimony of Chairman Ben S. Bernanke on U.S. financial markets before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, on September 23, 2008, and the testimony of Vice Chairman Donald L. Kohn on American International Group before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., on March 5, 2009. Based on my understanding of the facts and circumstances around market conditions in mid-September, I will defer to these descriptions of events.Q.2. Do you believe that if Basel II had been completely implemented in the United States that the trouble in the banking sector would have been much worse?A.2. To the degree that a fully implemented Basel II would have left large financial institutions with less capital, the financial crisis could have been more severe. To the degree that large financial institutions would have had improved risk management systems due to Basel II, perhaps the crisis would not have been as severe. In short, we cannot know with any precision how a fully implemented Basel II would have altered bank performance during the recent financial crisis; the effect that a fully implemented Basel II would have had on the depth and severity of the financial crisis would have depended on competing factors such as the two just noted. In any case, and consistent with my remarks during the recent hearing, I believe Basel II should undergo a thorough review to determine if and how policymakers should modify it.Q.3. Some commentators have suggested that the stress tests conducted on banks by the Federal Government have replaced Basel II as the nation's new capital standards. Do you believe that is an accurate description? Is that good, bad, or indifferent for the health of the U.S. banking system?A.3. As noted by the Board of Governors of the Federal Reserve System in ``The Supervisory Capital Assessment Program: Overview of Results'' (May 7, 2009), ``the SCAP buffer does not represent a new capital standard and is not expected to be maintained on an ongoing basis.'' I believe that policy is appropriate.Q.4. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.4. Consistent with my testimony, I believe that financial spillovers lead policymakers to provide extraordinary support to the creditors of systemically important financial institutions. To discourage policymakers from providing such support requires them to take action to reduce the threat of these spillovers. I provided examples of these actions in my written testimony.Q.5. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.5. As I noted in my written testimony, I do not believe that either reducing the size of financial institutions or creating a new resolution framework for nonbank financial institutions will, by itself, sufficiently address the ``too-big-to-fail'' problem. Neither step will effectively reduce the spillover problem that leads to the provision of government support for uninsured creditors of systemically important financial institutions in the first place. A resolution regime offers a tool to address some spillovers and not others. I detail in my written testimony recommendations to address spillovers.Q.6. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.6. We discussed issues surrounding so-called early termination, closeout netting, and other aspects of the treatment of derivative contracts in bankruptcy and their relation to the ``too-big-to-fail'' problem in our earlier analysis. (See Gary H. Stern and Ron J. Feldman, 2009, Too Big To Fail: The Hazards of Bank Bailouts, pp.118 and 119.) These issues deserve careful scrutiny in light of the AIG and Lehman situations to ensure that current policy and law adequately reflect the ``lessons learned'' from those two cases.Q.7. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward--senior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.'' With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.7. I see merit in creating a resolution regime for all systemically important financial firms that has similarities to the one currently used by the FDIC to resolve banks. As noted in my written testimony, ``such regimes would facilitate imposition of losses on equity holders, allow for the abrogation of certain contracts, and provide a framework for operating an insolvent firm. These steps address some spillovers and increase market discipline.'' However, as noted previously, these advantages do not address the full range of potential spillovers and thus may not sufficiently facilitate policymakers' decision to impose losses on creditors of systemically important firms. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM PETER J. WALLISONQ.1. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.1. The problem with a new resolution authority is that there will be too much political will to use it. My concern is that regulators will use the system to bail out failing financial companies when these companies should be allowed to go into bankruptcy. The result will be that the taxpayers will end up paying for something that--in bankruptcy--would be paid for by the company's creditors.Q.2. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.2. There is no reason to be concerned about the size of any company other than a commercial bank, and even then it would not be good policy to try to limit the size of a bank because we are afraid that its failure will cause a systemic problem. Companies and banks get large because they are good competitors and serve the public well. We shouldn't penalize them for that. In addition, our big international operating companies need big international banks to serve their needs. If we cut back the size of banks or insurance companies or securities firms because of fear about systemic risk, we would be adding costs for our companies for no good reason. Finally, I don't think that any financial company other than a large commercial bank can--even in theory--create a systemic problem. Banks alone have liabilities that can be withdrawn on demand and are used to make payment by businesses and individuals. If a bank fails, these funds might not be available, and that could cause a systemic problem. But other financial companies are more like large commercial operating companies. They borrow money for a term. If they fail, there are losses, but not the immediate loss of the funds necessary to meet daily obligations. For example, if GM goes into bankruptcy, it will cause a lot of disruption, but no one who is an investor in GM is expecting to use his investment to meet his payroll or pay his mortgage. That's also true of insurance companies, securities firms, hedge funds and others. If they fail they may cause losses to their investors, but over time, not the cascade of losses through the economy that is the signature of a systemic breakdown. We should not be concerned about losses to creditors and investors. It's the wariness about losses that creates market discipline-which is the best way to control risk-taking.Q.3. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.3. Most financial contracts are exempt from the automatic stay that occurs when a bankruptcy petition is filed. This allows the counterparties of a bankrupt company to sell the collateral they are holding and make themselves whole, or close to it. This prevents losses from cascading through the economy when they occur. They are stopped by the ability of counterparties to sell the collateral they hold and reimburse themselves. As a result, we have only one example of a Lehman counterparty encountering a serious and immediate financial problem as a result of Lehman's failure. That was the Reserve Fund, which was holding an excessive amount of Lehman's short term commercial paper. Other than that, Lehman's failure is an example of what I said above about nonbank financial institutions. They do not cause the kind of cascading losses that could occur when a bank fails. We do not therefore need a special resolution function for these nonbank firms. AIG should have been allowed to go into bankruptcy. I don't see any reason why AIG's failure would have caused the kind of systemic breakdown that was feared. Again, the ability of counterparties to sell their collateral would have reduced any possible losses. Much a ttention has been focues on credit default swaps, but we now know that Goldman Sachs, which was the largest AIG swap counterparty, would not have suffered any losses if AIG had been allowed by the Fed to go into bankruptcy. The reason that Goldman would not have suffered losses is that they had collateral coverage on their swap agreements, and if AIG had failed they would have been able to sell the collateral and make themselves whole. So the treatment of financial contracts in bankruptcy is a strong reason to allow bankruptcy to operate rather than substituting a government agency.Q.4.a. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forwardsenior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk.A.4.a. Exactly right.Q.4.b. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.''A.4.b. Again, exactly right.Q.4.c. With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.4.c. I am not enough of a bankruptcy specialist to make a recommendation. However, the Lehman bankruptcy seems to be going smoothly without any significant reforms. In the 2 weeks following its filing Lehman sold off its brokerage, investment banking and investment management businesses to 4 different buyers, and the process is continuing. Based on the Lehman case, it does not appear to me that any major changes are necessary. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM MARTIN NEIL BAILYQ.1. If there is an ordered resolution process, whether that's bankruptcy, a new structured bankruptcy or a new resolution authority--what can we do to generate the political will to use it?A.1. Presumably the key thought behind this question is what can be done to ensure that some class of creditors, in addition to shareholders, can be forced to incur at least some loss in the event a large systemically important financial institution were to subject to some resolution procedure? One way is to ensure that all such institutions are required to back at least of their assets by uninsured long-term subordinated (unsecured) debt, a security not subject to a ``run'' since its holders cannot ask for their money back until the debt matures. Precisely for this reason, regulatory authorities can safely permit the holders of such instruments to suffer some loss without a threat of wider financial contagion. In addition, Congress can and should exercise vigilant oversight over the activities of any authority that may be given the power to resolve such troubled institutions.Q.2. Should we be limiting the size of companies in the future to prevent a ``too-big-to-fail'' situation, or can we create a resolution process that only needs the political will to execute it that will eliminate the need to be concerned about a company's size?A.2. There is no principled basis, in our view, for imposing arbitrary size limits by institution. However, regulation can and should be designed to ensure that as institutions grow in size and begin to expose the financial system to danger should those institutions fail, the institutions internalize this ``externality.'' This can be accomplished by imposing progressively higher capital and liquidity requirements as financial institutions grow beyond a certain size, as well as more intensive supervision of their risk management practices. In addition, resolution authorities should be instructed to make an effort to break up troubled systemically important financial institutions, unless the costs of such breakups are projected to outweigh the benefits (in terms of reducing future exposure to systemic risk).Q.3. What role did the way financial contracts are treated in bankruptcy create in both the AIG and Lehman situations?A.3. We do not claim expertise in this area, and leave it to others to comment.Q.4. Chrysler's experience with the Federal Government and bankruptcy may prove a useful learning experience as to why bankruptcy despite some issues may still best protect the rights of various investors. A normal bankruptcy filing is straight forward--senior creditors get paid 100 cents on the dollar and everyone else gets in line. That imposes the losses on those who chose to take the risk. Indeed, the sanctity of a contract was paramount to our Founding Fathers. James Madison, in 1788, wrote in Federalist Papers Number 44 to the American people that, ``laws impairing the obligation of contracts are contrary to the first principles of the social compact, and to every principle of sound legislation.'' With that in mind, what changes can be made to bankruptcy to ensure an expedited resolution of a company that does not roil the financial markets and also keeps government from choosing winners and losers?A.4. We agree that the sanctity of contracts is of paramount importance in our constitution and our economy. Bankruptcy law is not an area of our expertise. In the area of financial institutions in particular, however, we reiterate that one way to retain at least some market discipline without threatening the financial system is to require large systemically important financial institutions to issue at least some long-term subordinated (unsecured) debt." CHRG-111hhrg48674--37 Mr. Bernanke," Congressman, that was very interesting. Could I respond to a couple of points you made? First of all, in the Great Depression, Milton Friedman's view was that the cause was the failure of the Federal Reserve to avoid excessively tight monetary policy in the early 1930's. That was Friedman and Schwartz's famous book. And with that lesson in mind, the Federal Reserve has reacted very aggressively to cut interest rates in this current crisis. And moreover, we have also tried to avoid the collapse of the banking system, which was another reason for the Depression in the 1930's. On the prices of housing and the like, we are not trying to prop up the price of housing. What we are trying to do is get the credit markets working again so that the free market can begin to function in a normal way instead of a seized-up way in which it is currently acting. And finally, on price fixing of so-called toxic or legacy assets, the plan that Secretary Geithner described this morning would have as an important component private asset managers making purchases based on their own profit-maximizing analysis. So that would be true market prices that would free up what is now a frozen market to get transactions flowing again and should restore real price discovery to those markets. Dr. Paul. But so far, every one of these suggestions over the past year was more money, more credit, more government involvement. Nothing seems to be working. Even today, the markets weren't very happy with these announcements. I think the market is still pretty powerful. " CHRG-111shrg54533--33 Secretary Geithner," Our plan does not address a range of other causes of this crisis, including policies pursued around the world that helped produce a long period of very low interest rates and a very, very substantial boom in asset prices, housing prices, not just in this country but in countries around the world. And I think you are right to underscore the basic fact that a lot of things contributed to this crisis. It was not just failures in supervision and regulation. And as part of what the world does, major countries around the world, in trying to reduce the risk we have a crisis like this in the future, it will require thinking better through how to avoid the risk that monetary macroeconomic policies contribute to future booms and asset prices and credit bubbles of this magnitude. Senator Bunning. Your plan puts a lot of faith in the Federal Reserve's ability to spot risk and exercise its power to prevent the next crisis. However, if the Fed and other regulators have been doing their jobs and paying attention to what the banks and other firms were doing earlier this decade, they almost certainly could have prevented the mess. And the Fed has proven it is unwilling to use its power it has. Let me give you an example. Just look how slow it addressed the credit card abuses, and it took 14 years for the Fed to write one regulation on mortgages after we gave them the power to do that. So giving them the power and making them act are two different things. What makes you think that the Fed will do better this time around? " FinancialCrisisInquiry--133 So you can make that happen. You can separate those two. And it goes back to the Glass- Steagall argument. But I think, of the institutions—we have four banks in the United States that owns 45 percent of the assets. We have 8,300 others that own the balance. Our whole system is very top-heavy here, and the reason that they’re systemically important is they’re that big. So I think, more holistically, we need to figure out what the structure of the system needs to look like, and we need to set what the leverage ratios are of those systemically important institutions. That’s my opinion. CHAIRMAN ANGELIDES: We’re going to go to questioning. And, actually, I’m going to keep the same order we did last time. We’ll reverse it, tomorrow, members. So Ms. Murren, why don’t you start off, and then we’ll do the same order for this panel and the next. Thank you. MURREN: Thank you, Mr. Chairman. And thank you, gentlemen, for appearing today. I wanted to follow up on this last topic since we didn’t have a chance to cover it too much in the first panel. But could you talk a little bit about financial institutions that lie outside of what be considered the core banking system and talk, perhaps, a little bit about whether you think any changes in regulation or standards should be made there? And then, a second question relates, actually, to short selling. And I wanted to talk a little bit about your position on whether or not short selling should be a disclosable item in the same manner that a long position would be. BASS: OK. With regard to institutions outside of the system, to reiterate the point I just made, first of all, we have to determine who’s systemically important and who isn’t. And if they systemically important, they need to have a higher risk premium charged to them, and we need to regulate them heavily. And if they’re not, they should be able to engage in these non- bank activities or even lending activities and lever however many times they’d like to be levered. But, again, if they fail, they need to be able to fail. In my testimony, I say, you know, capitalism without bankruptcy is like Christianity without hell. Right. There have to be consequences of excessive risk taking. CHRG-111hhrg56776--291 Mr. Gerhart," I have been a national bank. So I have been examined and supervised by the Comptroller of the Currency. We converted to a State charter in 2005, made the choice that we would like to remain a Fed member bank, so we applied with the Nebraska Department of Banking and Finance, along with the Federal Reserve Bank of Kansas City, and that is who our regulators are. What it does is it takes away from the dual banking system if you remove the Federal Reserve system from regulating us. They are-- " CHRG-111shrg52619--71 Mr. Tarullo," Certainly, Senator, with respect to mergers under the Bank Holding Company Act, there ought to be and is scrutiny under the anti-trust laws to determine whether there are going to be anti-competitive consequences to the merger. But you should understand that the competition analysis as it is put forth in the statute does not in itself directly feed into the issues of size and systemic risk. And so there does need to be an independent focus on systemic risk beyond the traditional anti-trust question of whether a merger would reduce competition in a particular market. Senator Merkley. Does anyone else want to add to that? " CHRG-111shrg54533--11 Chairman Dodd," Well, thank you for that. I only wish that the consumer protection had been more of a distraction at the Fed. In the HOEPA legislation in 1994, it was certainly an example where they dropped the ball entirely and had that authority. My time is up, but that is an underlying concern. Anyway, let me turn to Senator Shelby. Senator Shelby. Thank you, Mr. Chairman. Accountability at the Fed--Mr. Secretary, the Federal Reserve System was not designed to carry out the systemic risk oversight mission the administration proposes to give it. It is not a sole institution run under the direction of a single, ultimately responsible leader. Rather, it is a Federal system composed of a central governmental agency, the Board of Governors, and 12 regional quasi-public Federal Reserve Banks. The Board, as you well know, contains seven members. The Reserve Banks are run by presidents--you were one--who are selected by and subject to the oversight of each individual bank's board. Within the system, the Board and the Reserve Banks share responsibility for supervising and regulating certain banks and financial institutions. With decision-making authority dispersed to the Board and Reserve Banks, who will be accountable to Congress for the systemic risk regulation function as the ``system'' cannot appear to testify right here before Congress? " CHRG-111shrg52619--166 PREPARED STATEMENT OF JOHN C. DUGAN Comptroller of the Currency, Office of the Comptroller of the Currency March 19, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate this opportunity to discuss reforming the regulation of our financial system. Recent turmoil in the financial markets, the unprecedented distress and failure of large financial firms, the mortgage and foreclosure crises, and growing numbers of problem banks--large and small--have prompted calls to reexamine and revamp thenation's financial regulatory system. The crisis raises legitimate questions about whether our existing complex system has both redundancies and gaps that significantly compromise its effectiveness. At the same time, any restructuring effort that goes forward should be carefully designed to avoid changes that undermine the parts of our current regulatory system that work best. To examine this very important set of issues, the Committee will consider many aspects of financial regulation that extend beyond bank regulation, including the regulation of government-sponsored enterprises, insurance companies, and the intersection of securities and commodities markets. Accordingly, my testimony today focuses on key areas where I believe the perspective of the OCC--with the benefit of hindsight from the turmoil of the last two years--can most usefully contribute to the Committee's deliberations. Specifically, I will discuss the need to-- improve the oversight of systemic risk, especially with respect to systemically important financial institutions that are not banks; establish a better process for stabilizing, resolving or winding down such firms; reduce the number of bank regulators, while preserving a dedicated prudential supervisor; enhance mortgage regulation; and improve consumer protection regulation while maintaining its fundamental connection to prudential supervision.Improving Systemic Risk Oversight The unprecedented events of the past year have brought into sharp focus the issue of systemic risk, especially in connection with the failures or near failures of large financial institutions. Such institutions are so large and so intertwined with financial markets and other major financial institutions that the failure of one could cause a cascade of serious problems throughout the financial system--the very essence of systemic risk. Years ago, systemically significant firms were generally large banks, and our regime of extensive, consolidated supervision of banks and bank holding companies--combined with the market expertise provided by the Federal Reserve through its role as central bank--provided a means to address the systemic risk presented by these institutions. More recently, however, large nonbank financial institutions like AIG, Fannie Mae and Freddie Mac, Bear Stearns, and Lehman began to present similar risks to the system as large banks. Yet these nonbank firms were subject to varying degrees and different kinds of government oversight. In addition, no one regulator had access to risk information from these nonbank firms in the same way that the Federal Reserve has with respect to bank holding companies. The result, I believe, was that the risk these firms presented to the financial system as a whole could not be managed or controlled until their problems reached crisis proportions. One suggested way to address this problem going forward would be to assign one agency the oversight of systemic risk throughout the financial system. This approach would fix accountability, centralize data collection, and facilitate a unified approach to identifying and addressing large risks across the system. Such a regulator could also be assigned responsibility for identifying as systemically significant those institutions whose financial soundness and role in financial intermediation is important to the stability of U.S. and global markets. But the single systemic regulator approach would also face challenges due to the diverse nature of the firms that could be labeled systemically significant. Key issues would include the type of authority that should be provided to the regulator; the types of financial firms that should be subject to its jurisdiction; and the nature of the new regulator's interaction with existing prudential supervisors. It would be important, for example, for the systemic regulatory function to build on existing prudential supervisory schemes, adding a systemic point of view, rather than replacing or duplicating regulation and supervisory oversight that already exists. How this would be done would need to be evaluated in light of other restructuring goals, including providing clear expectations for financial institutions and clear responsibilities and accountability for regulators; avoiding new regulatory inefficiencies; and considering the consequences of an undue concentration of responsibilities in a single regulator. It has been suggested that the Federal Reserve Board should serve as the single agency responsible for systemic risk oversight. This makes sense given the comparable role that the Board already plays with respect to our largest banking companies; its extensive involvement with capital markets and payments systems; and its frequent interaction with central banks and supervisors from other countries. If Congress decides to take this approach, however, it would be necessary to define carefully the scope of the Board's authority over institutions other than the bank holding companies and state-chartered member banks that it already supervises. Moreover, the Board has many other critical responsibilities, including monetary policy, discount window lending, payments system regulation, and consumer protection rulewriting. Adding the broad role of systemic risk overseer raises the very real concerns of the Board taking on too many functions to do all of them well, while at the same time concentrating too much authority in a single government agency. The significance of these concerns would depend very much on both the scope of the new responsibilities as systemic risk regulator, and any other significant changes that might be made to its existing role as the consolidated bank holding company supervisor. Let me add that the contours of new systemic authority may need to vary depending on the nature of the systemically significant entity. For example, prudential regulation of banks involves extensive requirements with respect to risk reporting, capital, activities limits, risk management, and enforcement. The systemic supervisor might not need to impose all such requirements on all types of systemically important firms. The ability to obtain risk information would be critical for all such firms, but it might not be necessary, for example, to impose the full array of prudential standards, such as capital requirements or activities limits on all types of systemically important firms, e.g., hedge funds (assuming they were subject to the new regulator's jurisdiction). Conversely, firms like banks that are already subject to extensive prudential supervision would not need the same level of oversight as firms that are not--and if the systemic overseer were the Federal Reserve Board, very little new authority would be required with respect to banking companies, given the Board's current authority over bank holding companies. It also may be appropriate to allocate different levels of authority to the systemic risk overseer at different points in time depending on whether financial markets are functioning normally, or are instead experiencing unusual stress or disruption. For example, in a stable economic environment, the systemic risk regulator might focus most on obtaining and analyzing information about risks. Such additional information and analysis would be valuable not only for the systemic risk regulator, but also for prudential supervisors in terms of their understanding of firms' exposure to risks occurring in other parts of the financial services system to which they have no direct access. And it could facilitate the implementation of supervisory strategies to address and contain such risk before it increased to unmanageable levels. On the other hand, in times of stress or disruption it may be appropriate to authorize the systemic regulator to take actions ordinarily reserved for prudential supervisors, such as imposing specific conditions or requirements on operations of a firm. Such authority would need to be crafted to ensure flexibility, but the triggering circumstances and process for activating the authority should be clear. Mechanisms for accountability also should be established so that policymakers, regulated entities, and taxpayers can understand and evaluate appropriate use of the authority. Let me make one final point about the systemic risk regulator. Our financial system's ``plumbing''--the major systems we have for clearing payments and settling transactions--are not now subject to any clear, overarching regulatory system because of the variety in their organizational form. Some systems are clearinghouses or banking associations subject to the Bank Service Company Act. Some are securities clearing agencies or agency organizations pursuant to the securities or commodities laws. Others are chartered under the corporate laws of states. \1\--------------------------------------------------------------------------- \1\ For a description of the significance of payment and settlement systems and the various forms under which they are organized in the United States, see U.S. Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure 100-103 (March 2008) (2008 Treasury Blueprint).--------------------------------------------------------------------------- Certain of these payment and settlement systems are systemically significant for the liquidity and stability of our financial markets, and I believe these systems should be subjected to overarching federal supervision to reduce systemic risk. One approach to doing so was suggested in the 2008 Treasury Blueprint, which recommended establishing a new federal charter for systemically significant payment and settlement systems and authorizing the Federal Reserve Board to supervise them. I believe this approach is appropriate given the Board's extensive experience with payment system regulation.Resolving Systemically Significant Firms Events of the past year also have highlighted the lack of a suitable process for resolving systemically significant financial firms that are not banks. U.S. law has long provided a unique and well developed framework for resolving distressed and failing banks that is distinct from the federal bankruptcy regime. Since 1991, this unique framework, administered by the Federal Deposit Insurance Corporation, has also provided a mechanism to address the problems that can arise with the potential failure of a systemically significant bank--including, if necessary to protect financial stability, the ability to use the bank deposit insurance fund to prevent uninsured depositors, creditors, and other stakeholders of the bank from sustaining loss. Unfortunately, no comparable framework exists for resolving most systemically significant financial firms that are not banks, including systemically significant holding companies of banks. Such firms must therefore use the normal bankruptcy process unless they can obtain some form of extraordinary government assistance to avoid the systemic risk that might ensue from failure or the lack of a timely and orderly resolution. While the bankruptcy process may be appropriate for resolution of certain types of firms, it may take too long to provide certainty in the resolution of a systemically significant firm, and it provides no source of funding for those situations where substantial resources are needed to accomplish an orderly solution. As a result, in the last year as a number of large nonbank financial institutions faced potential failure, government agencies have had to improvise with various other governmental tools to address systemic risk issues at nonbanks, sometimes with solutions that were less than ideal. This gap needs to be addressed with an explicit statutory regime for facilitating the resolution of systemically important nonbank companies as well as banks. This new statutory regime should provide tools that are similar to those the FDIC currently has for resolving banks, including the ability to require certain actions to stabilize a firm; access to a significant funding source if needed to facilitate orderly dispositions, such as a significant line of credit from the Treasury; the ability to wind down a firm if necessary, and the flexibility to guarantee liabilities and provide open institution assistance if necessary to avoid serious risk to the financial system. In addition, there should be clear criteria for determining which institutions would be subject to this resolution regime, and how to handle the foreign operations of such institutions. One possible approach to a statutory change would be to simply extend the FDIC's current authority to nonbanks. That approach would not appear to be appropriate given the bank-centric nature of the FDIC's mission and resources. The deposit insurance fund is paid for by assessments on insured banks, with a special assessment mechanism available for certain losses caused by systemically important banks. It would not be fair to assess only banks for problems at nonbanks. In addition, institutional conflicts may arise when the insurer must fulfill the dual mission of protecting the insurance fund and advancing the broader U.S. Government interests at stake when systemically significant institutions require resolution. Indeed, important changes have recently been proposed to improve the FDIC's systemic risk assessment process to provide greater equity when the FDIC's protective actions extend beyond the insured depository institution to affiliated entities that are not banks. A better approach may be to provide the new authority to the new systemic risk regulator, in combination with the Treasury Department, given the likely need for a substantial source of government funds. The new systemic risk regulator would by definition have systemic risk responsibility, and the Treasury has direct accountability to taxpayers. If the systemic risk regulator were the Federal Reserve, then the access to discount window funding would also provide a critical resource to help address significant liquidity problems. It is worth noting that, in most other countries, it has been the Treasury Department or its equivalent that has provided extraordinary assistance to systemically important financial firms during this crisis, whether in the form of capital injections, government guarantees, or more significant government ownership.Reducing the Number of Bank Regulators It is clear that the United States has too many bank regulators. We have four federal regulators, 12 Federal Reserve Banks, and 50 state regulators, nearly all of which have some type of overlapping supervising responsibilities. This system is largely the product of historical evolution, with different agencies created for different legitimate purposes reflecting a much more segmented banking system from the past. No one would design such a system from scratch, and it is fair to say that, at times, it has not been the most efficient way to establish banking policy or supervise banks. Nevertheless, the banking agencies have worked hard over the years to make the system function appropriately despite its complexities. On many occasions, the diversity in perspectives and specialization of roles has provided real value. And from the perspective of the OCC, I do not believe that our sharing of responsibilities with other agencies has been a primary driver of recent problems in the banking system. That said, I recognize the considerable interest in reducing the number of bank regulators. The impulse to simplify is understandable, and it may well be appropriate to streamline our current system. But we ought not approach the task by prejudging the appropriate number of boxes on the organization chart. The better approach is to determine what would be achieved if the number of regulators were reduced. What went wrong in the current crisis that changes in regulatory structure (rather than regulatory standards) will fix? Will accountability be enhanced? Will the change result in greater efficiency and consistency of regulation? Will gaps be closed so that opportunities for regulatory arbitrage in the current system are eliminated? Will overall market regulation be improved? In this context, while there is arguably an agreement on the need to reduce the number of bank regulators, there is no such consensus on what the right number is or what their roles should be. Some have argued that we should have just one regulator responsible for bank supervision, and that it ought to be a new agency such as the Financial Services Agency in the UK, or that all such responsibilities should be consolidated in our central bank, the Federal Reserve Board. Let me explain why I don't think either of these ideas is the right one for our banking system. The fundamental problem with consolidating all supervision in a new, single independent agency is that it would take bank supervisory functions away from the Federal Reserve Board. In terms of the normal turf wars among agencies, it may sound strange for the OCC to take this position. But as the central bank and closest agency we have to a systemic risk regulator, I believe the Board needs the window it has into banking organizations that it derives from its role as bank holding company supervisor. More important, given its substantial role and direct experience with respect to capital markets, payments systems, the discount window, and international supervision, the Board provides unique resources and perspective to bank holding company supervision. Conversely, I believe it also would be a mistake to move all direct banking supervision to the Board, or even all such supervision for the most systemically important banks. The Board has many other critical responsibilities, including monetary policy, discount window lending, payments system regulation, and consumer protection rulewriting. Consolidating all banking supervision there as well would raise a serious concern about the Board taking on too many functions to do all of them well. There would also be a very real concern about concentrating too much authority in a single government agency. And both these concerns would be amplified substantially if the Board were also designated the new systemic risk regulator and took on supervisory responsibilities for systemically significant payment and clearing systems. Most important, moving all supervision to the Board would lose the very real benefit of having an agency whose sole mission is bank supervision. That is, of course, the sole mission of the OCC, and I realize that, coming from the Comptroller, support for preserving a dedicated prudential banking supervisor may be portrayed by some as merely protecting turf. That would be unfortunate, because I strongly believe that the benefits of dedicated supervision are real. Where it occurs, there is no confusion about the supervisor's goals and objectives, and no potential conflict with competing objectives. Responsibility is well defined, and so is accountability. Supervision takes a back seat to no other part of the organization, and the result is a strong culture that fosters the development of the type of seasoned supervisors that are needed to confront the many challenges arising from today's banking business. In the case of the OCC, I would add that our role as the front-line, on-the-ground prudential supervisor is complementary to the current role of the Federal Reserve Board as the consolidated holding company regulator. This model has allowed the Board to use and rely on our work to perform its role as supervisor for complex banking organizations that are often involved in many businesses other than banking. Such a model would also work well with respect to any new authority provided to a systemic risk regulator, whether or not the Board is assigned that role. In short, there are a number of options for reducing the number of bank regulators, and many detailed issues involved with each. It is not my intent to address these issues in detail in this testimony, but instead to make two fundamental and related points about changes to the banking agency regulatory structure. While it is important to preserve the Federal Reserve Board's role as a holding company supervisor, it is equally if not more important to preserve the role of a dedicated, front-line prudential supervisor for our nation's banks.Enhanced Mortgage Regulation The current financial crisis began and continues with problems arising from poorly underwritten residential mortgages, especially subprime mortgages. While these lending practices have been brought under control, and federal regulators have taken actions to prevent the worst abuses, more needs to be done. As part of any regulatory reform to address the crisis, Congress should establish a mortgage regulatory regime that ensures that the mortgage crisis is never repeated. A fundamental reason for poorly underwritten mortgages was the lack of consistent regulation for mortgage providers. Depository institution mortgage providers--whether state or federally chartered--were the most extensively regulated, by state and federal banking supervisors. Mortgage providers affiliated with depository institutions were less regulated, primarily by federal holding company supervisors, but also by state mortgage regulators. Mortgage providers not affiliated with depository institutions--including mortgage brokers and lenders--were the least regulated by far, with no direct supervision at the federal level, and limited ongoing supervision at the state level. The results have been predictable. As the 2007 Report of the Majority Staff of the Joint Economic Committee recognized, ``[s]ince brokers and mortgage companies are only weakly regulated, another outcome [of the increase in subprime lending] was a marked increase in abusive and predatory lending.'' \2\ Nondepository institution mortgage providers originated the overwhelming preponderance of subprime and ``Alt-A'' mortgages during the crucial 2005-2007 period, and the loans they originated account for a disproportionate percentage of defaults and foreclosures nationwide, with glaring examples in the metropolitan areas hardest hit by the foreclosure crisis. For example, a recent analysis of mortgage loan data prepared by OCC staff, from a well-known source of mortgage loan data, identified the 10 mortgage originators with the highest number of subprime and Alt-A mortgage foreclosures--in the 10 metropolitan statistical areas (MSAs) experiencing the highest foreclosure rates in the period 2005-2007. While each type of mortgage originator has experienced elevated levels of delinquencies and defaults in recent years, of the 21 firms comprising the ``worst 10'' in those ``worst 10'' MSAs, the majority--accounting for nearly 60 percent of nonprime mortgage loans and foreclosures--were exclusively supervised by the states. \3\--------------------------------------------------------------------------- \2\ Majority Staff of the Joint Economic Committee, 110th Cong., Report and Recommendations on the Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here 17 (October 2007). \3\ Letter from Comptroller of the Currency John Dugan to Elizabeth Warren, Chair, Congressional Oversight Panel, February 12, 2009, at http://www.occ.treas.gov/ftp/occ_copresponse_021209.pdf.--------------------------------------------------------------------------- In view of this experience, Congress should take at least two actions in connection with regulatory reform. First, it should establish national mortgage standards that would apply consistently regardless of originator, similar to the mortgage legislation that passed the House of Representatives last year. In taking this extraordinary step, Congress should provide flexibility to regulators to implement the statutory standards through regulations that protect consumers and balance the need for conservative underwriting with the equally important need for access to affordable credit. Second, Congress should also ensure that the new standards are applied and enforced in a comparable manner, again, regardless of originator. This objective can be accomplished relatively easily for mortgages provided by depository institutions or their affiliates: federal banking regulators have ample authority to ensure compliance through ongoing examination and supervision reinforced by broad enforcement powers. The objective is not so easily achieved with nonbank mortgage providers regulated exclusively by the states, however. The state regime for regulating mortgage brokers and lenders typically focuses on licensing, rather than ongoing examination and supervision, and enforcement by state agencies typically targets problems after they have become severe, not before. That difference between the federal and state regimes can result in materially different levels of compliance, even with a common federal standard. As a result, it will be important to develop a mechanism to facilitate a level of compliance at the state level that is comparable to compliance of depository institutions subject to federal standards. The goal should be robust national standards that are applied consistently to all mortgage providers.Enhanced Consumer Protection Regulation Effective protection for consumers of financial products and services is a vital part of financial services regulation. In the OCC's experience, and as the mortgage crisis illustrates, safe and sound lending practices are integral to consumer protection. Indeed, contrary to several recent proposals, we believe that the best way to implement consumer protection regulation of banks--the best way to protect consumers--is to do so through prudential supervision. Let me explain why. First, prudential supervisors' continual presence in banks through the examination process puts them in the very best position to ensure compliance with consumer protection requirements established by statute and regulation. Examiners are trained to detect weaknesses in banks' policies, systems, and procedures for implementing consumer protection mandates, and they gather information both on-site and off-site to assess bank compliance. Their regular communication with the bank occurs through examinations at least once every 18 months for smaller institutions, supplemented by quarterly calls with management, and for the very largest banks consumer compliance examiners are on site every day. We believe this continual supervisory presence creates especially effective incentives for consumer protection compliance, as well as allowing examiners to detect compliance failures much earlier than would otherwise be the case. Second, prudential supervisors have strong enforcement powers and exceptional leverage over bank management to achieve corrective action. Banks are among the most extensively supervised firms in any type of industry, and bankers understand very well the range of negative consequences that can ensue from defying their regulator. As a result, when examiners detect consumer compliance weaknesses or failures, they have a broad range of tools to achieve corrective action, from informal comments to formal enforcement action--and banks have strong incentives to move back into compliance as expeditiously as possible. Indeed, behind the scenes and without public fanfare, bank supervision results in significant reforms to bank practices and remedies for their customers--and it can do so much more quickly than litigation, formal enforcement actions, or other publicized events. For example, as part of the supervisory process, bank examiners identify weaknesses in areas pertaining both to compliance and safety and soundness by citing MRAs--``matters requiring attention''--in the written report of examination. An MRA describes a problem, indicates its cause, and requires the bank to implement a remedy before the matter can be closed. In the period between 2004 and 2007, OCC examiners cited 123 mortgage-related MRAs. By the end of 2008, satisfactory corrective action had been taken with respect to 109 of those MRAs, without requiring formal enforcement actions. Corrective actions were achieved for issues involving mortgage underwriting, appraisal quality, monitoring of mortgage brokers, and other consumer-related issues. We believe this type of extensive supervision and early warning oversight is a key reason why the worst form of subprime lending practices did not become widespread in the national banking system. Third, because examiners are continually exposed to the practical effects of implementing consumer protection rules for bank customers, the prudential supervisory agency is in the best position to formulate and refine consumer protection regulations for banks. Indeed, while most such rule-writing authority is currently housed in the Federal Reserve Board, we believe that the rule-writing process would benefit by requiring more formal consultation with other banking supervisors that have substantial supervisory responsibilities in this area. Recently, alternative models for financial product consumer protection regulation have been suggested. One is to remove all consumer protection regulation and supervision from prudential supervisors, instead consolidating such authority in a new federal agency. This model would be premised on an SEC-style regime of registration and licensing for all types of consumer credit providers, with standards set and compliance achieved through enforcement actions by a new agency. The approach would rely on self-reporting by credit providers, backstopped by enforcement or judicial actions, rather than ongoing supervision and examination. The attractiveness of this alternative model is that it would centralize authority and accountability in a single agency, which could write rules that would apply uniformly to financial services providers, whether or not they are depository institutions. Because the agency would focus exclusively on consumer protection, proponents also argue that such a model eliminates the concern sometimes expressed that prudential supervisors neglect consumer protection in favor of safety and soundness supervision. But the downside of this approach is considerable. It would not have the benefits of on-site examination and supervision and the very real leverage that bank supervisors have over the banks they regulate. That means, we believe, that compliance is likely to be less effective. Nor would this approach draw on the practical expertise that examiners develop from continually assessing the real-world impact of particular consumer protection rules--an asset that is especially important for developing and adjusting such rules over time. More troubling, the ingredients of this approach--registration, licensing and reliance on enforcement actions to achieve compliance with standards--is the very model that has proved inadequate to protect consumers doing business with state regulated mortgage lenders and brokers. Finally, I do not agree that the banking agencies have failed to give adequate attention to the consumer protection laws that they have been charged with implementing. For example, predatory lending failed to gain a foothold in the banking industry precisely because of the close supervision commercial banks, both state and national, received. But if Congress believes that the consumer protection regime needs to be strengthened, the best answer is not to create a new agency that would have none of the benefits of a prudential supervisor. Instead, the better approach is a crisp Congressional mandate to already responsible agencies to toughen the applicable standards and close any gaps in regulatory coverage. The OCC and the other prudential bank supervisors will rigorously apply them. And because of the tools we have that I've already mentioned, banks will comply more readily and consumers will be better protected than would be the case with mandates applied by a new federal agency.Conclusion My testimony today reflects the OCC's views on several key aspects of regulatory reform. We would be happy provide more details or additional views on other issues at the Committee's request. CHRG-111hhrg61852--4 Mr. Koo," Thank you, Chairman Frank, and members of the committee. I really appreciate this opportunity to present my case that what the whole world has caught is the same Japanese disease that Japan had to struggle with for the last 15, 20 years. And I was grateful that I was in this room when the morning session took place. All the debate that took place here actually took place in Japan 15, 20 years earlier. That was about zero interest rates, liquidity injections, quantitative easing, capital injections, guaranteeing bank liabilities, fiscal stimulus, large budget deficits, problems with rating agencies, and small companies not getting the funds. We went through that debate in Japan 15 years earlier, and after going through this very difficult period, we came to the conclusion that this is a very different disease. It is a completely different disease compared to what we are used to. And in this disease, where the recession is caused by a bursting of a nationwide asset price bubble, financed with debt, when that bubble bursts, asset prices collapse, liabilities remain, and the private sector finds out their balance sheets are all underwater--or many of them are underwater. And when the balance sheets are underwater, if you have no income or revenue, of course you are out of business. But if you still have some income or revenue or cash flow, then the right thing to do is to use that cash flow to pay down debt, because if you have a business, you don't want to tell your shareholders that well, we are bankrupt. We are out of business. Here is this piece of paper. You don't want to tell the bankers that it is a nonperforming loan. You don't want to tell your workers that they have no more jobs tomorrow. So for all the stakeholders involved, the right thing to do is to use the cash flow to pay down debt. But when everybody does this all at the same time, we enter a very different world where the economy would be continuously losing demand until private sector balance sheets are repaired. And I see the same thing happening in this country. There was a lot of discussion about corporate holding cash in this economy. I don't think they are just holding cash; they are paying down debt. And when this happens with zero interest rates, we enter a very different world. Because there is no name for this type of recession in economics, I call it balance sheet recession. And it happens in the following way: In the usual economy, if you have $1,000 of income, and I spent $900 myself and decide to save $100, the $900 is already someone else's income. The $100 that comes into the bank in the financial sector is lent to someone who can use it. That person then spends the money. That is $900 plus $100, and the economy moves forward. When there are too many borrowers, you raise interest rates. Some drop out. If too few, you bring rates down, and then someone will pick up the remaining sum, and that is how the economy moves forward. But in the recession that we found ourselves in, in Japan 15 or 20 years ago, was that you bring rates down to zero, there are no borrowers because everybody is paying down debt. No one is borrowing money, even with a zero interest rate. And when that happens, when $900 is spent, $100 gets stuck in the banking system because there are no borrowers, even at a zero interest rate, then the economy shrinks to $900. That $900 is someone else's income. That person gets the money and decides, let us say, to save 10 percent. So $810 is spent, $90 goes into the banking system, and that $90 gets stuck. So if we do nothing about the situation, the economy will shrink from $1,000, $900, $810, $730 very, very quickly, even with a zero interest rate. That is what happened in Japan, and that is exactly what happened during the Great Depression in the United States 80 years ago. Everybody was paying down debt. No one was borrowing money because their balance sheets were all underwater. When you face a situation like this, the only way to keep the economy going is for the government to borrow the $100 and put that back into the income stream, because the government cannot tell the private sector not to repair its balance sheets. The private sector must repair its balance sheets. The private sector has no choice. So government has to then take the $100, put that back into the income stream, and then you have $900 plus $100 against the original income, $1,000. Then, the economy will move forward. This government action will have to be kept in place for the entire period of private sector deleveraging because if you pull the plug at any moment when the private sector is still deleveraging, the economy will collapse very quickly. And we, in Japan, made that mistake in 1997 and in 2001. On both occasions, when the government pulled the plug, the economy collapsed; and the budget deficit, instead of decreasing, it actually increased massively. And it took us nearly 10 years to climb out of the hole. So when the private sector is deleveraging, my advice to those countries suffering from this problem is to keep the government spending in there until private sector balance sheets are repaired, until the private sector is strong enough to move forward. And until that point, I am afraid government will have to be in there, because that will be the cheapest way to save the economy at the end of the day. Our preliminary mistake, our premature fiscal consolidation in 1997 and 2001, prolonged the Japanese recession by at least 5 years, if not longer, and added massively to our budget deficit because the economy collapsed on both occasions, and we had to pull those economies out of that hole. So I would very much like to make sure that this economy, the most important one in the world, will not make the Japanese mistake of premature fiscal consolidation while the private sector is still deleveraging. [The prepared statement of Mr. Koo can be found on page 28 of the appendix.] " CHRG-110shrg50409--88 Chairman Dodd," Thank you, Senator. Senator Akaka. Senator Akaka. Thank you very much, Mr. Chairman. Let me add my welcome to Chairman Bernanke for being here, and my concerns in our country is to educate the people of America as well as to protect them and empower them in our financial system. Given the recent failures, I am concerned by the increasing lack of trust that individuals have in the banking system. When large numbers of depositors lose trust in their financial institution and demand their money back, the bank can fail as a result, and we know that. In addition, distrust of the banking system causes many immigrants to miss out on savings, borrowing, and low-cost remittance opportunities found at banks and credit unions. My question to you is: What must be done to increase trust in the banking system among depositors as well as among the unbanked? " CHRG-111hhrg55809--112 Mr. Bernanke," Well, I don't think it is creating money technically, but it is basically a loan from the banking system to the FDIC which will have to be replaced eventually by actual assessments on the rest of the banking system. " CHRG-111hhrg55809--20 Mr. Bernanke," Thank you. Chairman Frank, Ranking Member Bachus, and other members of the committee, I appreciate the opportunity to discuss ways of improving the financial regulatory framework to better protect against systemic risk. In my view, a-broad based agenda for reform should include at least five key elements: First, legislative change is needed to ensure that systemically important financial firms are subject to effective consolidated supervision, whether or not the firm owns the bank. Second, an oversight council made up of the agencies involved in financial supervision and regulation should be established, with a mandate to monitor and identify emerging risk to financial stability across the entire financial system, to identify regulatory gaps, and to coordinate the agencies' responses to potential systemic risks. To further encourage a more comprehensive and holistic approach to financial oversight, all Federal financial supervisors and regulators--not just the Federal Reserve--should be directed and empowered to take account of risks to the broader financial system as part of their normal oversight responsibilities. Third, a new special resolution process should be created that would allow the government to wind down a failing systemically important financial institution whose disorderly collapse would pose substantial risks to the financial system and the broader economy. Importantly, this regime should allow the government to impose losses on shareholders and creditors of the firm. Fourth, all systemically important payment, clearing, and settlement arrangements should be subject to consistent and robust oversight and prudential standards. And fifth, policymakers should ensure that consumers are protected from unfair and deceptive practices in their financial dealings. Taken together, these changes should significantly improve both the regulatory system's ability to constrain the buildup of systemic risks as well as the financial system's resiliency when serious adverse shocks occur. The current financial crisis has clearly demonstrated that risk to the financial system can rise not only in the banking sector but also from the activities of other financial firms--such as investment banks or insurance companies--that traditionally have not been subject to the type of regulation and consolidated supervision applicable to bank holding companies. To close this important gap in our regulatory structure, legislative action is needed that would subject all systemically important financial institutions to the same framework for consolidated prudential supervision that currently applies to bank holding companies. Such action would prevent financial firms that do not own a bank but that nonetheless pose risk to the overall financial system because of the size, risks, or interconnectedness of their financial activities from avoiding comprehensive supervisory oversight. Besides being supervised on a consolidated basis, systemically important financial institutions should also be subject to enhanced regulation and supervision, including capital, liquidity, and risk-management requirements that reflect those institutions' important roles in the financial sector. Enhanced requirements are needed not only to protect the stability of individual institutions and the financial system as a whole but also to reduce the incentives for financial firms to become very large in order to be perceived as ``too-big-to-fail.'' This perception materially weakens the incentive of creditors of the firm to retrain the firm's risk-taking, and it creates a playing field that is tilted against smaller firms not perceived as having the same degree of government support. Creation of a mechanism for the orderly resolution of systemically important non-bank financial firms, which I will discuss later, is an important additional tool for addressing the ``too-big-to-fail'' problem. The Federal Reserve is already the consolidated supervisor of some of the largest, most complex institutions in the world. I believe that the expertise we have developed in supervising large, diversified, interconnected banking organizations, together with our broad knowledge of the financial markets in which these organizations operate, makes the Federal Reserve well suited to serve as the consolidated supervisor for those systemically important financial institutions that may not already be subject to the Bank Holding Company Act. In addition, our involvement and supervision is critical for ensuring that we have the necessary expertise, information, and authorities to carry out our essential functions as a central bank of promoting financial stability and making effective monetary policy. The Federal Reserve has already taken a number of important steps to improve its regulation and supervision of large financial groups, building on lessons from the current crisis. On the regulatory side, we played a key role in developing the recently announced and internationally agreed-upon improvements to the capital requirements for trading activities and securitization exposures; and we continue to work with other regulators to strengthen the capital requirements for other types of on- and off-balance sheet exposures. In addition, we are working with our fellow regulatory agencies toward the development of capital standards and other supervisory tools that will be calibrated to the systemic importance of the firm. Options under consideration in this area include requiring systemically important institutions to hold aggregate levels of capital above current regulatory norms or to maintain a greater share of capital in the form of common equity or instruments with similar loss-absorbing attributes, such as ``contingent'' capital that converts to common equity when necessary to mitigate systemic risk. The financial crisis also highlighted weaknesses in liquidity risk management at major financial institutions, including an overreliance on short-term funding. To address these issues, the Federal Reserve helped lead the development of revised international principles for sound liquidity risk management, which had been incorporated into new interagency guidance now out for public comment. In the supervisory arena, the recently completed Supervisory Capital Assessment Program (SCAP), properly known as the stress test, was quite instructive for our efforts to strengthen our prudential oversight of the largest banking organizations. This unprecedented interagency process, which was led by the Federal Reserve, incorporated forward-looking, cross-firm, aggregate analyses of 19 of the largest bank holding companies, which together control a majority of the assets and loans within the U.S. banking system. Drawing on the SCAP experience, we have increased our emphasis on horizontal examinations, which focus on particular risks or activities across a group of banking organizations; and we have broadened the scope of the resources that we bring to bear on these reviews. We are also in the process of creating an enhanced quantitative surveillance program for large, complex organizations that will use supervisory information, firm-specific data analysis, and market-based indicators to identify emerging risk to specific firms as well as to the industry as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operation specialists, and other experts within the Federal Reserve System. Periodic scenario analysis will be used to enhance our understanding of the consequences of the changes in the economic environment for both individual firms and for the broader system. Finally, to support and complement these initiatives, we are working with the other Federal banking agencies to develop more comprehensive information-reporting requirements for the largest firms. For purposes of both effectiveness and accountability, the consolidated supervision of an individual firm, whether or not it is systemically important, is best vested with a single agency. However, the broader task of monitoring and addressing systemic risks that might arise from the interaction of different types of financial institutions and markets, both regulated and unregulated, may exceed the capacity of any individual supervisor. Instead, we should seek to marshal the collective expertise and information of all financial supervisors to identify and respond to developments that threaten the stability of the system as a whole. This objective can be accomplished by modifying the regulatory architecture in two important ways. First, an oversight council--composed of representatives of the agencies and departments involved in the oversight of the financial sector--should be established to monitor and identify emerging systemic risks across the full range of financial institutions and markets. Examples of such potential risks include: rising and correlated risk exposures across firms and markets; significant increases in leverage that could result in systemic fragility; and gaps in regulatory coverage that arise in the course of financial change and innovation, including the development of new practices, products, and institutions. A council could also play useful roles in coordinating responses by member agencies to mitigate emerging systemic risks, in recommending actions to reduce procyclicality and regulatory and supervisory practices, and in identifying financial firms that may deserve designation as systemically important. To fulfill its responsibilities, a council would need access to a broad range of information from its member agencies regarding the institutions and markets they supervise; and when the necessary information is not available through that source, they should have the authority to collect such information directly from financial institutions and markets. Second, the Congress should support a reorientation of individual agency mandates to include not only the responsibility to oversee the individual firms or markets within each agency scope of authority but also the responsibility to try to identify and respond to the risks that those entities may pose, either individually or through their interactions with other firms or markets, to the financial system more broadly. These actions could be taken by financial supervisors on their own initiative or based on a request or recommendation of the oversight council. Importantly, each supervisor's participation in the oversight council would greatly strengthen that supervisor's ability to see and understand emerging risk to financial stability. At the same time, this type of approach would vest the agency that has responsibility and accountability for the relevant firms or markets with the authority for developing and implementing effective and tailored responses to systemic threats arising within their purview. To maximize effectiveness, the oversight council could help coordinate responses when risks cross regulatory boundaries, as will often be the case. The Federal Reserve already has begun to incorporate a systemically focused approach into our supervision of large, interconnected firms. Doing so requires that we go beyond considering each institution in isolation and pay careful attention to interlinkages and interdependencies among firms and markets that could threaten the financial system in a crisis. For example, the failure of one firm may lead to runs by wholesale funders of other firms that are seen by investors as similarly situated or that have exposures to the failing firm. These efforts are reflected, for example, in the expansion of horizontal reviews and the quantitative surveillance program that I discussed earlier. Another critical element of the systemic risk agenda is the creation of a new regime that would allow the orderly resolution of failing, systemically important financial firms. In most cases, the Federal bankruptcy laws provide an appropriate framework for the resolution of non-bank financial institutions. However, the Bankruptcy Code does not sufficiently protect the public's strong interest in ensuring the orderly resolution of a non-bank financial firm whose failure would pose substantial risks to the financial system and to the economy. Indeed, after the Lehman Brothers and AIG experiences, there is little doubt that we need a third option between the choices of bankruptcy and bailout for those firms. A new resolution regime for non-banks, analogous to the regime currently used by the FDIC for banks, would provide the government the tools to restructure or wind down a failing systemically important firm in a way that mitigates the risks to financial stability and the economy and that protects the public interest. It also would provide the government a mechanism for imposing losses on the shareholders and the creditors of the firm. Establishing credible processes for imposing such losses is essential to restoring a meaningful degree of market discipline and addressing the ``too-big-to-fail'' problem. The availability of a workable resolution regime also will replace the need for the Federal Reserve to use its emergency lending authority under 13(3) of the Federal Reserve Act to prevent the failure of specific institutions. Payment, clearing, and settlement arrangements are the foundation of the Nation's financial infrastructure. These arrangements include centralized market utilities for clearing and settling payments, securities, and derivative transactions, as well as the decentralized activities through which financial institutions clear and settle transactions bilaterally. While these arrangements can create significant efficiencies and promote transparency in the financial markets, they also may concentrate substantial credit, liquidity, and operational risks and, absent strong risk controls, may themselves be a source of contagion in times of stress. Unfortunately, the current regulatory and supervisory framework for systemically important payment, clearing, and settlement arrangements is fragmented, creating the potential for inconsistent standards to be adopted or applied. Under the current system, no single regulators is able to develop a comprehensive understanding of the interdependencies, risks, and risk-management approaches across the full range of arrangements serving the financial markets today. In light of the increasing integration of global financial markets, it is important that systemically critical payment, clearing, and settlement arrangements be viewed from a systemwide perspective and that they be subject to strong and consistent prudential standards and supervisory oversight. We believe that additional authorities are needed to achieve these goals. As the Congress considers financial reform, it is vitally important that consumers be protected from unfair and deceptive practices in their financial dealings. Strong consumer protection helps preserve household savings, promotes confidence in financial institutions and markets, and adds materially to the strength of the financial system. We have seen in this crisis that flawed or inappropriate financial instruments can lead to bad results for families and for the stability of the financial sector. In addition, the playing field is uneven regarding examination and enforcement of consumer protection laws among banks and non-bank affiliates of bank holding companies on the one hand and firms not affiliated with banks on the other. Addressing this discrepancy is critical both for protecting consumers and for ensuring fair competition in the market for consumer financial products. Mr. Chairman, Ranking Member Bachus, thank you again for the opportunity to testify in these important matters. The Federal Reserve looks forward to working with the Congress and the Administration to enact meaningful regulatory reform that will strengthen the financial system and reduce both the probability and the severity of future crises. Thank you. [The prepared statement of Chairman Bernanke can be found on page 58 of the appendix.] " CHRG-111hhrg54869--27 Mr. Volcker," Right. " Mr. Bachus," --I think you have indicated, and I think many of us realize there is a difference in what was a commercial bank, a lending facility, and an investment or trading bank. In fact, if you look at the two investment banks, the two largest ones, their last report showed substantial profits from trading, which indicates a trade that they are still basically--their profits are being derived from trading derivatives and some of the things that you described. Do we go back to that system? " CHRG-110hhrg46591--240 Mr. Washburn," Thank you, Congressman. You took my first paragraph away. My name is Mike Washburn. I am here from Red Mountain Bank; I am president and CEO of that bank. We are a $351 million community bank in Hoover, Alabama. I am here to testify today on behalf of the Independent Community Bankers of America. I appreciate the opportunity to share the views of our Nation's community banks on the issue of financial restructuring and reform. Even though we are in the midst of very uncertain financial times, and there are many signs that we are headed for a recession, I am pleased to report that the community banking industry is sound. Community banks are strong. We are commonsense, small-business people who have stayed the course with sound underwriting that has worked well for us for many years. We have not participated in the practices that have caused the current crisis, but our doors are open to helping resolve it through prudent lending and restructuring. As we examine the roots of the current problems, one thing stands out: Our financial system has become too concentrated. As a result of the Federal Reserve and Treasury action, the four largest banking companies in the United States today now control more than 40 percent of the Nation's deposits and more than 50 percent of the Nation's assets. This is simply overwhelming. Congress should seriously consider whether it is prudent to put so much economic power and wealth into the hands of so few. Our current system of banking regulation has served this Nation well for decades. It should not be suddenly scrapped in the zeal for reform. Perhaps the most important point I would like to make to you today is the importance of deliberation and contemplation. Government and the private sector need to work together to get this right. We would like to make the following suggestions: Number 1: Preserve the system of multiple Federal regulators who provide checks and balances and who promote best practices among these agencies. Number 2: Protect the dual banking system, which ensures community banks have a choice of charters and of supervisory authority. Number 3: Address the inequity between the uninsured depositors at too-big-to-fail banks, which have 100 percent deposit protection, versus uninsured depositors at the too-small-to-save banks that could lose money, giving the too-big-to-fail banks a tremendous competitive advantage in attracting deposits. Number 4: Maintain the 10 percent deposit cap. There is a dangerous overconcentration of financial resources in too few hands. Number 5: Preserve the thrift charter and its regulator, the OTS. Number 6: Maintain GSEs in a viable manner to provide valuable liquidity and a secondary market outlet for mortgage loans. Number 7: Maintain the separation of banking and commerce and close the ILC loophole. Think how much worse this crisis would have been if the regulators had to unwind commercial affiliates as well as the financial firms. We also believe Congress should consider the following: Number 1: Unregulated institutions must be subject to Federal supervision. Like banks, these firms should pay for this supervision to reduce the risk of future failure. Number 2: Systemic risk institutions should be reduced in size. Allowing four companies to control the bulk of our Nation's financial resources invites future disasters. These huge firms should be either split up or be required to divest assets so they no longer pose a systemic risk. Number 3: There should be a tiered regulatory system that subjects large, complex institutions to a more thorough regulatory system, and they should pay a risk premium for the possible future hazard they pose to taxpayers. Number 4: Finally, mark-to-market and fair value accounting rules should be suspended. Mr. Chairman and members of the committee, thank you for inviting ICBA to present our views. Red Mountain Bank and the other 8,000 community banks in this country look forward to working with you as you address the regulatory and supervisory issues facing the financial services industry today. Thank you. [The prepared statement of Mr. Washburn can be found on page 168 of the appendix.] " CHRG-111shrg54675--77 PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON It is no exaggeration to say that our economy is currently experiencing extraordinary stress and volatility. As Congress and the Administration look at corrective policy changes, I am pleased to hold this hearing today to take a closer look at the role smaller financial institutions, specifically community banks and credit unions, play in our economy, especially in many rural communities. Throughout our Nation's economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders. There are many community banks and credit unions that did not contribute to the current crisis--many rural housing markets that didn't experience the boom that other parts of the country did, and community lending institutions didn't sell as many exotic loan products as other lenders sold. Nonetheless, small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis and the subsequent crisis in credit markets. Jobs are disappearing, ag loans are being called, small businesses can't get the lines of credit they need to continue operation, and homeowners are struggling to refinance. Smaller banks play a crucial role in our economy and in communities throughout our Nation; we need to be mindful that some institutions are now paying the price for the risky strategies employed by some larger financial institutions. In coming weeks, the Banking Committee will continue its review of the current structure of our financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, it will be important to consider the unique needs of smaller financial institutions and to preserve their viability as we come up with good, effective regulations that balance consumer protection and allow for sustainable economic growth. I would like to welcome our panel of witnesses, and thank them for their time and for their thoughtful testimony on how small lending institutions in rural communities have been affected by our troubled economy. I would also like to thank Senator Kohl for his interest in today's hearing topic. I will now turn to Senator Crapo, the Subcommittee's Ranking Member, for his opening statement. ______ CHRG-111hhrg54869--14 Mr. Volcker," Thank you, Mr. Chairman, and members of the committee. It has been a long time since I have been in the room. It is a familiar room, and I appreciate the opportunity because you are dealing with particularly important problems. Let me just say in a preliminary way, as you know, the President has said--as Mr. Geithner has said, if the market betters, the economy steadying, there has been some feeling of relaxation about some of these issues and some feeling of maybe just return to business as usual, return to making money, outside amounts of money, certain resistance to change. And from the comments that you have made, I am sure you will not respond to that by slowing down, but rather proceeding with all deliberate speed to get this right. It is really important. It is an incredibly complicated problem, and I want to concentrate on mainly the aspect that you have already emphasized. But before I do so, let me acknowledge that an awful lot of work is going on in various aspects by the regulatory agencies. They have taken important initiatives dealing with capital and liquidity, and they are working toward compensation practices. And I would point out it is relevant with the G-20 meeting that a lot of what needs to be done really does require a certain consistency internationally because these markets are global and that just adds another complication. You can't have capital requirements, for instance, for American banks that are way out of line of capital requirements elsewhere, to take an easy example. But that is an additional complication. But the central issue that I want to talk about really is what you have already said, moral hazard in financial markets. You know what that is all about. I don't have to explain it. But I would note that this is front and center because the active use of long-dormant emergency powers of the Federal Reserve together with extraordinary action by the Treasury and Congress to support non-bank institutions has extended this issue well beyond the world of commercial banking. ``Too-big-to-fail'' has been an issue in commercial banking; now it is an issue for finance generally. I think it raises very important substantive questions. It raises some administrative questions that I want to touch upon, too. It raise legal questions. And one of those questions is the role of the Federal Reserve, which I will return to. In dealing with that, I submitted a long statement which deals with all of this in more detail. Just to cut to the chase, you know, the Administration has set out a possible approach, which I feel somewhat resistant to or more than somewhat resistant because I think it does suffer from conceptual and practical difficulties. Now what they suggested is setting out a group of particular institutions that, in their judgment, would pose a systemic risk in the event of failure. I don't know what criteria would be used precisely in determining these institutions because the market changes, it is not always directly relevant to size. That in itself would be a great challenge. But I think it is fair to say that the great majority of systemically important institutions are today, and likely to be in the future, the mega-commercial banks. We are talking about in the center of things, the commercial banking problem. That is true here, that is true abroad, and in this case we already have an established safety net. The commercial banks that are at the heart of the problem are already subject to deposit insurance, central bank credit facilities, and other means of support. I have a little hobby of asking friends and acquaintances when they talk to me with experience in financial markets, I say, Now, outside of commercial banks, outside of insurance companies, which I would say parenthetically I hope better regulatory systems will be developed, maybe not as part of this legislation but next year. Apart from commercial banks and insurance companies, how many genuinely systemically important institutions do you think there are in the whole world, financial markets. I will tell you the answer I get consistently is somewhere between 5 and 25. The universe is not huge when you are talking about non-banking, non-insurance company, systemically important institutions. Now, if you extend this idea of developing a group of systemically important institutions for your own banks, then the moral hazards problem has obviously increased because the connotation is if they are systemically important, officially identified, they fall in the same category as banks, and the government better be especially alert to dealing with them in case of difficulty. Now, it does seem to me a better approach would be to confine the safety net to where it is, that is to commercial banking organizations. And as part of that organization now and even more so in the future, the banking supervisors would, I think, as a natural part of their responsibility, be especially attentive to the risks posed by the largest banking organizations. So they ought to have the discipline to insist upon best practice among those organizations, not just in the United States but generally worldwide by agreement. We have to agree to more adequate capital, responsible cooperation with other supervisory concerns, and leave it as ambiguous as you can as to whether government assistance would ever be provided in these emergency situations. Now that approach recognizes, I think, the reality that the commercial banks are the indispensable backbone of the financial system. Mr. Scott talked a bit about the importance of community banks, regional banks and credit. That is part of it. They also act as depository, they take care of the payment system, they offer investment advice, they maintain international financial flows. These are all essential services that justify a special sense of protection. Now, when you get to what are called capital market activity, a lot of trading, hedge funds, private equity funds, a lot of other activity, credit default swaps,CDOs, CDO squared, all that stuff, it is a different business. It is an impersonal position. It is a trading business, and it is useful. We need strong capital markets, but they are not the same as customer-related commercial banking functions and they do have substantial risks. Banking itself is risky enough. You add capital market operations to that, you are just compounding the risk. And I would note it is--they present conflicts of interest for customer relationships. When a bank is rendering advice and maybe investment advice to a company, it is rendering underwriting services and then it is turning around and creating in those same activities, does it bias the customer advice? Does it undercut the customer relationship? Is it consistent with the customer relationship? Those problems are enormously difficult, and I think demonstrably have been a big distraction for bank management and led to weaknesses in risk management practices. So I would say the logic of this situation is to prohibit the banking organizations, and by ``banking organizations,'' I am talking about the bank and its holding company and all of the related operations. I would prohibit them from sponsoring or capitalizing hedge funds, private equity funds, and I would have particularly strict supervision enforced by capital and collateral requirements toward proprietary trading in securities and derivatives. Now, how do you approach all of this and deal with the big nonbank that might get in trouble? That I think is where this resolution authority comes into play. Can we have a system, knowledge as to what we have with banks, a government authority can take over a failed or failing institution, manage that institution, try to find a merger partner if that is reasonable, force the end of the equity if there is no equity really left in the company, ask debt holders, negotiate with debt holders to exchange dept for equity to make the company solvent again, if that is possible. If none of that is possible, arrange an orderly liquidation. And none of that necessarily involves the injection of government money and taxpayer money but it provides an organized procedure for letting down what I hope is a very rare occurrence of the failure of a systemically important nonbank institution. Now who has all of this authority and how are the general regulatory and supervisory arrangements rejiggered, if at all, and I do think they do need some rejiggering. I would mention one aspect of that. The Treasury itself has correctly identified the need for what I call an overseer. Somebody, some organization that is responsible not just for individual institutions but responsible for surveying the whole financial system, identifying points of weakness, which may or may not lie in an individual institution. It may lie in new trading developments. But take two obvious examples. Who was alert to the rise of the subprime mortgage a few years ago? It may not have appeared to have presented a risk at the time for an individual institution, but it sure in its speed of increase and its weakness presented a risk to the whole system. Somebody should have been alerted to that. Who has been looking at credit default swaps and wondering whether they reach the point of creating a threat to the system? And the answer is basically nobody and not very well. And somebody should have that responsibility. The Treasury has been very eloquent on that point. They have suggested a kind of council or regulatory agency headed by the Treasury. I frankly don't think that is a very effective way to do it because getting a bunch of agencies together and getting to agreement on anything, and they all have their particular responsibilities, their particular constituencies are a very tough business. So if you do it that way you have to be a Treasury. You have to build up a new staff in the Treasury. The alternative is the Federal Reserve. I spent a lot of time in the Treasury so I am not particularly prejudiced of the Federal Reserve, I would argue, but I think this is a natural function for the Federal Reserve. I think consciously or unconsciously we have looked to the Federal Reserve. Whether the responsibility has been discharged effectively or not, there is a sense that the Federal Reserve is the agency, the major agency to be concerned with the whole financial market, and there is no doubt when you get in trouble, when anybody in the financial markets gets in real trouble they run to the Federal Reserve. The Federal Reserve has the authority, the money. It presumably has the experience and capabilities, and I think that simple fact ought to be recognized. It is a very important institution. It seems to be logical that they ought to be kind of assigned explicitly what I always thought they had implicitly, a kind of surveillance of a whole system. [The prepared statement of Mr. Volcker can be found on page 93 of the appendix.] " CHRG-111shrg54533--13 Secretary Geithner," Excellent question, and let me say a couple things in response. First is we did not envision quite that sweeping a scope or authority as you implied in your basic question. Our judgment is the core institutions at the center of the system that require a stronger framework of consolidated supervision and higher capital requirements at this stage--we have to go through a careful process to assess this--at this stage would largely entail the major banks and investment banks in the country today. Now, there are some exceptions to that. But we also believe that we want to have a system that is flexible enough in the future if other institutions emerge that could present the same kind of risks to the system that we saw emerge from AIG or from Bear Stearns and Lehman Brothers, that we want the system to be able to adapt and bring those institutions under the same basic framework of constraints on leverage that we think are appropriate for those banks at the core of the system that could threaten stability. But we do not envision quite as sweeping and broad a net as you suggested in your initial remarks, and that is one reason why we think the natural place for this is the Fed. Now, the Fed--again, the Fed has, relative to any other entity in our current system today, much more knowledge about how payment systems work. It is, because it does execute monetary policy on behalf of the Federal Reserve of the FOMC, and because it does fund the government on behalf of the Treasury, it has a greater knowledge and feel for broader market developments than is true for any other entity in that context. These things are all about alternatives and about choices. We don't think it is tenable to give those responsibilities to a committee, for reasons I think you understand. And we do not believe there is another place in the system better able to handle those responsibilities. And we think to create a new institution from scratch would leave us with a risk of losing, or not having in a moment of significant challenge, having the necessary expertise and experience. Senator Shelby. Thank you, Mr. Chairman. " CHRG-111shrg53176--160 PREPARED STATEMENT OF BARBARA ROPER Director of Investor Protection, Consumer Federation of America March 26, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee: My name is Barbara Roper. I am Director of Investor Protection of the Consumer Federation of America (CFA). CFA is a nonprofit association of approximately 280 organizations. It was founded in 1968 to advance the consumer interest through research, advocacy, and education. I appreciate the opportunity to appear before you today to discuss needed steps to strengthen investor protection. The topic we have been asked to address today, ``Enhancing Investor Protection and the Regulation of Securities Markets,'' is broad. It is appropriate that you begin your regulatory reform efforts by casting a wide net, identifying the many issues that should be addressed as we seek to restore the integrity of our financial system. In response, my testimony will also be broader than it is deep. In it, I will attempt to identify and briefly describe, but not comprehensively detail, solutions to a number of problems in three general categories: responding to the current financial crisis, reversing harmful policies, and adopting pro-investor reforms. I look forward to working with this Committee and its members on its legislative response.Introduction Before I turn to specific issues, however, I would like to take a few moments to discuss the environment in which this reform effort is being undertaken. I'm sure I don't need to tell the members of this Committee that the public is angry, or that investor confidence--not just in the safety of the financial markets but in their integrity--is at an all-time low. Perhaps you've seen the recent Harris poll, taken before the news hit about AIG's million-dollar bonuses, which found that 71 percent of respondents agreed with the statement that, ``Most people on Wall Street would be willing to break the law if they believed they could make a lot of money and get away with it.'' If not, you've surely heard a variant on this message when you've visited your districts or turned on the evening news. Right now, the public rage is unfocused, or rather it is focused on shifting targets in response to the latest headlines: Bernie Madoff's Ponzi scheme one day, bailout company conferences at spa resorts the next, AIG bonuses today. Imagine what will happen if the public ever really wakes up to the fact that all of the problems that have brought down our financial system and sent the global economy into deep recession--unsound and unsustainable mortgage lending, unregulated over-the-counter derivatives, and an explosive combination of high leverage and risky assets on financial institution balance sheets--were diagnosed years ago but left unaddressed by legislators and regulators from both political parties who bought into the idea that market discipline and industry self-interest were all that was needed to rein in Wall Street excesses and that preserving industry's ability to innovate was more important than protecting consumers and investors when those innovations turned toxic. Now, this Committee and others in Congress have begun the Herculean task of rewriting the regulatory rulebook and restructuring the regulatory system. That is an effort that CFA strongly supports. But, as the Securities Subcommittee hearing last week on risk management regulation made all too clear, those efforts are likely to have little effect if regulators remain reluctant to act in the face of obvious industry shortcomings and clear signs of abuse. After all, we might not be here today if regulators had done just that--if the Fed had used its authority under the Home Ownership and Equity Protection Act to rein in the predatory subprime lending that is at the root of this problem, or if SEC and federal banking regulators had required the institutions under their jurisdiction to adopt appropriate risk management practices that could have made them less vulnerable to the current financial storm. Before we heap too much scorn on the regulators, however, we would do well to remember that, in recent years at least, global competitiveness was the watchword, and regulators who took too tough a line with industry were more likely to be called on the carpet than those who were too lax. Even now, it is not clear how much that has changed. After all, just two weeks ago, the House Capital Markets Subcommittee subjected the Financial Accounting Standards Board (FASB) to a thorough grilling for doing too little to accommodate financial institutions seeking changes to fair value accounting, changes, by the way, that would make it easier for those institutions to hide bad news about the deteriorating condition of their balance sheets from investors and regulators alike. Unless something fundamental changes in the way we approach these issues, it is all too easy to imagine a new systemic risk regulator sitting in that same hot seat in a couple of years, asked to defend regulations industry groups complain are stifling innovation and undermining their global competitiveness. More than any single policy or practice, that antiregulatory bias among regulators and legislators is what needs to change if the goal is to better protect investors and restore the health and integrity of our securities markets.I. Respond to the Current Financial Crisis It doesn't take a rocket scientist to recognize that, in the midst of a financial crisis of global proportions, the top investor protection priority today must be fixing the problems that caused the financial meltdown. Largely as the result of a coincidence in the timing of Bear Stearns' failure and the release of the Treasury Department's Blueprint for Financial Regulatory Reform, many people have sought solutions to our financial woes in a restructuring of the financial regulatory system. CFA certainly agrees that our regulatory structure can, and probably should, be improved. We remain convinced, however, that structural weaknesses were not a primary cause of the current crisis, and structural changes alone will not prevent a recurrence. We appreciate the fact that this Committee has recognized the importance of treating these issues holistically and has pledged to take an inclusive approach. As the Committee moves forward with that process, the following are among the key investor protection issues CFA believes must be addressed as part of a comprehensive response to the financial meltdown.1. Shut down the ``shadow'' banking system The single most important step Congress can and should take immediately to reduce excessive risks in the financial system is to close down the shadow banking system completely and permanently. While progress is apparently being made (however slowly) in moving over-the-counter credit default swaps onto a clearinghouse, this is just a start, and a meager start at that. Meaningful financial regulatory reform must require that all financial activities be conducted in the light of regulatory oversight according to basic rules of transparency, fair dealing, and accountability. As Frank Partnoy argued comprehensively and persuasively in his 2003 book, Infectious Greed, a primary use of the ``shadow'' banking system--and indeed the main reason for its existence--is to allow financial institutions to do indirectly what they or their clients would not be permitted to do directly in the regulated markets. So, when Japanese insurers in the 1980s wanted to evade restrictions that prevented them from investing in the Japanese stock market, Bankers Trust designed a complex three-way derivative transaction between Japanese insurers, Canadian bankers, and European investors that allowed them to do just that. Institutional investors that were not permitted to speculate in foreign currencies could do so indirectly using structured notes designed by Credit Suisse Financial Products that, incidentally, magnified the risks inherent in currency speculation. And banks could do these derivatives deals through special purpose entities (SPEs) domiciled in business-friendly jurisdictions like the Cayman Islands in order to avoid taxes, keep details of the deal hidden, and insulate the bank from accountability. These same practices, which led to a series of mini-financial crises throughout the 1990s, are evident in today's crisis, but on a larger scale. Banks such as Citigroup were still using unregulated special purpose entities to hold toxic assets that, if held on their balance sheets, would have required them to set aside additional capital, relying on the fiction that the bank itself was not exposed to the risks. Investment banks such as Merrill Lynch sold subprime-related CDOs to pension funds and other institutional investors in private placements free from disclosure and other obligations of the regulated marketplace. And everyone convinced themselves that they were protected from the risks of those toxic assets because they had insured them using credit default swaps sold in the over-the-counter derivatives market, often by AIG, without the basic protections that trading on an exchange would provide, let alone the reserve or collateral requirements that would, in the regulated insurance market, provide some assurance that any claims would be paid. To be credible, any proposal to respond to the current crisis must confront the ``shadow banking system'' issue head-on. This does not mean that all investors must be treated identically or 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 based on appropriate standards. One focus of that regulation should be on protecting against risks 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 the two basic lessons from the current crisis: 1) protecting consumers and investors contributes to the safety and stability of the financial system; and 2) the sheer complexity of modern financial products has made former measures of investor ``sophistication'' obsolete. The basic justification for allowing two systems to grow up side-by-side--one regulated and one not--is that sophisticated investors do not require the protections of the regulated market. According to this line of reasoning, these investors are capable both of protecting their own interests and of absorbing any losses. That myth should have been dispelled back in the early 1990s, when Bankers Trust took ``sophisticated'' investors, such as Gibson Greeting, Inc. and Procter & Gamble, to the cleaners selling them risky interest rate swaps based on complex formulas that the companies clearly didn't understand. Or when Orange County, California lost $1.7 billion, and ultimately went bankrupt, buying structured notes with borrowed money in what essentially amounted to a $20 billion bet that interest rates would remain low indefinitely. Or when a once-respected conservative government bond fund, Piper Jaffray Institutional Government Income Portfolio, lost 28 percent of its value in less than a year betting on collateralized mortgage obligations that involved ``risks that required advanced mathematical training to understand.'' \1\--------------------------------------------------------------------------- \1\ Frank Partnoy, Infectious Greed, How Deceit and Risk Corrupted the Financial Markets, Henry Holt and Company (New York), 2003, p. 123.--------------------------------------------------------------------------- All of these deals, and many others like them, had several characteristics in common. In each case, the brokers and bankers who structured and sold the deal made millions while the customers lost fortunes. The deals were all carried out outside the regulated securities markets, where brokers, despite their best lobbying efforts throughout much of the 1990s, still faced a suitability obligation in their dealings with institutional clients. Once the deals blew up, efforts to recover losses were almost entirely unsuccessful. And, in many cases, strong evidence suggests that the brokers and bankers knowingly played on these ``sophisticated'' investors' lack of sophistication. Partnoy offers the following illustration of the culture at Bankers Trust: As one former managing director put it, ``Guys started making jokes on the trading floor about how they were hammering the customers. They were giving each other high fives. A junior person would turn to his senior guy and say, `I can get [this customer] for all these points.' The senior guys would say, `Yeah, ream him.' '' \2\--------------------------------------------------------------------------- \2\ Partnoy, p. 55, citing Brett D. Fromson, ``Guess What? The Loss is Now . . . $20 Million: How Bankers Trust Sold Gibson Greetings a Disaster,'' Washington Post, June 11, 1995, p. A1. More recent accounts suggest that little has changed in the intervening decades. As Washington Post reporter Jill Drew described in ---------------------------------------------------------------------------a story detailing the sale of subprime CDOs: The CDO alchemy involved extensive computer modeling, and those who wanted to wade into the details quickly found that they needed a PhD in mathematics. But the team understood the goal, said one trader who spoke on condition of anonymity to protect her job: Sell as many as possible and get paid the most for every bond sold. She said her firm's salespeople littered their pitches to clients with technical terms. They didn't know whether their pitches made sense or whether the clients understood. \3\--------------------------------------------------------------------------- \3\ Jill Drew, ``Frenzy,'' Washington Post, December 16, 2008, p. A1. The sophisticated investor myth survived earlier scandals thanks to Wall Street lobbying and the fact that the damage from these earlier scandals was largely self-contained. What's different this time around is the harm that victimization of ``sophisticated'' investors has done to the broader economy. Much as they had in the past, ``sophisticated'' institutional investors have once again loaded up on toxic assets--in this case primarily mortgage-backed securities and collateralized debt obligations--without understanding the risks of those investments. In an added twist this time around, many financial institutions also remained exposed to the risk of these assets, either because they made a conscious decision to retain a portion of the investments or because they couldn't sell off their inventory after the market collapsed. As events of the last year have shown, the damage this time is not self-contained; it has led to a 50 percent drop in the stock market, a freezing of credit markets, and a severe global recession. Meanwhile, the administration is still struggling to find a way to clear toxic assets from financial institutions' balance sheets. Once it has closed existing gaps in the regulatory system, Congress will still need to give authority to some entity--presumably whatever entity is designated as systemic risk regulator--to prevent financial institutions from opening up new regulatory loopholes as soon as the old ones are closed. That regulator must have the ability to determine where newly emerging activities will be covered within the regulatory structure. In making those decisions, the governing principle should be that activities and products are regulated according to their function. For example, where credit default swaps are used as a form of insurance, they should be regulated according to standards that are appropriate to insurance, with a focus on ensuring that the writer of the swaps will be able to make good on any claims. The other governing principle should be that financial institutions are not permitted to engage in activities indirectly that they would be prohibited from engaging in directly. Until that happens, anything else Congress does to reduce the potential for systemic risks is likely to have little effect.2. Strengthen regulation of credit rating agencies 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. Over the years, the number of financial regulations and other practices tied to credit ratings has grown rapidly. For example, money market mutual funds, bank capital standards, and pension fund investment policies all rely on credit ratings to one degree or another. As Jerome S. Fons and Frank Partnoy wrote in a recent New York Times op ed: ``Over time, ratings became valuable . . . because they ``unlock'' markets; that is, they are a sort of regulatory license that allows money to flow.'' \4\ This growing reliance on credit ratings has come about despite their abysmal record of under-estimating risks, particularly the risks of arcane derivatives and structured finance deals. Although there is ample historical precedent, never was that more evident than in the current crisis, when thousands of ultimately toxic subprime-related mortgage-backed securities and CDOs were awarded the AAA ratings that made them eligible for purchase by even the most conservative of investors.--------------------------------------------------------------------------- \4\ Jerome S. Fons and Frank Partnoy, ``Rated F for Failure,'' New York Times, March 16, 2009.--------------------------------------------------------------------------- Looking back, many have asked what would possess a ratings agency to slap a AAA rating on, for example, a CDO composed of the lowest-rated tranches of a subprime mortgage-backed security. (Some, like economists Joshua Rosner and Joseph Mason, pointed out the flaws in these ratings much earlier, at a time when, if regulators had heeded their warning, they might have acted to address the risks that were lurking on financial institutions' balance sheets.) \5\ Money is the obvious answer. Rating structured finance deals pays generous fees, and ratings agencies' profitability has grown increasingly dependent in recent years on their ability to win market share in this line of business. Within a business model where rating agencies are paid by issuers, the perception at least is that they too often win business by showing flexibility in their ratings. Another possibility, no more attractive, is that the agencies simply weren't competent to rate the highly complex deals being thrown together by Wall Street at a breakneck pace. One Moody's managing director reportedly summed up the dilemma this way in an anonymous response to an internal survey: ``These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.'' \6\--------------------------------------------------------------------------- \5\ Joseph R. Mason and Joshua Rosner, How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? (preliminary paper presented at Hudson Institute) February 15, 2007. \6\ Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught Napping?'' New York Times, December 7, 2008.--------------------------------------------------------------------------- The Securities and Exchange Commission found support for both explanations in its July 2008 study of the major ratings agencies. \7\ It documented both lapses in controls over conflicts of interest and evidence of under-staffing and shoddy practices: assigning ratings despite unresolved issues, deviating from models in assigning ratings, a lack of due diligence regarding information on which ratings are based, inadequate internal audit functions, and poor surveillance of ratings for continued accuracy once issued. Moreover, in addition to the basic conflict inherent in the issuer-paid model, credit rating agencies can be under extreme pressure from issuers and investors alike to avoid downgrading a company or its debt. With credit rating triggers embedded in AIG's credit default swaps agreements, for example, a small reduction in rating exposed the company to billions in obligations and threatened to disrupt the CDS market.--------------------------------------------------------------------------- \7\ U.S. Securities and Exchange Commission, Summary Report of Issues Identified in the Commission Staff's Examinations of Select Credit Rating Agencies, July 2008.--------------------------------------------------------------------------- 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. This is the recommendation that Fons and Partnoy arrive at in their Times op ed. ``Regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies,'' they conclude. ``That tool is called judgment.'' Unfortunately, Fons and Partnoy may have identified the only thing less reliable than credit ratings on which to base our investor protections. The other frequently suggested solution is to abandon the issuer-paid business model. Simply moving to an investor-paid model suffers from two serious shortcomings, however. First, it is not as free from conflicts as it may on the surface appear. While investors generally have an interest in receiving objective information before they purchase a security--unless they are seeking to evade standards they view as excessively restrictive--they may be no more interested than issuers in seeing a security downgraded once they hold it in their portfolio. Moreover, we stand to lose ratings transparency under a traditional investor-paid model, since investors who purchase the rating are unlikely to want to share that information with the rest of the world on a timely basis. SEC Chairman Mary Schapiro indicated in her confirmation hearing before this Committee that she was exploring other payment models designed to get around these problems. We look forward to reviewing concrete suggestions that could form an important part of any comprehensive solution to the credit rating problem. While it is easier to diagnose the problems with credit ratings than it is to prescribe a solution, we believe the best approach is found in simultaneously reducing reliance on ratings, increasing accountability of ratings agencies, and improving regulatory oversight. Without removing references to ratings from our legal requirements entirely, Congress could reduce reliance on ratings by clarifying, in each place where ratings are referenced, that reliance on ratings does not substitute for due diligence. So, for example, a money market fund would still be restricted to investing in bonds rated in the top two categories, but they would also be accountable for conducting meaningful due diligence to determine that the investment in question met appropriate risk standards. At the same time, credit rating agencies must lose the First Amendment protection that shields them from accountability. Although we cannot be certain, we believe ratings agencies would have been less tolerant of the shoddy practices uncovered in the SEC study and congressional hearings if they had known that investors who relied on those ratings could hold them accountable in court. First Amendment protections based on the notion that ratings are nothing more than opinions are inconsistent with the ratings agencies' legally recognized status and their legally sanctioned gatekeeper function in our markets. Either their legal status or their protected status must go. As noted above, we believe the best approach is to retain their legal function but to add the accountability that is appropriate to that function. Finally, while we appreciate the steps Congress, and this Committee in particular, took in 2006 to enhance SEC oversight of ratings agencies, we believe this legislation stopped short of the comprehensive reform that is needed. New legislation should specifically address issues raised by the SEC study (a study made possible by the earlier legislation), such as lack of due diligence regarding information on which ratings are based, weaknesses in post-rating surveillance to ensure continued accuracy, and inadequacy of internal audits. In addition, it should give the SEC express authority to oversee ratings agencies comparable to the authority the Sarbanes-Oxley Act granted the PCAOB to oversee auditors. In particular, the agency should have authority to examine individual ratings engagements to determine not only that analysts are following company practices and procedures but that those practices and procedures are adequate to develop an accurate rating. Congress would need to ensure that any such oversight function was adequately funded and staffed.3. Address risks created by securitization Few practices illustrate better than securitization the capacity for market innovations to both bring tremendous benefits and do enormous harm. On the one hand, securitization makes it possible to expand consumer and business access to capital for a variety of beneficial purposes. It was already evident by the late 1990s, however, that securitization had fundamentally altered underwriting practices in the mortgage lending market. By the middle of this decade, it was glaringly obvious to anyone capable of questioning the wisdom of the market that lenders were responding to those changes by writing huge numbers of unsustainable mortgages. Unfortunately, the Fed, which had the power to rein in unsound lending practices, was among the last to wake up to the systemic risks that they posed. In belated recognition that incentives had gotten out of whack, many are now advocating that participants in securitization deals be required to have ``skin in the game,'' in the form of some retained exposure to the risks of the deal. This is an approach that CFA supports, although we admit it is easier to describe in theory than to design in practice. We look forward to working with the Committee as it seeks to do just that. However, we also caution against putting exclusive faith in this approach. Given the massive fees that lenders and underwriters have earned, it will be difficult to design an incentive strong enough to counter the lure of high fees. Financial regulators will need to continue to monitor for signs that lenders are once again abandoning sound lending practices and use their authority to rein in those practices wherever they find them. Another risk associated with securitization has gotten less attention, though it is at the heart of the difficulties the administration now faces in restoring the financial system. Their sheer complexity makes it extremely difficult, if not impossible to unwind these deals. As a result, that very complexity becomes a source of systemic risk. New standards to counteract this design flaw should be included in any measure to reduce securitization risks.4. Improve systemic risk regulation Contrary to conventional wisdom, the current crisis did not stem from the lack of a regulator with sufficient information and the tools necessary to protect the financial system as a whole against systemic risks. In the key areas that contributed to the current crisis--unsound mortgage lending, the explosive combination of risky assets and excessive leverage on financial institutions' balance sheets, and the growth of an unregulated ``shadow'' banking system--regulators had all the information they needed to identify the crucial risks that threatened our financial system but either didn't use the authority they had or, in the case of former CFTC Chair Brooksley Born, were denied the authority they requested to rein in those risks. Unless that reluctance to regulate changes, simply designating and empowering a systemic risk regulator is unlikely to have much effect. Nonetheless, CFA agrees that, if accompanied by a change in regulatory approach and adoption of additional concrete steps to reduce existing systemic threats, designating some entity to oversee systemic risk regulation could enhance the quality of systemic risk oversight going forward. Financial Services Roundtable Chief Executive and CEO Steve Bartlett summed up the problem well in earlier testimony before the Senate Banking Committee when he said that the recent crisis had revealed that our regulatory system ``does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, high-risk activities, or vulnerable interconnections between firms and markets that can create systemic risk.'' In keeping with that diagnosis of the problem, CFA believes the goals of systemic risk regulation should be: 1) to ensure that risks that could threaten the broader financial system are identified and addressed; 2) to reduce the likelihood that a ``systemically significant'' institution will fail; 3) to strengthen the ability of regulators to take corrective actions before a crisis to prevent imminent failure; and 4) to provide for the orderly failure of nonbank financial institutions. The latter point deserves emphasis, because this appears to be a common misconception: the goal of systemic risk regulation is not to protect certain ``systemically significant'' institutions from failure, but rather to simultaneously reduce the likelihood of such a failure and ensure that, should it occur, there is a mechanism in place to allow that to happen with the minimum possible disruption to the broader financial markets. Although there appears to be near universal agreement about the need to improve systemic risk regulation, strong disagreements remain in some areas regarding the best way to accomplish that goal. Certain issues we believe are clear: (1) systemic risk regulation should not be focused exclusively on a few ``systemically significant'' institutions; (2) the systemic risk regulator should have broad authority to survey the entire financial system; (3) regulatory oversight should be an on-going responsibility, not emergency authority that kicks in when we find ourselves on the brink of a crisis; (4) it should include authority to require corrective actions, not just survey for risks; (5) it should, to the degree possible, build incentives into the system to discourage private parties from taking on excessive risks and becoming too big or too inter-connected to fail; and (6) it should include a mechanism for allowing the orderly unwinding of troubled or failing nonbank financial institutions. CFA has not yet taken a position on the controversial question of who should be the systemic risk regulator. Each of the approaches suggested to date--assigning this responsibility to the Federal Reserve, creating a new agency to perform this function, or relying on a panel of financial regulators to coordinate systemic risk regulation--has its flaws, and it is far easier to poke holes in the various proposals than it is to design a fool-proof system for improving risk regulation. Problems that have been identified with assigning this role to the Fed strike us as particularly difficult to overcome. Regardless of the approach Congress chooses to adopt, it will need to take steps to address the weaknesses of that particular approach. One step we urge Congress to take, regardless of which approach it chooses, is to appoint a high-level advisory panel of independent experts to consult on issues related to systemic risk. Such a panel could include academics and other analysts from a variety of disciplines with a reputation for independent thinking and, preferably, a record of identifying weaknesses in the financial system. Names such as Nouriel Roubini, Frank Partnoy, Joseph Mason, and Joshua Rosner immediately come to mind as attractive candidates for such an assignment. The panel would be charged with conducting an ongoing and independent assessment of systemic risks to supplement the efforts of the regulators. It would report periodically to both Congress and the regulatory agencies on its findings. It could be given privileged access to information gathered by the regulators to use in making its assessment. When appropriate, it might recommend either legislative or regulatory changes with a goal of reducing risks to the financial system. CFA believes such an approach would greatly enhance the accountability of regulators and reduce the risks of group-think and complacency. The above discussion merely skims the surface of issues related to systemic risk regulation. Included at the back of this document is testimony CFA presented last week in the House Financial Services Committee that goes into greater detail on the various strengths and weaknesses of the different approaches that have been suggested to enhance systemic risk regulation and, in particular, the issue of who should regulate.5. Reform executive compensation practices Executive pay practices appear to have contributed to excessive risk-taking at financial institutions. Those who have analyzed the issues have typically identified two factors that contributed to the problem: (1) a short-term time horizon for incentive pay that allows executives to cash out before the consequences of their actions are apparent; and (2) compensation practices, such as through stock options, that provide unlimited up-side potential while effectively capping down-side exposure. While the first encourages executives to focus on short-term results rather than long-term growth, the latter may make them relatively indifferent to the possibility that things could go wrong. As AFL-CIO General Counsel Damon Silvers noted in recent testimony before the House Financial Services Committee, this is ``a terrible way to incentivize the manager of a major financial institution, and a particularly terrible way to incentivize the manager of an institution the Federal government might have to rescue.'' Silvers further noted that adding large severance packages to the mix further distorts executive incentives: ``If success leads to big payouts, and failure leads to big payouts, but modest achievements either way do not, then there is once again a big incentive to shoot for the moon without regard to downside risk.'' In keeping with this analysis, we believe executive compensation practices at financial institutions should be examined for their potential to create systemic risk. Practices such as tying incentive pay to longer time horizons, encouraging payment in stock rather than options, and including claw-back provisions should be encouraged. As with other practices that contribute to systemic risk, compensation practices that do so could trigger higher capital requirements or larger insurance premiums as a way to make risk-prone compensation practices financially unattractive. At the same time, reforms that go beyond the financial sector are needed to give shareholders greater say in the operation of the companies they own, including through mandatory majority voting for directors, annual shareholder votes on company compensation practices, and improved proxy access for shareholders. This is the great unfinished business of the post-Enron era. Adoption of crucial reforms in this area should not be further delayed.6. Bring enforcement actions for law violations that contributed to the crisis CFA is encouraged by the changes we see new SEC Chairman Mary Schapiro making to reinvigorate the agency's enforcement program. Mounting a tough and effective enforcement effort is essential both to deterring future abuses and to reassuring investors that the markets are fair and honest. While we recognize that many of the activities that led to the current crisis were legal, evidence suggests that certain areas deserve further investigation. Did investment banks fulfill their obligation to perform due diligence on the deals they underwrote? Did they provide accurate information to credit rating agencies rating those deals? Did brokers fulfill their obligation to make suitable recommendations? In many cases, violations of these standards may be out of reach of regulators, either because the sales were conducted through private placements or the products sold were outside the reach of securities laws. Nonetheless, we urge the agency to determine whether at least some of what appear to have been rampant abuses were conducted in ways that make them vulnerable to SEC enforcement authority. Such an investigation would not only be crucial to restoring investor confidence that the agency is committed to representing their interests, it could also provide regulators with a roadmap to use in identifying regulatory gaps that increase the potential for systemic risks.II. Reverse Harmful Policies Instead of identifying and addressing emerging risks that contributed to the current crisis, the SEC has devoted its energies in recent years to advancing a series of policy proposals that would reduce regulatory oversight, weaken investor protections, and limit industry accountability. In all but one case, these are issues that can be dealt with through a reversal in policy at the agency, and new SEC Chair Mary Schapiro's statements at her confirmation hearing suggested that she is both aware of the problems and prepared to take a different course. The role of the Committee in these cases is simply to provide appropriate support and oversight to ensure that those efforts remain on track. The other issue, where this Committee can play a more direct role, is in ensuring that the SEC receives the resources it needs to mount an effective regulatory and enforcement program.1. Increase funding for the SEC The new SEC chairman inherited a broken and demoralized agency. By all accounts, she has begun to undertake the thorough overhaul that the situation demands. Some, but not all, of the needed changes can be accomplished within the agency's existing budget, but others (such as upgrading agency technology) will require an infusion of funds. Moreover, while we recognize this Committee played an important role in securing additional funds for the agency in the wake of the accounting scandals earlier in this decade, we are convinced that the agency remains under-funded and under-staffed to fulfill its assigned responsibilities. Perhaps you recall a study Chairman Dodd commissioned in 1988 to explore the possibility of self-funding for the SEC. It documented the degree to which the agency had been starved for resources during the preceding decade, a period in which its workload had undergone rapid growth. Although agency resources experienced more volatility in the 1990s--with years that saw both significant increases and substantial cuts--the overall picture was roughly the same: a funding level that did not keep pace with either the market's overall growth or, of even greater concern, the dramatic increase in market participation by average, unsophisticated retail investors. After the Enron and Worldcom scandals, Congress provided a welcome and dramatic increase in funding. Certainly, the approximate doubling of the agency's budget was as much as the SEC could be expected to absorb in a single year. Operating under the compressed timeline that the emergency demanded, however, no effort was made at that time to thoroughly assess what funding level was needed to allow the agency to fulfill its regulatory mandate. The previous Chairman proved reluctant to request additional resources once the original infusion of cash was absorbed. We believe that the time has come to conduct an assessment, comparable to the review provided by this Committee in 1988, of the agency's resource needs. Once conducted, that review could provide the basis for a careful, staged increase in funding targeted at specific shortcomings in agency operations.2. Halt mutual recognition negotiations Last August, the SEC announced that it had entered a mutual recognition agreement with Australia that would allow eligible Australian stock exchanges and broker-dealers to offer their services to certain types of U.S. investors and firms without being subject to most SEC regulation. At the same time, the agency announced that it was negotiating similar agreements with other jurisdictions. The agency adopted this radical departure in regulatory approach without first assessing its potential costs, risks and unintended consequences, without setting clear standards to be used in determining whether a country qualifies for mutual recognition and submitting them for public comment, and without offering any evidence that this regulatory approach is in the public interest. It is our understanding that, thanks in part to the intervention of members of this Committee, this agreement has not yet been implemented. We urge members of this Committee to continue to work with the new SEC Chair to ensure that no further actions are taken to implement a mutual recognition policy at least until the current financial crisis is past. At a bare minimum, we believe any decision to give further consideration to mutual recognition must be founded on a careful assessment of the potential risks of such an approach, clear delineation of standards that would be used to assess whether another jurisdiction would qualify for such treatment, and transparency regarding the basis on which the agency made that determination. CFA believes, however, that this policy is ill-advised even under the best of circumstances, since no other jurisdiction is likely to place as high a priority on protecting U.S. investors as our own regulators. As such, we believe the best approach is simply to abandon this policy entirely and to focus instead on promoting cooperation with foreign regulators on terms that increase, rather than decrease, investor protections. At the same time, we urge Congress and the SEC to work with the Public Company Accounting Oversight Board (PCAOB) to ensure that it does not proceed with its similarly ill-conceived proposal to rely on foreign audit oversight boards to conduct inspections of foreign audit firms that play a significant role in the audits of U.S. public companies. This proposal is, in some ways, even more troubling than the SEC's mutual recognition proposal, since the oversight bodies to be relied are, many of them, still in their infancy, lack adequate resources, and do not meet the Sarbanes-Oxley Act's standards for independence. Prior to issuing this proposal, the PCAOB had focused its efforts on developing a program of joint inspections that is clearly in the best interests of U.S. and foreign investors alike. This proposed change in policy at the PCAOB has thrown that program into jeopardy, and it is important that it be gotten back on track.3. Do not approve the IFRS Roadmap In a similar vein, the SEC has recently proposed to abandon a long and fruitful policy of encouraging convergence between U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards. In its place, the agency has proposed to move rapidly toward U.S. use of international standards. Once again, the agency has proposed this change in policy without adequate regard to the potentially enormous costs of the transition, the loss of transparency that could result, or the strong opposition of retail and institutional investors to the proposal. We urge the Committee to work with the SEC to ensure that we return to a path of encouraging convergence of the two sets of standards so that, eventually, as that convergence is achieved, financial statements prepared under the two sets of standards would be comparable.4. Enhance investor representation on FASB In arguing against adoption of the IFRS roadmap, CFA has in the past cited IASB's lack of adequate due process and susceptibility to industry and political influence. Unfortunately, FASB's recent proposal to bow to industry pressure and weaken fair value accounting standards--and to do so after a mere two-week comment period and with no meaningful time for consideration of comments before a vote is taken--suggests that FASB's vaunted independence and due process are more theoretical than real. We recognize and appreciate that leaders of this Committee have long shown a respect for the independence of the accounting standard-setting process. Moreover, we appreciate the steps that this Committee took, as part of the Sarbanes-Oxley Act, to try to enhance FASB's independence. However, in light of recent events, CFA believes more needs to be done to shore up those reforms. Specifically, we urge you to strengthen the standards laid out in SOX for recognition of a standard-setting body by requiring that a majority of both the board itself and its board of trustees be investor representatives with the requisite accounting expertise.5. Ignore calls to weaken materiality standards and lessen issuer and auditor accountability for financial misstatements The SEC Advisory Committee on Improvements of Financial Reporting (CIFiR) released its final report last August detailing recommendations to ``increase the usefulness of financial information to investors, while reducing the complexity of the financial reporting system to investors, preparers, and auditors.'' While the report includes positive suggestions--including a suggestion to increase investor involvement in the development of accounting standards--it also includes anti-investor proposals to: (1) revise the guidance on materiality in order to make it easier to dismiss large errors as immaterial; (2) revise the guidance on when errors have to be restated to permit more material errors to avoid restatements; and (3) offer some form of legal protection to faulty professional judgments made according to a recommended judgment framework. Weakening investor protections in this way is ill-advised at any time, but it is particularly so when we find ourselves in the midst of a financial crisis of global proportions. While we are confident that the new SEC Chair understands the need to strengthen, not weaken, financial reporting transparency, reliability, and accountability, we urge this Committee to continue to provide oversight in this area to ensure that these efforts remain on track.III. Adopt Additional Pro-Investor Reforms In addition to responding directly to the financial crisis and preventing a further deterioration of investor protections, there are important steps that Congress and the SEC can take to strengthen our markets by strengthening the protections we offer to investors. These include issues--such as regulation of financial professionals and restoring private remedies--that have already been raised in the context of financial regulatory reform. We look forward to a time, once the crisis is past, when we have the luxury of also returning our attention to additional issues, such as disclosure, mutual fund, and broker compensation reform, where a pro-investor agenda has languished and is in need of revival. For now, however, we will focus in this testimony only on the first set of issues.1. Adopt a rational, pro-investor policy for the regulation of financial professionals Reforming regulation of financial professionals has been a CFA priority for more than two decades, with precious little to show for it. Today, investment service providers who use titles and offer services that appear indistinguishable to the average investor are still regulated under two very different standards. In particular, brokers have been given virtually free rein to label their salespeople as financial advisers and financial consultants and to offer extensive personalized investment advice without triggering regulation under the Investment Advisers Act. As a result, customers of these brokers are encouraged to believe they are in an advisory relationship but are denied the protections afforded by the Advisers Act's fiduciary duty and obligation to disclose conflicts of interest. Moreover, customers still don't receive useful information to allow them to make an educated choice among different types of investment service providers. This inconsistent regulatory treatment and lack of effective pre-engagement disclosure are of particular concern given research that shows that the selection of an investment service provider is the last real investment decision many investors will ever make. Once they have made that choice, most are likely to rely on the recommendations they receive from that individual with little or no additional research to determine the costs or appropriateness of the investments recommended. Some now suggest that the efforts being undertaken by Congress to reform our regulatory system offer an opportunity to ``harmonize'' regulation of brokers, investment advisers, and financial planners. CFA agrees, but only so long as any ``harmonization'' strengthens investor protections. It is not clear that most proposals put forward to date meet that standard. Instead, the broker-dealer community appears to be trying to use this occasion to distract from the central issue--that brokers have over the years been allowed to transform themselves into advisers without being regulated as advisers--and to push an investment adviser SRO and a watered down ``universal standard of care.'' Unfortunately, this is one area where the new SEC Chairman's Finra background appears to have influenced her thinking, and she echoed these sentiments during her confirmation hearing. It will therefore be incumbent on members of this Committee to ensure that investor interests predominate in any reforms that may be adopted to ``harmonize'' our system of regulating investment professionals. As a first principle, CFA believes that investment service providers should be regulated according to what they do rather than what type of firm they work for. Had the SEC implemented the Investment Advisers Act consistent with the clear intent of Congress, this would be the situation we find ourselves in today. That is water under the bridge, however, and we are long past the point where we can recreate the clear divisions that once was envisioned between advisory services and brokers' transaction-based services. Instead, we believe the best approach is to clarify the responsibilities that go with different functions and to apply them consistently across the different types of firms. \8\--------------------------------------------------------------------------- \8\ While we have discussed this approach here in the context of investment service providers, CFA believes this is an appropriate approach throughout the financial services industries: a suitability obligation for sales--whether of securities, insurance, mortgages or whatever--and an overriding fiduciary duty that applies in an advisory relationship. A Fiduciary Duty for Advice: All those who offer investment advice should be required to place their clients' interests ahead of their own, to disclose material conflicts of interest, and to take steps to minimize those potential conflicts. That fiduciary duty should govern the entire relationship; it must not be something the provider adopts when giving advice but drops when selling the investments to implement --------------------------------------------------------------------------- recommendations. A Suitability Obligation for Sales: Those who are engaged exclusively in a sales relationship should be subject to the know-your-customer and suitability obligations that govern brokers now. No Misleading Titles: Those who choose to offer solely sales-based services should not be permitted to adopt titles that imply that they are advisers. Either they should be prohibited from using titles, such as financial adviser or financial consultant, designed to mislead the investor into thinking they are in an advisory relationship, or use of such titles should automatically carry with it a fiduciary duty to act in clients' best interests. Because of the obvious abuses in this area that have grown up over the years, we have focused on the inconsistent regulatory treatment of advice offered by brokers, investment advisers, and financial planners. If, however, there are other services that investment advisers or financial planners are being permitted to offer outside the appropriate broker-dealer protections, we would apply the same principle to them. They should be regulated according to what they do, subject to the highest existing level of investor protections. One issue that has come up in this regard is whether investment advisers should be subject to oversight by a self-regulatory organization. The underlying argument here is that, while the Investment Advisers Act imposes a higher standard for advice, it is not backed by as robust a regulatory regime as that which governs broker-dealers. Finra has made no secret of its ambition to expand its authority in this area, at least with regard to the investment advisory activities of its broker-dealer member firms. There is at least a surface logic to this proposal. As Finra is quick to note, it brings significant resources to the oversight function and has rule-making authority that in some areas appears to go beyond that available to the SEC. Despite that surface logic, there are several hurdles that Finra must overcome in making its case. The first is that Finra's record of using its rule-making authority to benefit investors is mixed at best. Nowhere is that more evident than on this central question of the obligation brokers owe investors when they offer advice or portray themselves as advisers. For the two decades that this debate has raged, Finra and its predecessor, NASD regulation, have consistently argued this issue from the broker-dealer industry point of view. This is not an isolated instance. Finra has shown a similar deference to industry concerns on issues related to disclosure and arbitration. This is not to say that Finra never deviates from the industry viewpoint, but it does mean that investors must swim against a strong tide of industry opposition in pushing reforms and that those reforms, when adopted, tend to be timid and incremental in nature. This is, in our view, a problem inherent to self-regulation. Should Congress choose to place further reliance on bodies other than the SEC to supplement the agency's oversight and rulemaking functions, it should at least examine what reforms are needed to ensure that those authorities are not captured by the industries they regulate and operate in a fully transparent and open fashion. We believe the governance model at the PCAOB offers a better model to ensure the independence of any body on which we rely to perform a regulatory function. The second issue regarding expanded Finra authority relates to its oversight record. It is ironic at best, cynical at worst, that Finra has tried to capitalize on its oversight failure in the Madoff case to expand its responsibilities to cover investment adviser activities. There may be good reasons why Finra's predecessor, NASD Regulation, missed a fraud that operated under its nose for several decades. NASD Regulation was not, as we understand it, privy to the whistleblower reports that the SEC received. One factor that clearly was not responsible for NASD Regulation's oversight failure, however, was its lack of authority over Madoff's investment adviser operations. This should be patently obvious from the fact that there was no Madoff investment adviser for the first few decades in which the fraud was apparently being conducted. During that time, Madoff's regulatory reports apparently indicated that he was engaged exclusively in proprietary trading and market making and did not have clients. NASD Regulation apparently did not take adequate steps to verify this information, despite general industry knowledge and extensive press reports to the contrary. What concerns us most about this situation is not that Finra missed the Madoff fraud. Individuals and institutions make mistakes, and the problems that lead to those mistakes can be corrected. We are far more concerned by what we view as Finra's lack of honesty in accounting for this failure. That suggests a problem with the culture of the organization that is not as easily corrected. We have nothing but respect for new Finra President and CEO Rick Ketchum. However, the above analysis suggests he faces a significant task in overhauling Finra to make it more responsive to investor concerns, more effective in providing industry oversight, and more transparent in its dealings. Until that has been accomplished, we would caution against any expansion of Finra's authority or any increased reliance on self-regulatory bodies generally.2. Restore private remedies In an era in which investors have been exposed to constantly expanding risks and repeated frauds, they have also experienced a continual erosion of their right to redress. This has occurred largely through unfavorable court decisions that have undermined investors' ability to recover losses from those who aided the fraud and, with recent decisions on loss causation, even from those primarily responsible for perpetrating it. To restore balance and fairness to the system, CFA supports legislation to restore aiding and abetting liability, to eliminate the ability of responsible parties to avoid liability by manipulating disclosures, and to protect the ability of plaintiffs to aggregate small claims and access federal courts. CFA also supports the elimination of pre-dispute binding arbitration clauses in all consumer contracts, including those with securities firms. For many, even most investors, arbitration will remain the most attractive means for resolving disputes. However, not all cases are suitable for resolution in a forum that lacks a formal discovery process or other basic procedural protections. By forcing all cases into an industry-run arbitration process, regardless of suitability, binding arbitration clauses undermine investor confidence in the fairness of the system while making the system more costly and slower for all. While Finra has taken steps to address some of the worst problems, these reforms have been slow to come and have been incremental at best. We believe investors are best served by having a choice of resolution mechanisms that they are currently denied because of the nearly universal use of pre-dispute binding arbitration clauses.Conclusion For roughly the past three decades, regulatory policy has been driven by an irrational faith that market discipline and industry self-interest could be relied on to rein in Wall Street excesses. Regulation was seen as, at best, a weak supplement to these market forces and, at worst, a burdensome impediment to innovation. The recent financial meltdown has proven the basic fallacy of that assumption. In October testimony before the House Oversight and Government Reform Committee, former Federal Reserve Chairman Alan Greenspan acknowledged, in clearer language than has been his wont, the basic failure of this regulatory approach: Those of us who looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets' state of balance . . . If it fails, as occurred this year, market stability is undermined . . . I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms. Former Chairman Greenspan deserves credit for this forthright acknowledgement of error. What remains to be seen is whether Congress and the Administration will together devise a regulatory reform plan that reflects this fundamental shift. A bold and comprehensive plan is needed that restores basic New Deal regulatory principles and recognizes the role of regulation in preventing crises, not simply cleaning up in their wake. This approach, adopted in response to the Great Depression, brought us decades of economic growth, free from the recurring financial crises that have characterized the last several decades. If, on the other hand, policymakers do not acknowledge the pervasive and deep-seated flaws in financial markets, they will inevitably fail in their efforts to reform regulation, setting the stage for repeated crises and prompting investors to question not just the integrity and safety of our markets, but the ability of our policymakers to act in their interest. Even as we testify here today, Treasury Secretary Geithner is reportedly scheduled to present the Administration's regulatory reform plan before another congressional committee. We will be subjecting that proposal and others that are developed as this process moves forward to a thorough analysis to determine whether it meets this standard: does the boldness and scope of the plan match the severity of the current crisis? We look forward to working with members of this Committee in the days and months ahead to craft a regulatory reform plan that meets this test and restores investors' faith in the integrity of our markets and the effectiveness of our government. AppendixTestimony of Travis Plunkett, Legislative Director, Consumer Federation of America March 17, 2009 Mr. Chairman and Members of the Committee, my name is Travis Plunkett. I am Legislative Director of the Consumer Federation of America (CFA). CFA is a nonprofit association of 280 organizations that, since 1968, has sought to advance the consumer interest through research, advocacy, and education. I greatly appreciate the opportunity to appear before you today to testify about one of the most important issues Congress will need to address as it develops a comprehensive agenda to reform our Nation's failed financial regulatory system--how to better protect the system as a whole and the broader economy from systemic risks. Recent experience has shown us that our current system was not up to the task, either of identifying significant risks, or of addressing those risks before they spun out of control, or of dealing efficiently and effectively with the situation once it reached crisis proportions. The effects of this failure on the markets and the economy have been devastating, rendering reform efforts aimed at protecting the system against systemic threats a top priority. In order to design an effective regulatory response, it is necessary to understand why the system failed. It has been repeated so often in recent months that it has taken on the aura of gospel, but it is simply not the case that the systemic risks that have threatened the global financial markets and ushered in the most serious economic crisis since the Great Depression arose because regulators lacked either sufficient information or the tools necessary to protect the financial system as a whole against systemic risks. (Though it is true that, once the crisis struck, regulators lacked the tools needed to deal with it effectively.) On the contrary, the crisis resulted from regulators' refusal to heed overwhelming evidence and repeated warnings about growing threats to the system. Former Congressman Jim Leach and former CFTC Chairwoman Brooksley Born both identified the potential for systemic risk in the unregulated over-the-counter derivatives markets in the 1990s. Housing advocates have been warning the Federal Reserve since at least the early years of this decade that securitization had fundamentally changed the underwriting standards for mortgage lending, that the subprime mortgages being written in increasing numbers were unsustainable, that foreclosures were on the rise, and that this had the potential to create systemic risks. The SEC's risk examination of Bear Stearns had, according to the agency's Inspector General, identified several of the risks in that company's balance sheet, including its use of excessive leverage and an over-concentration in mortgage-backed securities. Contrary to conventional wisdom, these examples and others like them provide clear and compelling evidence that, in the key areas that contributed to the current crisis--unsound mortgage lending, the explosive combination of risky assets and excessive leverage on financial institutions' balance sheets, and the growth of an unregulated ``shadow'' banking system--regulators had all the information they needed to identify the crucial risks that threatened our financial system but either didn't use the authority they had or, in Born's case, were denied the authority they needed to rein in those risks. Regulatory intervention at any of those key points had the potential to prevent, or at least greatly reduce the severity of, the current financial crisis--either by preventing the unsound mortgages from being written that triggered the crisis, or by preventing investment banks and other financial institutions from taking on excessive leverage and loading up their balance sheet with risky assets, leaving them vulnerable to failure when the housing bubble burst, or by preventing complex networks of counterparty risk to develop among financial institutions that allowed the failure of one institution to threaten the failure of the system as a whole. This view is well-articulated in the report of the Congressional Oversight Panel, which correctly identifies a fundamental abandonment of traditional regulatory principles as the root cause of the current financial crisis and prescribes an appropriately comprehensive response. So what is the lesson to be learned from that experience for Congress's current efforts to enhance systemic risk regulation? The lesson is emphatically not that there is no need to improve systemic risk regulation. On the contrary, this should be among the top priorities for financial regulatory reform. But there is a cautionary lesson here about the limitations inherent in trying to address problems of inadequate systemic risk regulation with a structural solution. In each of the above examples, and others like them, the key problem was not insufficient information or inadequate authority; it was an unwillingness on the part of regulators to use the authority they had to rein in risky practices. That lack of regulatory will had its roots in an irrational faith among members of both political parties in markets' ability to self-correct and industry's ability to self-police. Until we abandon that failed regulatory philosophy and adopt in its place an approach to regulation that puts its faith in the ability and responsibility of government to serve as a check on industry excesses, whatever we do on systemic risk is likely to have little effect. Without that change in governing philosophy, we will simply end up with systemic risk regulation that exhibits the same unquestioning, market-fundamentalist approach that has characterized substantive financial regulation to a greater or lesser degree for the past three decades. If the ``negative'' lesson from recent experience is that structural solutions to systemic risk regulation will have limited utility without a fundamental change in regulatory philosophy, there is also a positive corollary. Simply closing the loopholes in the current regulatory structure, reinvigorating federal regulators, and doing an effective job at the day-to-day tasks of routine safety and soundness and investor and consumer protection regulation would go a long way toward eliminating the greatest threats to the financial system.The ``Shadow'' Banking System Represents the Greatest Systemic Threat In keeping with that notion, the single most significant step Congress could and should take right now to decrease the potential for systemic risk is to shut down the shadow banking system completely and permanently. While important progress is apparently being made (however slowly) in moving credit default swaps onto a clearinghouse, this is just a start, and a meager start at that. Meaningful financial regulatory reform must require that all financial activities be conducted in the light of regulatory oversight according to basic rules of transparency, fair dealing, and accountability. As Frank Partnoy argued comprehensively and persuasively in his 2003 book, Infectious Greed, a primary use of the ``shadow'' banking system--and indeed the main reason for its existence--is to allow financial institutions to do indirectly what they or their clients would not be permitted to do directly in the regulated markets. So banks used unregulated special purpose entities to hold toxic assets that, if held on their balance sheets, would have required them to set aside additional capital, relying on the fiction that the bank itself was not exposed to the risks. Investment banks sold Mezzanine CDOs to pension funds in private placements free from disclosure and other obligations of the regulated marketplace. And everyone convinced themselves that they were protected from the risks of those toxic assets because they had insured them using credit default swaps sold in the over-the-counter market without the basic protections that trading on an exchange would provide, let alone the reserve or collateral requirements that would, in the regulated insurance market, provide some assurance that any claims would be paid. The basic justification for allowing two systems to grow up side-by-side--one regulated and one not--is that sophisticated investors are capable of protecting their own interests and do not require the basic protections of the regulated market. That myth has been dispelled by the current crisis. Not only did ``sophisticated'' institutional investors load up on toxic mortgage-backed securities and collateralized debt obligations without understanding the risks of those investments, but financial institutions themselves either didn't understand or chose to ignore the risks they were exposing themselves to when they bought toxic assets with borrowed money or funded long-term obligations with short-term financing. By failing to protect their own interests, they damaged not only themselves and their shareholders, but also the financial markets and the global economy as a whole. This situation simply cannot be allowed to continue. Any proposal to address systemic risk must confront this issue head-on in order to be credible.Other Risk-Related Priorities Should Also Be Addressed There are other pressing regulatory issues that, while not expressly classified as systemic risk, are directly relevant to any discussion of how best to reduce systemic risk. Chairman Frank has appropriately raised the issue of executive compensation in this context, and CFA supports efforts to reduce compensation incentives that promote excessive risk-taking. Similarly, improving the reliability of credit ratings while simultaneously reducing our reliance on those ratings is a necessary component of any comprehensive plan to reduce systemic risk. Ideally, some mechanism will be found to reduce the conflicts of interest associated with the agencies' issuer-paid compensation model. Whether or not that is the case, we believe credit rating agencies must face increased accountability for their ratings, the SEC must have increased authority to police their ratings activities to ensure that they follow appropriate due diligence standards in arriving at and maintaining those ratings, and laws and rules that reference the ratings must make clear that reliance on ratings alone does not satisfy due diligence obligations to ensure the appropriateness of the investment. In addition, CFA believes one of the most important lessons that have been learned regarding the collapse of our financial system is that improved, up-front product-focused regulation will significantly reduce systemic risk. For example, if federal regulators had acted more quickly to prevent abusive sub-prime mortgage loans from flooding the market, it is likely that the current housing and economic crisis would not have been triggered. As a result, we have endorsed the concept advanced by COP Chair Elizabeth Warren and legislation introduced by Senator Richard Durbin and Representative William Delahunt to create an independent financial safety commission to ensure that financial products meet basic standards of consumer protection. Some opponents of this proposal have argued that it would stifle innovation. However, given the damage that recent ``innovations'' such as liar's loans and Mezzanine CDOs have done to the global economy, this hardly seems like a compelling argument. By distinguishing between beneficial and harmful innovations, such an approach could in our view play a key role in reducing systemic risks.Congress Needs To Enhance the Quality of Systemic Risk Oversight In addition to addressing those issues that currently create a significant potential for systemic risk, Congress also needs to enhance the quality of systemic risk oversight going forward. Financial Services Roundtable Chief Executive and CEO Steve Bartlett summed up the problem well in earlier testimony before the Senate Banking Committee when he said that the recent crisis had revealed that our regulatory system ``does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, high-risk activities, or vulnerable interconnections between firms and markets that can create systemic risk.'' In keeping with that diagnosis of the problem, CFA believes the goals of systemic risk regulation should be: (1) to ensure that risks that could threaten the broader financial system are identified and addressed; (2) to reduce the likelihood that a ``systemically significant'' institution will fail; (3) to strengthen the ability of regulators to take corrective actions before a crisis to prevent imminent failure; and (4) to provide for the orderly failure of nonbank financial institutions. The latter point deserves emphasis, because this appears to be a common misconception: the goal of systemic risk regulation is not to protect certain ``systemically significant'' institutions from failure, but rather to simultaneously reduce the likelihood of such a failure and ensure that, should it occur, there is a mechanism in place to allow that to happen with the minimum possible disruption to the broader financial markets. Although there appears to be near universal agreement about the need to improve systemic risk regulation, strong disagreements remain over the best way to accomplish that goal. The remainder of this testimony will address those key questions regarding such issues as who should regulate for systemic risk, who should be regulated, what that regulation should consist of, and how it should be funded. CFA has not yet reached firm conclusions on all of these issues, including on the central question of how systemic risk regulation should be structured. Where our position remains unresolved, we will discuss possible alternatives and the key issues we believe need to be resolved in order to arrive at a conclusion.Should There Be a Central Systemic Risk Regulator? As discussed above, we believe all financial regulators should bear a responsibility to monitor for and mitigate potential systemic risks. Moreover, we believe a regulatory approach that both closes regulatory loopholes and reinvigorates traditional regulation for solvency and consumer and investor protection would go a long way toward accomplishing that goal. Nonetheless, we agree with those who argue that there is a benefit to having some central authority responsible and accountable for overseeing these efforts, if only to coordinate regulatory efforts related to systemic risk and to ensure that this remains a priority once the current crisis is past. Perhaps the best reason to have one central authority responsible for monitoring systemic risk is that, properly implemented, such an approach offers the best assurance that financial institutions will not be able to exploit newly created gaps in the regulatory structure. Financial institutions have devoted enormous energy and creativity over the past several decades to finding, maintaining, and exploiting gaps in the regulatory structure. Even if Congress does all that we have urged to close the regulatory gaps that now exist, past experience suggests that financial institutions will immediately set out to find new ways to evade legal restrictions. A central systemic risk regulatory authority could and should be given responsibility for quickly identifying any such activities and assigning them to their appropriate place within the regulatory system. Without such a central authority, regulators may miss activity that does not explicitly fall within their jurisdiction or disputes may arise over which regulator has authority to act. CFA believes designating a central authority responsible for systemic risk regulation offers the best hope of quickly identifying and addressing new risks that emerge that would otherwise be beyond the reach of existing regulations.Who Should It Be? Resolving who should regulate seems to be the most vexing problem in designing a system for improved systemic risk regulation. Three basic proposals have been put forward: (1) assign responsibility for systemic risk regulation to the Fed; (2) create a new market stability regulator; and (3) expand the President's Working Group on Financial Markets (PWG) and give it an explicit mandate to coordinate and oversee regulatory efforts to monitor and mitigate systemic threats. Each approach has its flaws, and it is far easier to poke holes in the various proposals than it is to design a fool-proof system for improving risk regulation. The Federal Reserve Board--Many people believe the Federal Reserve Board (the ``Fed'') is the most logical body to serve as systemic risk overseer. Those who favor this approach argue that the Fed has the appropriate mission and expertise, an experienced staff, a long tradition of independence, and the necessary tools to serve in this capacity (e.g., the ability to act as lender of last resort and to provide emergency financial assistance during a financial crisis). Robert C. Pozen summed up this viewpoint succinctly when he testified before the Senate Committee on Homeland Security and Governmental Affairs. He said: Congress should give this role to the Federal Reserve Board because it has the job of bailing out financial institutions whose failure would threaten the whole financial system . . . If the Federal Reserve Board is going to bail out a broad array of financial institutions, and not just banks, it should have the power to monitor systemic risks so it can help keep institutions from getting to the brink of failure. Two other, more pragmatic arguments have been cited in favor of giving these responsibilities to the Fed: (1) its ability to obtain adequate resources without relying on the congressional budget process and (2) the relative speed and ease with which this expansion of authority could be accomplished, particularly in comparison with the challenges of establishing a new agency for this purpose. Others are equally convinced that the Fed is the last agency that should be entrusted with responsibility for systemic risk regulation. Some cite concerns about conflicts inherent in the governance role bank holding companies play in the regional Federal Reserve Banks. Particularly when combined with the Board's closed culture and lack of public accountability, this conflict is seen as likely to undermine public trust in the objectivity of agency decisions about which institutions will be bailed out and which will be allowed to fail in a crisis. Opponents of the Fed as systemic risk regulator also cite a conflict between its role setting monetary policy and its potential role as a systemic risk regulator. One concern is that its role in setting monetary policy requires freedom from political interference, while its role as systemic risk regulator would require full transparency and public accountability. Another involves the question of how the Fed as systemic risk regulator would deal with the Fed as central banker if its monetary policy was contributing to systemic risk (as it clearly did in the run-up to the current crisis). Others simply point to what they see as the Fed's long history of regulatory failure. This includes not only failures directly related to the current crisis--its failure to address unsound mortgage lending on a timely basis, for example, as well as its failure to prevent banks from holding risky assets in off-balance-sheet special purpose entities and its cheerleading of the rapid expansion of the shadow banking system--but also a perceived past willingness at the Fed to allow banks to hide their losses. According to this argument, Congress ultimately passed FDICIA in 1991 (requiring regulators to close financial institutions before all the capital or equity has been depleted) precisely because the Fed had been unwilling to do so absent that requirement. Should Congress determine to give systemic risk responsibility to the Fed, we believe it is essential that you take meaningful steps to address what we believe are compelling concerns about this approach. Even some who have spoken in favor of the Fed in this capacity have acknowledged that it will require significant restructuring. As former Federal Reserve Chairman Paul Volcker noted in remarks before the Economic Club of New York last April: If the Federal Reserve is also . . . to have clear authority to carry effective `umbrella' oversight of the financial system, internal reorganization will be essential. Fostering the safety and stability of the financial system would be a heavy responsibility paralleling that of monetary policy itself. Providing direction and continuity will require clear lines of accountability . . . all backed by a stronger, larger, highly experienced and reasonably compensated professional staff. CFA concurs that, if systemic risk regulation is to be housed at the Fed, systemic risk regulation must not be relegated to Cinderella status within the agency. Rather, it must be given a high priority within the organization, and significant additional staff dedicated to this task must be hired who have specific risk assessment expertise. Serious thought must also be given to (1) how to resolve disputes between these two potentially competing functions of setting monetary policy and mitigating systemic risks, and (2) how to ensure that systemic risk regulation is carried out with the full transparency and public accountability that it demands. A New Systemic Risk Regulatory Agency--Some have advocated creation of an entirely new regulatory agency devoted to systemic risk regulation. The idea behind this approach is that it would allow a singular focus on issues of systemic risk, both providing clear accountability and allowing the hiring of specialized staff devoted to this task. Furthermore, such an agency could be structured to avoid the significant concerns associated with designating the Fed to perform this function, including the conflict between monetary policy and systemic risk regulation. Although it has its advocates, this approach appears to trigger neither the broad support nor the impassioned opposition that the Fed proposal engenders. Those who favor this approach, including Brookings scholar Robert Litan, tend to do so only if it is part of a more radical regulatory restructuring. Adding such an agency to the existing regulatory structure would ``add still another cook to the regulatory kitchen, one that is already too crowded, and thus aggravate current jurisdictional frictions,'' Litan said in recent testimony before the Senate Committee on Homeland Security and Governmental Operations. Moreover, even its advocates tend to acknowledge that it would be a challenge, and possibly an insurmountable challenge, to get such an agency up and running in a timely fashion. Expanded and Refocused President's Working Group--The other approach that enjoys significant support entails giving an expanded version of the President's Working Group for Financial Markets clear, statutory authority for systemic risk oversight. Its current membership would be expanded to include all the major federal financial regulators as well as representatives of state securities, insurance, and banking officials. By formalizing the PWG's authority through legislation, the group would be directly accountable to Congress, allowing for meaningful congressional oversight. Among the key benefits of this approach: the council would have access to extensive information about and expertise in all aspects of financial markets. The regulatory bodies with primary day-to-day oversight responsibility would have a direct stake in the panel and its activities, maximizing the chance that they would be fully cooperative with its efforts. For those who believe the Fed must play a significant role in systemic risk regulation, this approach offers the benefit of extensive Fed involvement as a member of the PWG without the problems associated with exclusive Fed oversight of systemic risk. This approach, while offering attractive benefits, is not without its shortcomings. One is the absence of any single party who is solely accountable for regulatory efforts to mitigate systemic risks. Because it would have to act primarily through its member bodies, it could result in an inconsistent and even conflicting approach among regulators. It also raises the risk that systemic risk regulation will not be given adequate priority. In dismissing this approach, Litan acknowledges that it may be the most politically feasible but he maintains: ``A college of regulators clearly violates the Buck Stops Here principle, and is a clear recipe for jurisdictional battles and after-the-fact finger pointing.'' Despite the many attractions of this approach, this latter point is particularly compelling, in our view. Regulators have a long history of jurisdictional disputes. There is no reason to believe those problems would simply dissipate under this arrangement. Decisions about who has responsibility for newly emerging activities would likely be particularly contentious. If Congress were to decide to adopt this approach, it would need to set out some clear mechanism for resolving any such disputes. Alternatively, it could combine this approach with enhanced systemic risk authority for either the Fed or a new agency, as the Financial Services Roundtable has suggested, providing that agency with the benefit of the panel's broad expertise and improving coordination of regulatory efforts in this area. FDIC--A major reason federal authorities were forced to improvise in managing the events of the past year is that we lack a mechanism for the orderly unwinding of nonbank financial institutions that is comparable to the authority that the FDIC has for banks. Most systemic risk plans seem to contemplate expanding FDIC authority to include nonbank financial institutions, although some would house this authority within a systemic risk regulator. CFA believes this is an essential component of a comprehensive plan for enhanced systemic risk regulation. While we have not worked out exactly how this should operate, we believe the FDIC, the systemic risk regulator, or the two agencies working together must also have authority to intervene when failure appears imminent to require corrective actions. A Systemic Risk Advisory Panel--One of the key criticisms of making the Fed the systemic risk regulator is its dismal regulatory record. But if we limited our selections to those regulators with a credible record of identifying and addressing potential systemic risks while they are still at a manageable stage, we'd be forced to start from scratch in designing a new regulatory body. And there is no guarantee we would get it right this time. A number of academics and others outside the regulatory system were far ahead of the regulators in recognizing the risks associated with unsound mortgage lending, unreliable ratings on mortgage-backed securities and CDOs, the build-up of excessive leverage, the questionable risk management practices of investment banks, etc. Regardless of what approach Congress chooses to adopt for systemic risk oversight, we believe it should also mandate creation of a high-level advisory panel on systemic risk. Such a panel could include academics and other analysts from a variety of disciplines with a reputation for independent thinking and, preferably, a record of identifying weaknesses in the financial system. Names such as Nouriel Roubini, Frank Partnoy, Joseph Mason, and Joshua Rosner immediately come to mind as attractive candidates for such a panel. The panel would be charged with conducting an on-going and independent assessment of systemic risks to supplement the efforts of the regulators. It would report periodically to both Congress and the regulatory agencies on its findings. It could be given privileged access to information gathered by the regulators to use in making its assessment. When appropriate, it might recommend either legislative or regulatory changes with a goal of reducing risks to the financial system. CFA believes such an approach would greatly enhance the accountability of regulators and reduce the risks of group-think and complacency. We urge you to include this as a component of your regulatory reform plan.Who Should Be Regulated? The debate over who should be regulated for systemic risk basically boils down to two main points of view. Those who see systemic risk regulation as something that kicks in during or on the brink of a crisis, to deal with the potential failure of one or more financial institutions, tend to favor a narrower approach focused on a few large or otherwise ``systemically important'' institutions. In contrast, those who see systemic risk regulation as something that is designed, first and foremost, to prevent risks from reaching that degree of severity tend to favor a much more expansive approach. Recognizing that systemic risk can derive from a variety of different practices, proponents of this view argue that all forms of financial activity must be subject to systemic risk regulation and that the systemic risk regulator must have significant flexibility and authority to determine the extent of its reach. CFA falls firmly into the latter camp. We are not alone; this expansive view of systemic risk jurisdiction has many supporters, at least when it comes to the regulator's authority to monitor the markets for systemic risk. The Government Accountability Office, for example, has said that such efforts ``should cover all activities that pose risks or are otherwise important to meeting regulatory goals.'' Bartlett of the Financial Services Roundtable summed it up well in his testimony when he said that: authority to collect information should apply not only to depository institutions, but also to all types of financial services firms, including broker/dealers, insurance companies, hedge funds, private equity firms, industrial loan companies, credit unions, and any other financial services firms that facilitate financial flows (e.g., transactions, savings, investments, credit, and financial protection) in our economy. Also, this authority should not be based upon the size of an institution. It is possible that a number of smaller institutions could be engaged in activities that collectively pose a systemic risk.The case for giving a systemic risk regulator broad authority to monitor the markets for systemic risk is obvious, in our opinion. Failure to grant a regulator this broad authority risks allowing risks to grow up outside the clear jurisdiction of functional regulators, a situation financial institutions have shown themselves to be very creative at exploiting. While the case for allowing the systemic risk regulator broad authority to monitor the financial system as a whole seems obvious, the issue of whether to also grant that regulator authority to constrain risky conduct wherever they find it is more complex. Those who favor a narrower approach argue that the proper focus of any such regulatory authority should be limited to those institutions whose failure would be likely to create a systemic risk. This view is based on the sentiment that, if an institution is too big to fail, it must be regulated. While CFA shares the view that those firms that are ``too big to fail'' must be regulated, we take that view one step further. As we have discussed above, we believe that the best way to reduce systemic risk is to ensure that all financial activity is regulated to ensure that it is conducted according to basic principles of transparency, fair dealing, and accountability. Those like Litan who favor a narrower approach focused on ``systemically important'' institutions defend it against charges that it creates unacceptable moral hazard by arguing that it is essentially impossible to expand on the moral hazard that has already been created by recent federal bailouts simply by formally designating certain institutions as systemically significant. We agree that, based on recent events and unless the approach to systemic risk is changed, the market will assume that large firms will be rescued, just as the market rightly assumed for years, despite assurances to the contrary, that the government would stand behind the GSEs. Nonetheless, we do not believe it follows that the appropriate approach to systemic risk regulation is to focus exclusively on these institutions that are most likely to receive a bailout. Instead, we believe it is essential to attack risks more broadly, before institutions are threatened with failure and, to the degree possible, to eliminate the perception that large institutions will always be rescued. The latter goal could be addressed both by reducing the practices that make institutions systemically significant and by creating a mechanism to allow their orderly failure. Ultimately, we believe a regulatory approach that relies on identifying institutions in advance that are systemically significant is simply unworkable. The fallibility of this approach was demonstrated conclusively in the wake of the government's determination that Lehman Brothers, unlike Bear Stearns, was not too big to fail. As Richard Baker, President and CEO of the Managed Funds Association, said in his testimony before the House Capital Markets Subcommittee, ``There likely are entities that would be deemed systemically relevant . . . whose failure would not threaten the broader financial system.'' We also agree with NAIC Chief Executive Officer Therese Vaughn, who said in testimony at the same hearing, ``In our view, an entity poses systemic risk when that entity's activities have the ability to ripple through the broader financial system and trigger problems for other counterparties, such that extraordinary action is necessary to mitigate it.'' The factors that might make an institution systemically important are complex--going well beyond asset size and even degree of leverage to include such considerations as nature and degree of interconnectivity to other financial institutions, risks of activities engaged in, nature of compensation practices, and degree of concentration of financial assets and activities, to name just a few. Trying to determine in advance where that risk is likely to arise would be all but impossible. And trying to maintain an accurate list of systemically important institutions going forward, considering the complex array of factors that are relevant to that determination, would require constant and detailed monitoring of institutions on the borderline, would be extremely time-consuming, and ultimately would almost certainly allow certain risky institutions and practices to fall through the cracks.How Should They Regulate? There are three key issues that must be addressed in determining the appropriate procedures for regulating to mitigate systemic risk: Should responsibility and authority to regulate for systemic risks kick in only in a crisis, or on the brink of a crisis, or should it be an on-going, day-to-day obligation of financial regulators? What regulatory tools should be available to a systemic risk regulator? For example, should a designated systemic risk regulator have authority to take corrective actions, or should it be required (or encouraged) to work through functional regulators? If a designated systemic risk regulator has authority to require corrective actions, should it apply generally to all financial institutions, products, and practices or should it be limited to a select population of systemically important institutions? When the Treasury Department issued its Blueprint for regulatory reform a year ago, it proposed to give the Federal Reserve broad new authority to regulate systemic risk but only in a crisis. Despite the sweeping scope of its restructuring proposals, Treasury clearly envisioned a strictly limited role within systemic risk regulation for regulatory interventions exercised primarily through its role as lender of last resort. Although there are a few who continue to advocate a version of that viewpoint, we believe events since the Blueprint's release have conclusively proven the disadvantages of this approach. As Volcker stated in his New York Economic Club speech: ``I do not see how that responsibility can be turned on only at times of turmoil--in effect when the horse has left the barn.'' We share that skepticism, convinced like the authors of the COP Report that, ``Systemic risk needs to be managed before moments of crisis, by regulators who have clear authority and the proper tools.'' As noted above, most parties appear to agree that a systemic risk regulator must have broad authority to survey all areas of financial markets and the flexibility to respond to emerging areas of potential risk. CFA shares this view, believing it would be both impractical and dangerous to require the regulator to go back to Congress each time it sought to extend its jurisdiction in response to changing market conditions. Others have described a robust set of additional tools that regulators should have to minimize systemic risks. As the Group of 30 noted in its report on regulatory reform: `` . . . a legal regime should be established to provide regulators with authority to require early warnings, prompt corrective actions, and orderly closings'' of certain financial institutions. The specific regulatory powers various parties have recommended as part of a comprehensive framework for systemic risk regulation include authority to: Set capital, liquidity, and other regulatory requirements directly related to risk management; Require firms to pay some form of premium, much like the premiums banks pay to support the federal deposit insurance fund, adjusted to reflect the bank's size, leverage, and concentration, as well as the risks associated with its activities; Directly supervise at least certain institutions; Act as lender of last resort with regard to institutions at risk of failure; Act as a receiver or conservator of a failed nondepository organization and to place the organization in liquidation or take action to restore it to a sound and solvent condition; Require corrective actions at troubled institutions that are similar to those provided for in FDICIA; Make regular reports to Congress; and Take enforcement actions, with powers similar to what Federal Reserve currently has over bank holding companies.Without evaluating each recommendation individually or in detail, CFA believes this presents an appropriately comprehensive view of the tools necessary for systemic risk regulation. Most of those who have commented on this topic would give at least some of this responsibility and authority--such as demanding corrective actions to reduce risks--directly to a systemic risk regulator. Others would require in all but the most extreme circumstances that a systemic risk regulator exercise this authority only in cooperation with functional regulators. Both approaches have advantages and disadvantages. Giving a systemic risk regulator this authority would ensure consistent application of standards and establish a clear line of accountability for decision-making in this area. But it would also demand, perhaps unrealistically, that the regulator have a detailed understanding of how those standards would best be implemented in a vast variety of firms and situations. Relying on functional regulators to act avoids the latter problem but sets up a potential for jurisdictional conflicts as well as inconsistent and delayed implementation. If Congress decides to adopt the latter approach, it will need to make absolutely clear what authority the systemic risk regulator has to require its regulatory partners to take appropriate action. Without that clarification, disputes over jurisdiction are inevitable, and inconsistencies and conflicts are bound to emerge. It would also be doubly important under such an approach to ensure that gaps in the regulatory framework are closed and that all regulators share a responsibility for reducing systemic risk. Many of those who would give a systemic risk regulator this direct authority to demand corrective actions would limit its application to a select population of systemically important institutions. The Securities Industry and Financial Markets Association has advocated, for example, that the resolution system for nonbank firms apply only to ``the few organizations whose failure might reasonably be considered to pose a threat to the financial system.'' In testimony before the House Capital Markets Subcommittee, SIFMA President and CEO T. Timothy Ryan, Jr. also suggested that the systemic risk regulator should only directly supervise systemically important financial institutions. Such an approach requires a systemic risk regulator to identify in advance those institutions that pose a systemic risk. Others express strong opposition to this approach. As former Congressman Baker of the MFA said in his recent House Subcommittee testimony: An entity that is perceived by the market to have a government guarantee, whether explicit or implicit, has an unfair competitive advantage over other market participants. We strongly believe that the systemic risk regulator should implement its authority in a way that avoids this possibility and also avoids the moral hazards that can result from a company having an ongoing government guarantee against failure. Unfortunately, the recent actions the government was called on to take to rescue a series of nonbank financial institutions has already created that implied backing. Simply refraining from designating certain institutions as systemically significant will not be sufficient to dispel that expectation, and it would at least provide the opportunity to subject those firms to tougher standards and enhanced oversight. As discussed above, however, CFA believes this approach to be unworkable. That is a key reason why we believe it is absolutely essential to provide for corrective action and resolution authority as part of a comprehensive plan for enhanced systemic risk regulation. As money manager Jonathan Tiemann argued in a recent article entitled ``The Wall Street Vortex'': Some institutions are so large that their failure would imperil the financial system. As such, they enjoy an implicit guarantee, which could . . . force us to nationalize their losses. But we need for all financial firms that run the risk of failure to be able to do so without causing a widespread financial meltdown. The most interesting part of the debate should be on this point, whether we could break these firms into smaller pieces, limit their activities, or find a way to compartmentalize the risks that their various business units take. CFA believes this is an issue that deserves more attention than it has garnered to date. One option is to try to maximize the incentives of private parties to avoid risks, for example by subjecting financial institutions to risk-based capital requirements and premium payments. To serve as a significant deterrent to risk, these requirements would have to ratchet up dramatically as institutions grew in size, took on risky assets, increased their level of leverage, or engaged in other activities deemed risky by regulators. It has been suggested, for example, that the Fed could have prevented the rapid growth in use of over-the-counter credit default swaps by financial institutions if it had adopted this approach. It could, for example, have imposed capital standards for use of OTC derivatives that were higher than the margin requirements associated with trading the same types of derivatives on a clearinghouse and designed to reflect the added risks associated with trading in the over-the-counter markets. In order to minimize the chances that institutions will avoid becoming too big or too inter-connected to fail, CFA urges you to include such incentives as a central component of your systemic risk regulation legislation.Conclusion Decades of Wall Street excess unchecked by reasonable and prudential regulation have left our markets vulnerable to systemic shock. The United States, and indeed the world, is still reeling from the effects of the latest and most severe of a long series of financial crises. Only a fundamental change in regulatory approach will turn this situation around. While structural changes are a part of that solution, they are by no means the most important aspect. Rather, returning to a regulatory approach that recognizes both the disastrous consequences of allowing markets to self-regulate and the necessity of strong and effective governmental controls to rein in excesses is absolutely essential to achieving this goal. ______ CHRG-111shrg62643--163 Mr. Bernanke," We are trying simultaneously to think about the small versus large bank or systemically critical versus noncritical bank capital issues. At the same time, we are looking with our colleagues internationally to try and establish relationships between capital standards across countries. So I do not think we really have come to a conclusion there. It is not a straightforward thing to answer that question, in part because large banks and small banks have such different portfolios and such different activities that they will have different capital levels even for the same set of rules. We are committed by the legislation and by our own approach, to requiring more capital of systemically critical firms, and in a progressive way as firms become even more critical, interconnected, essential to the functioning of the system that they need to both have higher capital and to be subject to tougher prudential regulation because of the effects they have on the whole system if they fail. " fcic_final_report_full--624 Sections 105 and 365 of the Bankruptcy Code to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivatives Contracts, Lehman Brothers Holdings Inc., et al., No. 08- 13555 (Bankr. S.D.N.Y. Nov. 13, 2008) [Docket No. 1498], p. 4; Debtors’ Motion for an Order Approving Consensual Assumption and Assignment of Prepetition Derivatives Contracts, Lehman Brothers Hold- ings Inc., et al., No. 08-13555 (Bankr. S.D.N.Y. Jan. 16, 2009) [Docket No.2561], p. 3. 9. Money market fund holdings of all types of taxable commercial paper decreased from $671 billion at the end of August 2008 to $505 billion at the end of September (data provided by ICI/Crane to the FCIC). BNY Mellon, in its role as tri-party clearing bank, reported that Treasury-backed repos rose from $195 billion (13%) to $466 billion (27%) of its tri-party business between March 31 and December 31, 2008 (data provided by BNY Mellon to the FCIC). 10. Harvey Miller, interview by FCIC, August 5, 2010. 11. The Reserve Fund, Semi-annual report to shareholders, March 2006. 12. Complaint, SEC v. Reserve Management Company Inc., Resrv Partners Inc., Bruce Bent Sr., Bruce Bent II, and The Reserve Primary Fund (S.D.N.Y. May 5, 2009), p. 12 (para. 35); “Fidelity, BlackRock, Dreyfus, Reserve Make Big Gains Past 12 Months,” Crane Data News Archives, September 12, 2008. 13. The Reserve Primary Fund management, interview by FCIC, March 25, 2010. 14. SEC Complaint against Reserve Management Company Inc., pp. 2, 18 (paras. 3, 59), p. 30 (para. 101); The Reserve, “The Primary Fund: Plan of Liquidation and Distribution of Assets,” December 3, 2008, p. 2. 15. SEC Complaint, pp. 26–33 (paras. 88–113); The Reserve, “The Primary Fund: Plan of Liquida- tion,” p. 2. 16. SEC Complaint, p. 35 (para. 121). The SEC notes that the Primary Fund likely broke the buck prior to 11:00 A . M . on September 16 because of the redemption requests and the valuation of Lehman’s debt; moreover, RMCI announced on November 26, 2008, that owing to an administrative error, its NAV should have been calculated as $0.99 between 11:00 A . M . and 4:00 P . M . on September 16 (pp. 34–33, paras. 119, 120). 17. Moody’s Investors Service articles, “Sponsor Support Key to Money Market Funds,” August 9, 2010, p. 4; “Moody’s Proposes New Money Market Fund Rating Methodology and Symbols,” September 7, 2010. 18. Patrick McCabe and Michael Palumbo, interview by FCIC, September 28, 2010. 19. Ibid. 20. Investment Company Institute, Historical Weekly Money Market Data. While nongovernment funds lost $434 billion during the period between September 10 and October 1, 2008, government funds—investing in Treasuries and GSE debt—increased by $357 billion during the same period. 21. McCabe and Palumbo, interview. 22. FCIC survey of money market mutual funds. Holdings for the five firms decreased from $58 bil- lion to $29 billion from September 12, 2008, to September 19, 2008. See FCIC website for details. 23. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 2: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 135. 24. McCabe and Palumbo, interview. 25. “Treasury Announces Guaranty Program for Money Market Funds,” Treasury Department press release, September 19, 2008. President George W. Bush approved the use of existing authorities by Secre- tary Henry M. Paulson Jr. to make available as necessary the assets of the Exchange Stabilization Fund (ESF) for up to $50 billion to guarantee payments to support money market mutual funds. The original objective of the ESF, established by the Gold Reserve Act of 1934, was to stabilize the value of the dollar in the depths of the Depression. It authorized the treasury secretary, with the approval of the president, to “deal in gold, foreign exchange, and other instruments of credit and securities” to promote international financial stability. 26. The program was called the Asset-Backed Commercial Paper Money Market Mutual Fund Liq- uidity Facility (AMLF). 27. Neel Kashkari, interview by FCIC, November 2, 2010. 28. John Mack, interview by FCIC, November 2, 2010. 29. New York Federal Reserve, internal email, October 22, 2008, p. 2. 30. David Wong, email to Fed and SEC officials, September 15, 2008. 621 31. Jonathan Stewart, FRBNY, internal email, September 17, 2008. 32. One year later, the Senior Supervisors Group—a cross-agency task force looking back on the causes of the financial crisis—would write, “Before the crisis [at the investment banks post-Lehman], many broker-dealers considered the prime brokerage business to be either a source of liquidity or a liq- uidity-neutral business. As a result, the magnitude and unprecedented severity of events in September– October 2008 were largely unanticipated.” Senior Supervisors Group, “Risk Management Lessons from the Global Banking Crisis of 2008,” October 21, 2009, p. 9. 33. Jonathan Wood, Whitebox Advisors, interview by FCIC, August 11, 2010. 34. The FCIC surveyed hedge funds that survived the crisis. Those in the three largest quartiles ranked by size received investor redemption requests averaging 20% of their assets in the fourth quarter of 2008 (the first available redemption date after the Lehman bankruptcy). 35. IFSL Research, “Hedge Funds 2009,” April 2009. 36. David Wong, treasurer of Morgan Stanley, interview by FCIC, October 15, 2010. 37. Mack, interview. 38. Wong, interview. 39. Patrice Maher (Morgan Stanley), email to William Brodows (Federal Reserve BNY) et al., Septem- ber 28, 2008, with data in an attachment. Hedge fund values are the Prime Brokerage Outflows (NY+In- ternational). 40. Wong, interview. 41. Matthew Eichner, internal email, September 16, 2008. 42. Angela Miknius, email to NY Bank Sup, September 18, 2008. 43. Amy G. White, internal NYFBR email, September 19, 2008. 44. Morgan Stanley, “Liquidity and Financing Activity: 08/28/08,” “Liquidity and Financing Activity: 09/18/08,” “Liquidity and Financing Activity: 10/03/08,” reports to the New York Federal Reserve. 45. Morgan Stanley Corporate Treasury, “Meeting with Federal Reserve: September 20, 2008,” attach- ment to Morgan Stanley email to NYFRB, September 20, 2008, including “Forward Forecast.” 46. Morgan Stanley Corporate Treasury, “Liquidity Landscape: 09/12–09/18/2008,” in attachment to Morgan Stanley email to NYFRB, September 20, 2008; Amy White, internal NYFRB emails, September 16 and 19, 2008. 47. Lloyd Blankfein, testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 1: Fi- nancial Institution Representatives, January 13, 2010, transcript, pp. 34–35. 48. Bernanke, closed-door session. 49. Thomas Baxter, interview by FCIC, April 30, 2010. 50. The switch to bank holding company status required a simple charter change. Both Morgan and Goldman already owned banks that they had chartered as industrial loan companies, a type of bank that is allowed to accept FDIC-insured deposits without having any Fed supervision over the bank’s parent or other affiliated companies. 51. Federal Reserve, “Discount Window Payment System Risk: Getting Started,” last updated Novem- ber 17, 2009. 52. Mack, interview. 53. Mack, interview. 54. Wong, interview. 55. Amy G. White, internal FRBNY email, September 19, 2008. 56. It should be borne in mind that lack of regulation of this market rendered it extremely opaque. Shortcomings in transparency, lack of reporting requirements, and limited data collection by third par- ties make it difficult to document and describe the various market trading problems that emerged during the crisis. 57. Michael Masters, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial CHRG-110shrg50409--19 Mr. Bernanke," Well, Senator, as you point out, we are not the primary regulator of that institution, but we were involved in it---- Senator Shelby. Absolutely. " Mr. Bernanke," ----because the Federal Reserve Bank of San Francisco was attempting to assist in the wind down, and we certainly had extensive communication with the FDIC and the OTS about that bank. My assessment of IndyMac is that it was particularly weighted down with low-quality mortgages, subprime and other exotic mortgages, and those losses created a capital hole that it was unable to fill. So in that respect, I think its failure, barring acquisition by another firm, which did not occur, was inevitable. So, again, I think it was basically the asset quality of the bank that had that effect. Of course, all banks are being challenged by credit conditions now. The good news is that the banking system did come into this episode extremely well capitalized, extremely profitable. I do not have any forecast to make. I think Chairman Bair gave a good discussion yesterday about the pressures that banks are facing, and she discussed her list of problem banks. I suppose it is a bit of good news that most of the problem banks that she had is a far smaller list than we have seen in some episodes in the past, in the 1990s, for example. Senator Shelby. Overall, looking at our banking system, could you say today here in the Senate that you believe as Chairman of the Federal Reserve that our banking system is stable and capitally strong? " CHRG-111hhrg48875--207 Secretary Geithner," That was a very thoughtful set of questions. I just want to correct one thing. I have never been a regulator, for better or worse. And I think you are right to say that we have to be very skeptical that regulation can solve all these problems. We have parts of the system which are overwhelmed by regulation, overwhelmed by regulation. It wasn't the absence of regulation that was a problem. It was, despite the presence of regulation, you got huge risks built up. But in banks, because banks by definition take on leverage and transform short-term liabilities into long-term assets for the good of the system as a whole, they are vulnerable to runs. Because they are vulnerable to runs, governments around the world have put in place insurance protections to protect against that risk. Because of the existence of those protections, you have to impose standards on them on leverage to protect against the moral hazard created by the insurance. That is a good economic case for regulation-- Dr. Paul. Excuse me, but I only have a couple of seconds left. But see if you can address the subject of giving more respect to that individual who is accused of a crime. Can't we assume that the government has the burden of proof? " CHRG-111shrg56376--154 Mr. Ludwig," First, Canada does have a Federal system, and there are some smaller institutions. But there is no place on Earth that really quite has the number of commercial banking institutions that we do. Having said that, the point is well taken that Germany does have a good many landesbanks, and I think a survey of the world would reveal other consolidated supervisory mechanisms that deal with small banks and large banks and do it effectively. And I think Canada is probably a pretty good example, actually, though they are not as numerous. " CHRG-110shrg38109--74 Chairman Dodd," Thank you very much, Senator Martinez. Senator Bayh. Senator Bayh. Mr. Chairman, I would like to ask you some questions about our national security interests and the role of the Fed in our financial system in protecting those interests. As you probably have read, there are the tentative outlines of an agreement with North Korea to begin to get them to change their behavior with regard to their nuclear program. And one of the reasons that we were able to at least achieve a tentative understanding was because of pressure that we brought to bear on a bank in Macau that the North Koreans used to interact with the global banking system. Iran, as you know, is pursuing nuclear ambitions as well. Several Iranian banks do business in Western Europe. We are currently attempting to do something similar with regard to a couple of Iranian banks. My question to you is: What can the Fed do, what can the United States banking system do, to cut off Iranian access to the global banking system to exert some pressure on them to behave in a more responsible way with regard to their nuclear ambitions? " CHRG-111shrg52619--171 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System March 19, 2009 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I appreciate this opportunity to present the views of the Federal Reserve Board on the important issue of modernizing financial supervision and regulation. For the last year and a half, the U.S. financial system has been under extraordinary stress. Initially, this financial stress precipitated a sharp downturn in the U.S. and global economies. What has ensued is a very damaging negative feedback loop: The effects of the downturn--rising unemployment, declining profits, and decreased consumption and investment--have exacerbated the problems of financial institutions by reducing further the value of their assets. The impaired financial system has, in turn, been unable to supply the credit needed by households and businesses alike. The catalyst for the current crisis was a broad-based decline in housing prices, which has contributed to substantial increases in mortgage delinquencies and foreclosures and significant declines in the value of mortgage-related assets. However, the mortgage sector is just the most visible example of what was a much broader credit boom, and the underlying causes of the crisis run deeper than the mortgage market. They include global imbalances in savings and capital flows, poorly designed financial innovations, and weaknesses in both the risk-management systems of financial institutions and the government oversight of such institutions. While stabilizing the financial system to set the stage for economic recovery will remain its top priority in the near term, the Federal Reserve has also begun to evaluate regulatory and supervisory changes that could help reduce the incidence and severity of future financial crises. Today's Committee hearing is a timely opportunity for us to share our thinking to date and to contribute to your deliberations on regulatory modernization legislation. Many conclusions can be drawn from the financial crisis and the period preceding it, ranging across topics as diverse as capital adequacy requirements, risk measurement and management at financial institutions, supervisory practices, and consumer protection. In the Board's judgment, one of the key lessons is that the United States must have a comprehensive strategy for containing systemic risk. This strategy must be multifaceted and involve oversight of the financial system as a whole, and not just its individual components, in order to improve the resiliency of the system to potential systemic shocks. In pursuing this strategy, we must ensure that the reforms we enact now are aimed not just at the causes of our current crisis, but at other sources of risk that may arise in the future. Systemic risk refers to the potential for an event or shock triggering a loss of economic value or confidence in a substantial portion of the financial system, with resulting major adverse effects on the real economy. A core characteristic of systemic risk is the potential for contagion effects. Traditionally, the concern was that a run on a large bank, for example, would lead not only to the failure of that bank, but also to the failure of other financial firms because of the combined effect of the failed bank's unpaid obligations to other firms and market uncertainty as to whether those or other firms had similar vulnerabilities. In fact, most recent episodes of systemic risk have begun in markets, rather than through a classic run on a bank. A sharp downward movement in asset prices has been magnified by certain market practices or vulnerabilities. Soon market participants become uncertain about the values of those assets, an uncertainty that spreads to other assets as liquidity freezes up. In the worst case, liquidity problems become solvency problems. The result has been spillover effects both within the financial sector and from the financial sector to the real economy. In my remarks, I will discuss several components of a broad policy agenda to address systemic risk: consolidated supervision, the development of a resolution regime for systemically important nonbank financial institutions; more uniform and robust authority for the prudential supervision of systemically important payment and settlement systems; consumer protection; and the potential benefits of charging a governmental entity with more express responsibility for monitoring and addressing systemic risks in the financial system. In elaborating this agenda, I will both discuss the actions the Federal Reserve is taking under existing authorities and identify areas in which we believe legislation is needed.Effective Consolidated Supervision of Systemically Important Firms For the reasons I have just stated, supervision of individual financial firms is not a sufficient condition for fostering financial stability. But it is surely a necessary condition. Thus a first component of an agenda for systemic risk regulation is that each systemically important financial firm be subject to effective consolidated supervision. This means ensuring both that regulatory requirements apply to each such firm and that the consequent supervision is effective. As to the issue of effectiveness, many of the current problems in the banking and financial system stem from risk-management failures at a number of financial institutions, including some firms under federal supervision. Clearly, these lapses are unacceptable. The Federal Reserve has been involved in a number of exercises to understand and document the risk-management lapses and shortcomings at major financial institutions, including those undertaken by the Senior Supervisors Group, the President's Working Group on Financial Markets, and the multinational Financial Stability Forum. \1\--------------------------------------------------------------------------- \1\ See Senior Supervisors Group (2008), ``Observations on Risk Management Practices during the Recent Market Turbulence'' March 6, www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf; President's Working Group on Financial Markets (2008), ``Policy Statement on Financial Market Developments,'' March 13, www.treas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf; and Financial Stability Forum (2008), ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 7, www.fsforum.org/publications/FSF_Report_to_G7_11_April.pdf.--------------------------------------------------------------------------- Based on the results of these and other efforts, the Federal Reserve is taking steps to improve regulatory requirements and risk management at regulated institutions. Our actions have covered liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit exposures, and commercial real estate. Liquidity and capital have been given special attention. The crisis has undermined previous conventional wisdom that a company, even in stressed environments, may readily borrow funds if it can offer high-quality collateral. For example, the inability of Bear Stearns to borrow even against U.S. government securities helped cause its collapse. As a result, we have been working to bring about needed improvements in institutions' liquidity risk-management practices. Along with our U.S. supervisory colleagues, we are closely monitoring the liquidity positions of banking organizations--on a daily basis for the largest and most critical firms--and are discussing key market developments and our supervisory analyses with senior management. We use these analyses and findings from examinations to ensure that liquidity and funding management, as well as contingency funding plans, are sufficiently robust and incorporate various stress scenarios. Looking beyond the present period, we also have underway a broader-ranging examination of liquidity requirements. Similarly, the Federal Reserve is closely monitoring the capital levels of banking organizations on a regular basis and discussing our evaluation with senior management. As part of our supervisory process, we have been conducting our own analysis of loss scenarios to anticipate the potential future capital needs of institutions. These needs may arise from, among other things, future losses or the potential for off-balance-sheet exposures and assets to come on balance sheet. Here, too, we have been discussing our analyses with bankers and ensuring that their own internal analyses reflect a broad range of scenarios and capture stress environments that could impair solvency. We have intensified efforts to evaluate firms' capital planning and to bring about improvements where needed. Going forward, we will need changes in the capital regime as the financial environment returns closer to normal conditions. Working with other domestic and foreign supervisors, we must strengthen the existing capital rules to achieve a higher level and quality of required capital. Institutions should also have to establish strong capital buffers above current regulatory minimums in good times, so that they can weather financial market stress and continue to meet customer credit needs. This is but one of a number of important ways in which the current pro-cyclical features of financial regulation should be modified, with the aim of counteracting rather than exacerbating the effects of financial stress. Finally, firms whose failure would pose a systemic risk must be subject to especially close supervisory oversight of their risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards. Turning to the reach of consolidated supervision, the Board believes there should be statutory coverage of all systemically important financial firms--not just those affiliated with an insured bank as provided for under the Bank Holding Company Act of 1956 (BHC Act). The current financial crisis has highlighted a fact that had become more and more apparent in recent years--that risks to the financial system can arise not only in the banking sector, but also from the activities of financial firms that traditionally have not been subject to the type of consolidated supervision applied to bank holding companies. For example, although the Securities and Exchange Commission (SEC) had authority over the broker-dealer and other SEC-registered units of Bear Stearns and the other large investment banks, it did not have statutory authority to supervise the diversified operations of these firms on a consolidated basis. Instead, the SEC was forced to rely on a voluntary regime for monitoring and addressing the capital and liquidity risks arising from the full range of these firms' operations. In contrast, all holding companies that own a bank--regardless of size--are subject to consolidated supervision for safety and soundness purposes under the BHC Act. \2\ A robust consolidated supervisory framework, like the one embodied in the BHC Act, provides a supervisor the tools it needs to understand, monitor and, when appropriate, restrain the risks associated with an organization's consolidated or group-wide activities. These tools include the authority to establish consolidated capital requirements for the organization, obtain reports from and conduct examinations of the organization and any of its subsidiaries, and require the organization or its subsidiaries to alter their risk-management practices or take other actions to address risks that threaten the safety and soundness of the organization.--------------------------------------------------------------------------- \2\ Through the exploitation of a loophole in the BHC Act, certain investment banks, as well as other financial and nonfinancial firms, acquired control of a federally insured industrial loan company (ILC) while avoiding the prudential framework that Congress established for the corporate owners of other full-service insured banks. For the reasons discussed in prior testimony before this Committee, the Board continues to believe that this loophole in current law should be closed. See Testimony of Scott G. Alvarez, General Counsel of the Board, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Oct. 4, 2007.--------------------------------------------------------------------------- Application of a similar regime to systemically important financial institutions that are not bank holding companies would help promote the safety and soundness of these firms and the stability of the financial system generally. It also is worth considering whether a broader application of the principle of consolidated supervision would help reduce the potential for risk taking to migrate from more-regulated to less-regulated parts of the financial sector. To be fully effective, consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of an organization. Accordingly, specific consideration should be given to modifying the limits currently placed on the ability of consolidated supervisors to monitor and address risks at an organization's functionally regulated subsidiaries.Improved Resolution Processes The importance of extending effective consolidated supervision to all systemically important firms is, of course, linked to the perception of market participants that such firms will be considered too-big-to-fail, and will thus be supported by the government if they get into financial difficulty. This perception has obvious undesirable effects, including possible moral hazard effects if firms are able to take excessive risks because of market beliefs that they can fall back on government assistance. In addition to effective supervision of these firms, the United States needs improved tools to allow the orderly resolution of systemically important nonbank financial firms, including a mechanism to cover the costs of the resolution if government assistance is required to prevent systemic consequences. In most cases, federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, this framework does not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure would pose substantial systemic risks. Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task that will take some time to complete. We can begin, however, by learning from other models, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008. Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a ``bridge'' institution to facilitate an orderly sale or liquidation of the firm. The authority to ``bridge'' a failing institution through a receivership to a new entity reduces the potential for market disruption, limits the value-destruction impact of a failure, and--when accompanied by haircuts on creditors and shareholders--mitigates the adverse impact of government intervention on market discipline. Any new resolution regime would need to be carefully crafted. For example, clear guidelines are needed to define which firms could be subject to the new, alternative regime and the process for invoking that regime, analogous perhaps to the procedures for invoking the so called systemic risk exception under the FDIA. In addition, given the global operations of many large and diversified financial firms and the complex regulatory structures under which they operate, any new resolution regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization. In addition to developing an alternative resolution regime for systemically critical financial firms, policymakers and experts should carefully review whether improvements can be made to the existing bankruptcy framework that would allow for a faster and more orderly resolution of financial firms generally. Such improvements could reduce the likelihood that the new alternative regime would need to be invoked or government assistance provided in a particular instance to protect financial stability and, thereby, could promote market discipline.Oversight of Payment and Settlement Systems As suggested earlier, a comprehensive strategy for controlling systemic risk must focus not simply on the stability of individual firms. Another element of such a strategy is to provide close oversight of important arenas in which firms interact with one another. Payment and settlement systems are the foundation of our financial infrastructure. Financial institutions and markets depend upon the smooth functioning of these systems and their ability to manage counterparty and settlement risks effectively. Such systems can have significant risk-reduction benefits--by improving counterparty credit risk management, reducing settlement risks, and providing an orderly process to handle participant defaults--and can improve transparency for participants, financial markets, and regulatory authorities. At the same time, these systems inherently centralize and concentrate clearing and settlement risks. Thus, if a system is not well designed and able to appropriately manage the risks arising from participant defaults or operational disruptions, significant liquidity or credit problems could result. Well before the current crisis erupted, the Federal Reserve was working to strengthen the financial infrastructure that supports trading, payments, clearing, and settlement in key financial markets. Because this infrastructure acts as a critical link between financial institutions and markets, ensuring that it is able to withstand--and not amplify--shocks is an important aspect of reducing systemic risk, including the very real problem of institutions that are too big or interconnected to be allowed to fail in a disorderly manner. The Federal Reserve Bank of New York has been leading a major joint initiative by the public and private sectors to improve arrangements for clearing and settling credit default swaps (CDS) and other over-the-counter (OTC) derivatives. As a result, the accuracy and timeliness of trade information has improved significantly. In addition, the Federal Reserve, working with other supervisors through the President's Working Group on Financial Markets, has encouraged the development of well-regulated and prudently managed central clearing counterparties for OTC trades. Along these lines, the Board has encouraged the development of two central counterparties for CDS in the United States--ICE Trust and the Chicago Mercantile Exchange. In addition, in 2008, the Board entered into a memorandum of understanding with the SEC and the Commodity Futures Trading Commission to promote the application of common prudential standards to central counterparties for CDS and to facilitate the sharing of information among the agencies with respect to such central counterparties. The Federal Reserve also is consulting with foreign financial regulators regarding the development and oversight of central counterparties for CDS in other jurisdictions to promote the application of consistent prudential standards. The New York Federal Reserve Bank, in conjunction with other domestic and foreign supervisors, continues its effort to establish increasingly stringent targets and performance standards for OTC market participants. In addition, we are working with market participants to enhance the resilience of the triparty repurchase agreement (repo) market. Through this market, primary dealers and other major banks and broker-dealers obtain very large amounts of secured financing from money market mutual funds and other short-term, risk-averse investors. \3\ We are exploring, for example, whether a central clearing system or other improvements might be beneficial for this market, given the magnitude of exposures generated and the vital importance of the market to both dealers and investors.--------------------------------------------------------------------------- \3\ Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. The New York Reserve Bank's Open Market Desk engages in trades on behalf of the Federal Reserve System to implement monetary policy.--------------------------------------------------------------------------- Even as we pursue these and similar initiatives, however, the Board believes additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems. 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 critical payment and settlement systems have the necessary procedures and controls in place to manage their risks. By contrast, many major central banks around the world have an explicit statutory basis for their oversight of these systems. Given how important robust payment and settlement systems are to financial stability, and the functional similarities between many payment and settlement systems, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems. The Federal Reserve has significant expertise regarding the risks and appropriate risk management practices at payment and settlement systems, substantial direct experience with the measures necessary for the safe and sound operation of such systems, and established working relationships with other central banks and regulators that we have used to promote the development of strong and internationally accepted risk management standards for the full range of these systems. Providing such authority would help ensure that these critical systems are held to consistent and high prudential standards aimed at mitigating systemic risk.Consumer Protection Another lesson of this crisis is that pervasive consumer protection problems can signal, and even lead to, trouble for the safety and soundness of financial institutions and for the stability of the financial system as a whole. Consumer protection in the area of financial services is not, and should not be, limited to practices with potentially systemic consequences. However, as we evaluate the range of measures that can help contain systemic problems, it is important to recognize that good consumer protection can play a supporting role by--among other things--promoting sound underwriting practices. Last year the Board adopted new regulations under the Home Ownership and Equity Protection Act to enhance the substantive protections provided high-cost mortgage customers, such as requiring tax and insurance escrows in certain cases and limiting the use of prepayment penalties. These rules also require lenders providing such high-cost loans to verify the income and assets of a loan applicant and prohibit lenders from making such a loan without taking into account the ability of the borrower to repay the loan from income or assets other than the home's value. More recently, the Board adopted new rules to protect credit card customers from a variety of unfair and deceptive acts and practices. The Board will continue to update its consumer protection regulations as appropriate to provide households with the information they need to make informed credit decisions and to address new unfair and deceptive practices that may develop as practices and products change.Systemic Risk Authority One issue that has received much attention recently is the possible benefit of establishing a systemic risk authority that would be charged with monitoring, assessing and, if necessary, curtailing systemic risks across the entire U.S. financial system. At a conceptual level, expressly empowering a governmental authority with responsibility to help contain systemic risks should, if implemented correctly, reduce the potential for large adverse shocks and limit the spillover effects of those shocks that do occur, thereby enhancing the resilience of the financial system. However, no one should underestimate the challenges involved with developing or implementing a supervisory and regulatory program for systemic risks. Nor should the establishment of such an authority be viewed as a panacea that will eliminate periods of significant stress in the financial markets and so reduce the need for the other important reforms that I have discussed. The U.S. financial sector is extremely large and diverse--with value added amounting to nearly $1.1 trillion or 8 percent of gross domestic product in 2007. Systemic risks may arise across a broad range of firms or markets, or they may be concentrated in just a few key institutions or activities. They can occur suddenly, such as from a rapid and substantial decline in asset prices, even if the probability of their occurrence builds up slowly over time. Moreover, as the current crisis has illustrated, systemic risks may arise at nonbank entities (for example, mortgage brokers), from sectors outside the traditional purview of federal supervision (for example, insurance firms), from institutions or activities that are based in other countries or operate across national boundaries, or from the linkages and interdependencies among financial institutions or between financial institutions and markets. And, while the existence of systemic risks may be apparent in hindsight, identifying such risks ex ante and determining the proper degree of regulatory or supervisory action needed to counteract a particular risk without unnecessarily hampering innovation and economic growth is a very challenging assignment for any agency or group of agencies. \4\--------------------------------------------------------------------------- \4\ For example, while the existence of supranormal profits in a market segment may be an indicator of supranormal risks, it also may be the result of innovation on the part of one or more market participants that does not create undue risks to the system.--------------------------------------------------------------------------- For these reasons, any systemic risk authority would need a sophisticated, comprehensive and multi-disciplinary approach to systemic risk. Such an authority likely would require knowledge and experience across a wide range of financial institutions and markets, substantial analytical resources to identify the types of information needed and to analyze the information obtained, and supervisory expertise to develop and implement the necessary supervisory programs. To be effective, however, these skills would have to be combined with a clear statement of expectations and responsibilities, and with adequate powers to fulfill those responsibilities. While the systemic risk authority should be required to rely on the information, assessments, and supervisory and regulatory programs of existing financial supervisors and regulators whenever possible, it would need sufficient powers of its own to achieve its broader mission--monitoring and containing systemic risk. These powers likely would include broad authority to obtain information--through data collection and reports, or when necessary, examinations--from a range of financial market participants, including banking organizations, securities firms, key financial market intermediaries, and other financial institutions that currently may not be subject to regular federal supervisory reporting requirements. How might a properly constructed systemic risk authority use its expertise and authorities to help monitor, assess, and mitigate potentially systemic risks within the financial system? There are numerous possibilities. One area of natural focus for a systemic risk authority would be the stability of systemically critical financial institutions. It also likely would need some role in the setting of standards for capital, liquidity, and risk-management practices for financial firms, given the importance of these matters to the aggregate level of risk within the financial system. By bringing its broad knowledge of the interrelationships between firms and markets to bear, the systemic risk authority could help mitigate the potential for financial firms to be a source of, or be negatively affected by, adverse shocks to the system. It seems most sensible that the role of the systemic risk authority be to complement, not displace, that of a firm's consolidated supervisor (which, as I noted earlier, all systemically critical financial institutions should have). Under this model, the firm's consolidated supervisor would continue to have primary responsibility for the day-to-day supervision of the firm's risk management practices, including those relating to compliance risk management, and for focusing on the safety and soundness of the individual institution. Another key issue is the extent to which a systemic risk authority would have appropriately calibrated ability to take measures to address specific practices identified as posing a systemic risk--in coordination with other supervisors when possible, or independently if necessary. For example, there may be practices that appear sound when considered from the perspective of a single firm, but that appear troublesome when understood to be widespread in the financial system, such as if these practices reveal the shared dependence of firms on particular forms of uncertain liquidity. Other activities that a systemic risk authority might undertake include: (1) monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets; (2) assessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (3) analyzing possible spillovers between financial firms or between firms and markets, for example through the mutual exposures of highly interconnected firms; (4) identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole; and (5) issuing periodic reports on the stability of the U.S. financial system, in order both to disseminate its own views and to elicit the considered views of others. Thus, there are numerous important decisions to be made on the substantive reach and responsibilities of a systemic risk regulator. How such an authority, if created, should be structured and located within the federal government is also a complex issue. Some have suggested the Federal Reserve for this role, while others have expressed concern that adding this responsibility would overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve, acting either alone or as part of a collective body, depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, and how well they complement those of the Federal Reserve's long-established core missions. Nevertheless, as Chairman Bernanke has noted, effectively identifying and addressing systemic risks would seem to require some involvement of the Federal Reserve. As the central bank of the United States, the Federal Reserve has a critical part to play in the government's responses to financial crises. Indeed, the Federal Reserve was established by the Congress in 1913 largely as a means of addressing the problem of recurring financial panics. The Federal Reserve plays such a key role in part because it serves as liquidity provider of last resort, a power that has proved critical in financial crises throughout modern history. In addition, the Federal Reserve has broad expertise derived from its other activities, including its role as umbrella supervisor for bank and financial holding companies and its active monitoring of capital markets in support of its monetary policy and financial stability objectives. It seems equally clear that each financial regulator must be involved in a successful overall strategy for containing systemic risk. In the first place, of course, appropriate attention to systemic issues in the normal regulation of financial firms, markets, and practices may itself support this strategy. Second, the information and insight gained by financial regulators in their own realms of expertise will be important contributions to the demanding job of analyzing inchoate risks to financial stability. Still, while a collective process will surely be valuable in assessing systemic risk, it will be important to assign clearly any responsibilities and authorities for actual systemic risk regulation, since shared authority without clearly delineated responsibility for action is sometimes a prescription for inaction.Conclusion I have tried today to identify the elements of an agenda for limiting the potential for financial crises, including actions that the Federal Reserve is taking to address systemic risks and several measures that Congress should consider to make our financial system stronger and safer. In doing so, we must avoid responding only to the current crisis, but must instead fashion a system that will be up to the challenge of regulating a dynamic and innovative financial system. We at the Federal Reserve look forward to working with the Congress on legislation that meets these objectives. ______ CHRG-111hhrg56847--9 Mr. Bernanke," Yes, Mr. Chairman, I do. We and other countries around the world took strenuous measures in the fall of 2008 to avert the collapse of the global financial system and to restore appropriate functioning to global financial markets. It took a while for that to work, but currently financial markets are in much better shape obviously than they were a year and a half ago. Monetary and fiscal policy have been quite supportive and also added to growth. So we see at this point a moderate recovery, not as fast as we would like, but certainly we have averted what I think would have been, absent those interventions, an extraordinarily severe downturn and perhaps a great depression. " CHRG-111shrg56376--227 PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD This afternoon, we will examine how best to ensure the strength and security of our banking system. I would like to thank our witnesses for returning to share your expertise after the last hearing was postponed. Today, we have a convoluted system of bank regulators created by historical accident. Experts agree that nobody would have designed a system that worked like this. For over 60 years, Administrations of both parties, members of Congress, commissions, and scholars have proposed streamlining this irrational system. Last week I suggested further consolidation of bank regulators would make a lot of sense. We could combine the Office of the Comptroller of the Currency and the Office of Thrift Supervision while transferring bank supervision authorities from the Federal Deposit Insurance Corporation and the Federal Reserve, leaving them to focus on their core functions. Since that time, I have heard from many who have argued that I should not push for a single bank regulator. The most common argument is not that it's a bad idea--it's that consolidation is too politically difficult. That argument doesn't work for me. Just look what the status quo has given us. In the last year some of our biggest banks needed billions of dollars of taxpayer money to prop them up, and dozens of smaller banks have failed outright. It's clear that we need to end charter shopping, where institutions look around for the regulator that will go easiest on them. It's clear that we must eliminate the overlaps, redundancies, and additional red tape created by the current alphabet soup of regulators. We don't need a super-regulator with many missions, but a single Federal bank regulator whose sole focus is the safe and sound operation of the Nation's banks. A single operator would ensure accountability and end the frustrating pass the buck excuses we've been faced with. We need to preserve our dual banking system. State banks have been a source of innovation and a source of strength in their communities. A single Federal bank regulator can work with the 50 State bank regulators. Any plan to consolidate bank regulators would have to ensure community banks are treated appropriately. Community banks did not cause this crisis and they should not have to bear the cost or burden of increased regulation necessitated by others. Regulation should be based on risk--community banks do not present the same type of supervisory challenges their large counterparts do. But we need to get this right, which is why you are all here today. I am working with Senator Shelby and my colleagues on the Committee to find consensus as we craft this incredibly important bill. ______ CHRG-111shrg52619--24 Mr. Tarullo," Thank you, Mr. Chairman, Senator Shelby, and Members of the Committee. We are here this morning because of systemic risk. We have had a systemic crisis. We are still in the middle of it, and I would endorse wholeheartedly Senator Shelby's three-part approach to responding to that crisis. In the weeks that I have been at the Federal Reserve, the discussions that have taken place internally, both among staff and among the members, have focused on the issue of systemic risk and how to prevent it going forward. The important point I would make as a prelude to our recommendations is that the source of systemic risk in our financial system has to some considerable extent migrated from traditional banking activities to markets over the last 20 or 25 years. If you think about the problems that led to the Depression, that were apparent even in the 1970s among some banks, the concern was that there would be a run on a bank, that depositors would be worried about the safety and soundness of that bank and that there would be contagion spreading to other institutions as depositors were uncertain as to the status of those institutions. What has been seen more recently is a systemic problem starting in the interactions among institutions in markets. Now, banks are participants in markets, so this can still be something that affects banks. But we have also seen other kinds of institutions at the source of the systemic problems we are undergoing right now. I think you cannot focus on a single institution or even just look at institutions as a series of silos, as it were, and concentrate solely on trying to assure their safety and soundness. We need to look at the interaction among institutions. Sometimes that means their actual counterparty relationships with one another. Sometimes it means the fora in which they interact with one another, in payment systems and the like. Sometimes it even means the parallel strategies which they may be pursuing--when, for example, they are all relying on the same sources of liquidity if they have to change their investing strategies. So they may not even know that they are co-dependent with other actors in the financial markets. For all of these reasons, our view is that the focus needs to be on an agenda for financial stability, an agenda for systemic risk management. I emphasize that because, although there is rightly talk about a systemic risk regulator, it is important that we understand each component of an agenda which is going to be fulfilled by all the financial regulators over which you have jurisdiction. So what do we mean by this agenda? Well, I tried in my testimony to lay out five areas in which we should pay attention. First, we do need effective consolidated supervision of any systemically important institution. We need consolidated supervision and it needs to be effective. There are institutions that are systemically important, and certainly were systemically important over the last few years, which were not subject to consolidated prudential supervision by any regulator. But that supervision needs to be effective. I think everybody is aware, and ought to be aware, of the ways in which the regulation and supervision of our financial institutions in recent years has fallen short. And unless, as Senator Shelby suggests, we all concentrate on it and reflect on it without defensiveness, we are not going to learn the lessons that need to be learned. Second, there is need for a resolution mechanism. I am happy to talk about that in the back and forth with you, but Comptroller Dugan and Chairman Bair have laid that out very well. Third, there does need to be more oversight of key areas in which market participants interact in important ways. We have focused in particular on payments and settlement systems, because there the Fed's oversight authority derives largely from the coincidence that some of the key actors happen to be member banks. But if they weren't, if they had another corporate form, there is no statutory authority right now for us to exercise prudential supervision over those markets in which problems can arise. Fourth, consumer protection. Now, consumer protection is not and should not be limited to its relationship with potential systemic risk. But, as the current crisis demonstrated, there are times in which good consumer protection is not just good consumer protection, but it is an important component of an agenda for containment of systemic risk. Fifth and finally is the issue of a systemic risk regulator. This is something that does seem to fit into an overall agenda. There are gaps in covering systemically important institutions. There are also gaps in attempting to monitor what is going on across the system. I think in the past there have been times at which there was important information being developed by various regulators and supervisors which, if aggregated, would have suggested developing issues and problems. But without a charge to one or more entities to try to put all that together, one risks looking at things, as I said, in a more siloed fashion. The extent of those authorities for a systemic risk regulator is something that needs to be debated in this Committee and in the entire Congress. But I do think that it is an important complement to the other components of this agenda and the improvements in supervision and regulation under existing authorities, and thus something that ought to be considered. I am happy to answer any questions that you may have. " FinancialCrisisReport--231 Washington Mutual was not the only failed thrift overseen by OTS. In 2008, OTS closed the doors of five thrifts with combined assets of $354 billion. 878 Another seven thrifts holding collective assets of $350 billion were sold or declared bankruptcy. 879 Virtually all of these thrifts conducted high risk lending, accumulated portfolios with high risk assets, and sold high risk, poor quality mortgages to other financial institutions and investors. At the Subcommittee hearing, the Treasury Inspector General testified that, after completing 17 reviews and working on another 33 reviews of a variety of failed financial institutions, he could say that OTS’ lack of enforcement action was “not unique to WaMu” and lax enforcement by the relevant federal banking regulator was “not unique to OTS.” 880 Mortgage lenders other than banks also failed. Many of these mortgage lenders had operated as private firms, rather than as depository institutions, and were not overseen by any federal or state bank regulator. Some were overseen by the SEC; others were not overseen by any federal financial regulator. Some became large companies handling billions of dollars in residential loans annually, yet operated under minimal and ineffective regulatory oversight. When residential loans began to default in late 2006, and the subprime securitization market dried up in 2007, these firms were unable to sell their loans, developed liquidity problems, and went out of business. Together, these failed mortgage lenders, like the failed thrifts, contributed to systemic risk that damaged the U.S. banking system, U.S. financial markets, and the U.S. economy as a whole. (a) Countrywide Countrywide Financial Corporation, now a division of Bank of America and known as Bank of America Home Loans, was formerly the largest independent mortgage lender in the United States and one of the most prolific issuers of subprime mortgages. 881 For a number of years, Countrywide operated as a national bank under the OCC. In March 2007, it converted to a thrift charter and operated for its last 18 months under the regulatory supervision of OTS. 882 At its height, Countrywide had approximately $200 billion in assets, 62,000 employees, and issued in excess of $400 billion in residential mortgages each year. In 2008, Countrywide originated 878 1/2009 Center for Responsible Lending report, “The Second S&L Scandal,” at 1, Hearing Exhibit 4/16-84. 879 Id. 880 April 16, 2010 Subcommittee Hearing at 18 (Testimony of Treasury IG Thorson). The Treasury IG also reviewed, for example, failed banks overseen by the OCC. 881 See, e.g., “Mortgage Lender Rankings by Residential Originations,” charts prepared by MortgageDaily.com, http://www.mortgagedaily.com/MortgageLenderRanking.asp (indicating Countrywide was one of the top three issuers of U.S. residential mortgages from 2003 to 2008); “A Mortgage Crisis Begins to Spiral, and the Casualties Mount,” New York Times (3/5/2007). 882 3/5/2007 OTS press release, “OTS Approves Countrywide Application,” http://www.ots.treas.gov/_files/777014.html. nearly 20% of all mortgages in the United States. 883 But in August 2008, after the collapse of the subprime secondary market, Countrywide could no longer sell or securitize its subprime loans and was unable to obtain replacement financing, forcing the bank into a liquidity crisis. 884 By the end of the summer of 2008, it would have declared bankruptcy, but for its sale to Bank of CHRG-111shrg54675--94 RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM ARTHUR C. JOHNSONQ.1. Mr. Hopkins and Mr. Johnson, both of your institutions are members of the Federal Home Loan Bank system. How do you use the Federal Home Loan Bank to support your bank's lending in your market? Has the current economic crisis and the liquidity crisis affected your use of the Federal Home Loan Banks? Last year, HERA expanded the number of community banks that can use collateral to borrow from the FHLBanks. Has your institution's ability to pledge this collateral been helpful?A.1. The FHLBanks have delivered innovation and service to the U.S. housing market for 76 years, and currently have more than 8,100 members in all 50 States and the District of Columbia, American Samoa, Guam, Puerto Rico, and the Northern Mariana and U.S. Virgin Islands. The Federal Home Loan Bank System (FHLBanks) remains viable and strong, despite losses at a number of the Home Loan Banks similar to those incurred by most of the financial services industry due to the economic downturn. Indeed, without the ability by banks and other lenders to borrow from the Federal Home Loan Banks, the credit crisis of the last year would have been significantly worse. From the outset of the credit crisis, the Federal Home Loan Banks have engaged to ensure liquidity to the financial system. Advances to FHLB Member Banks increased from $640,681 billon at year end 2006 to $928,638 billion at year end 2008. This increase of nearly $300 billion in liquidity went, in large part, to community bank members of the Federal Home Loan Banks. Many small banks rely on the System for term advances to meet day to day liquidity demands. Because the System is a cooperative, members have a vested interest in the prudent lending and operations of the Banks. The result is a liquidity source which is transparent and self monitored. Additionally, the recent GSE reform legislation which combined the regulation of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks has led to a more sophisticated, detailed and experienced regulatory regime for the System and its members. ------ CHRG-111shrg56376--56 Chairman Dodd," Thank you. Senator Tester. Senator Tester. Thank you, Mr. Chairman, and I thank the panelists for being here today. An interesting discussion. I think we all agree that the gaps exist. I think we all agree that we still have not sealed those gaps up. And so I guess referring to the testimony from a gentleman on the second panel, a former Comptroller of the Currency, Mr. Ludwig, he writes and, in fact, recommends to ``streamline the current `alphabet soup' of regulators by creating a single world-class financial institution-specific regulator at the Federal level while retaining the dual banking system,'' which is very, very close to what, quite honestly, I have in mind. And he goes on to lay out a system of critiques, and you guys have somewhat addressed this in some of your other questions. But going back to what Senator Menendez asked in that he wanted to know if it could be laid out to seal these gaps by rulemaking or some other method, I am not sure I got an answer to that question. So I want you to share your thoughts as concisely as possible, because each one of you could burn 4 minutes and 50 seconds with one answer if you wanted. As to why significant reform in this direction is not the direction to go, taking off your hat as your individual department leaders--because I know turf does play a role. If somebody said, ``I am going to dissolve your farm,'' I would be a little upset with it. But just tell me how we can get these gaps closed without doing something like this and why this would not be a good idea. Go ahead, Sheila. We will just go down the line. Ms. Bair. Again, I think the issue was not about the choice among bank charters. It was between being a bank or not being a bank and being much less regulated in the nonbanking sphere. I think that is the arbitrage that needs to be addressed. Senator Tester. And what you are saying is that could not be addressed with one---- Ms. Bair. No, it would not, because you would just be consolidating what we all do for insured depository institutions. That would not expand beyond the already heavily regulated sector. Senator Tester. Could it? Ms. Bair. I think with a systemic risk council it could, at least for risks that are systemic in nature. You would be able to give this new systemic risk council--which would also include the SEC and the CFTC--some ability to look across systems and to impose prudential requirements regarding capital and leverage where needed to mitigate systemic risk. And, yes, that would be across all sectors, not just for banks. " fcic_final_report_full--558 Bakersfield, session 2: Local Banking, September 7, 2010, transcript pp. 25, 61. 9. William Martin, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 2: The Impact of the Financial Crisis on Businesses of Nevada, September 8, 2010, transcript, p. 76. 10. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Mar- ket (: Inside Mortgage Finance, 2009), p. 4, “Mortgage Product by Origination.” 11. Data provided to the FCIC by National Association of Realtors: national home price data from sales of existing homes, comparing second-quarter 1998 ($135,800) and second-quarter 2006 ($227,100), the national peak in prices. 12. Core-based statistical area house prices for Sacramento–Arden–Arcade–Roseville CA Metropoli- tan Statistical Area, CoreLogic data. 13. Data provided by CoreLogic, Home Price Index for Urban Areas. FCIC staff calculated house price growth from January 2001 to peak of each market. Prices increased at least 50% in 401 cities, at least 75% in 217 cities, at least 100% in 112 cities, at least 125% in 63 cities, and more than 150% in 16 cities. 14. Updated data provided by James Kennedy and Alan Greenspan, whose data originally appeared in “Sources and Uses of Equity Extracted from Homes,” Finance and Economics Discussion Series, Federal Reserve Board, 2007-20 (March 2007). 15. “Mortgage Originations Rise in First Half of 2005; Demand for Interest Only, Option ARM and Alt-A Products Increases,” Mortgage Bankers Association press release, October 25, 2005. 16. In 2007, the weekly wage of New York investment banker was $16,849; of the average privately employed worker, $841. 17. Federal Reserve Survey of Consumer Finances, tabulated by FCIC. 18. Angelo Mozilo, interview by FCIC, September 24, 2010. 19. Michael Mayo, testimony before the First Public Hearing of the FCIC, day 1, panel 2: Financial Market Participants, January 13, 2010, transcript, p. 114. 20. “Mortgage Originations Rise in First Half of 2005,” MBA press release, October 27, 2005. 21. Yuliya Demyanyk and Yadav K. Gopalan, “Subprime ARMs: Popular Loans, Poor Performance,” Federal Reserve Bank of St. Louis, Bridges (Spring 2007). 22. Ann Fulmer, vice president of Business Relations, Interthinx (session 1: Overview of Mortgage Fraud), and Ellen Wilcox, special agent, Florida Department of Law Enforcement (session 2: Uncovering Mortgage Fraud in Miami), testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Miami, September 21, 2010. 23. Julia Gordon and Michael Calhoun, Center for Responsible Lending, interview by FCIC, Septem- ber 16, 2010. 24. Faith Schwartz, at Consumer Advisory Council meeting, Thursday, March 30, 2006. 25. Federal Reserve Board, “Mean Value of Mortgages or Home-Equity Loans for Families with Hold- ings,” in SCF Chartbook, June 15, 2009, tables updated to February 18, 2010. 26. Christopher Cruise, interview by FCIC, August 24, 2010. 27. Ibid. 28. Robert Kuttner, interview by FCIC, August 5, 2010. 29. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 2: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 146. 30. James Ryan, chief marketing officer at CitiFinancial and John Schachtel, executive vice president of CitiFinancial, interview by FCIC, February 3, 2010. 31. These points were made to the FCIC by consumer advocates: e.g., Kevin Stein, associate director, California Reinvestment Coalition, at the Hearing on the Impact of the Financial Crisis—Sacramento, ses- sion 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, Septem- ber 23, 2010; Gail Burks, president and CEO, Nevada Fair Housing Center, at the Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010. See also Federal Reserve Consumer Advisory Council transcripts, March 25, 2004; June 24, 2004; October 28, 2004; March 17, 2005; October 27, 2005; June 22, 2006; October 26, 2006. 555 32. Bob Gnaizda, interview by FCIC, March 25, 2010. 33. James Rokakis, interview by FCIC, November 8, 2010. 34. Ibid. 35. Fed Governor Edward M. Gramlich, “Tackling Predatory Lending: Regulation and Education,” remarks at Cleveland State University, Cleveland, Ohio, March 23, 2001. 36. Rokakis, interview. 37. John Taylor, chairman and chief executive officer, National Community Reinvestment Coalition, letter to Office of Thrift Supervision, July 3, 2000, provided to the FCIC. 38. Stein, testimony before the FCIC, transcript, pp. 73–74, 71. 39. U.S. Department of the Treasury and U.S Department of Housing and Urban Development, “Joint fcic_final_report_full--424 HOW OUR APPROACH DIFFERS FROM OTHERS’ During the course of the Commission’s hearings and investigations, we heard fre- quent arguments that there was a single cause of the crisis. For some it was interna- tional capital flows or monetary policy; for others, housing policy; and for still others, it was insufficient regulation of an ambiguously defined shadow banking sec- tor, or unregulated over-the-counter derivatives, or the greed of those in the financial sector and the political influence they had in Washington. In each case, these arguments, when used as single-cause explanations, are too simplistic because they are incomplete. While some of these factors were essential contributors to the crisis, each is insufficient as a standalone explanation. The majority’s approach to explaining the crisis suffers from the opposite prob- lem–it is too broad. Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor im- pact. Not every regulatory change related to housing or the financial system prior to the crisis was a cause. The majority’s almost -page report is more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is. As an example, non-credit derivatives did not in any meaningful way cause or contribute to the financial crisis. Neither the Community Reinvestment Act nor re- moval of the Glass-Steagall firewall was a significant cause. The crisis can be ex- plained without resorting to these factors. We also reject as too simplistic the hypothesis that too little regulation caused the crisis, as well as its opposite, that too much regulation caused the crisis. We question this metric for determining the effectiveness of regulation. The amount of financial regulation should reflect the need to address particular failures in the financial sys- tem. For example, high-risk, nontraditional mortgage lending by nonbank lenders flourished in the s and did tremendous damage in an ineffectively regulated en- vironment, contributing to the financial crisis. Poorly designed government housing policies distorted market outcomes and contributed to the creation of unsound mortgages as well. Countrywide’s irresponsible lending and AIG’s failure were in part attributable to ineffective regulation and supervision, while Fannie Mae and Freddie Mac’s failures were the result of policymakers using the power of government to blend public purpose with private gains and then socializing the losses. Both the “too little government” and “too much government” approaches are too broad-brush to explain the crisis. The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis. For example: • A credit bubble appeared in both the United States and Europe. This tells us that our primary explanation for the credit bubble should focus on factors common to both regions. CHRG-111hhrg49968--65 Mr. Bernanke," That is a concern because, given the losses to the banking system, if those losses were made up very quickly, it would be a fairly heavy tax on banks, including community banks. And for that reason, my understanding is the FDIC is trying to arrange to spread that assessment over a longer period of time, which would be, I think, desirable in the sense that this is not a time to be putting sort of a tax, essentially, on the banking system when we need them to be making loans. " CHRG-111hhrg48867--110 Mrs. McCarthy," My question was not American banks, such as Citibank and JPMorgan Chase that are international banks. Obviously we have a huge stake in saving these financial institutions. My question is, should we be bailing out the Bank of Germany, which is owned by the German Government, or a French-owned bank, in their countries? So personally I don't feel that is systemic risk to the American financial system. Maybe we could go down the line and people could give their opinions. To me, I don't believe that, in my opinion, bailing out a French or a German bank poses systemic risk to the financial security, safety, and soundness of financial institutions. If anyone else would like to speak, Mr. Silvers, Mr. Plunkett, Mr. Ryan, Mr. Yingling, I would like to hear your opinion, too. " FOMC20080625meeting--300 298,MR. KOHN.," Thank you, Mr. Chairman. I think I would just like to dig into some of the comments that President Lockhart and President Evans just made, just for a second, take a step back, and ask why we are here having this conversation. I know the timing is because we have this PDCF, but what happened was that the financial markets evolved in such a way that simply having a liquidity backstop for commercial banks was not sufficient to protect the economy from systemic risk. I myself have been very surprised--I will be very open about this--at the persistence, the extent, the depth, and the spread of this crisis and how long it went and what it covered. Every couple of months, I thought it was about to be over, and then another wave would come. I think that we have learned something about the financial system in the process, and we have learned that the regulatory structure and the liquidity provision structure were not sufficient to give the economy the protection it needed from the new style of financial system. That is really the background of why we are here, not just because we made the loan or we set up the facilities because we thought we needed to do so to protect the system under the circumstances. I completely support, Mr. Chairman, your suggested path forward for the near-tointermediate term. I think that is the right way to go. I would say, relative to the two senators that I testified in front of last week, that they were very supportive of the memorandum of understanding between the Fed and the SEC and particularly supportive of the efforts that the Federal Reserve Bank of New York and the other regulators are leading to strengthen the infrastructure of the OTC derivatives markets. We didn't get into tri-party repos, fortunately. But I'm sure they would have been supportive of that, too. I think everybody has raised very good questions about where, in this new financial system, you draw the boundaries. What do you need to do? There are no easy answers here, and I look forward to coming back to this. My going-in position is that our liquidity facilities outside of commercial banks ought to be available in systemic circumstances, not in just any circumstances, and they ought to be available at this point to just broker-dealers or investment banks. I would hesitate to get outside that realm. Those guys are already regulated, and so what we're talking about is strengthening the regulation. I think that we can strengthen the core of the system to make it resilient to things happening outside, but I am not totally dug in on that. So I look forward to more discussion. It is going to be very hard to draw the line and make it credible. I agree, partly this will be defining what we mean by ""systemic,"" but I don't think we will ever really get to the point of having a bright line around that. It will always need a great amount of judgment, combined with--as you said, Mr. Chairman--a process by which you make that decision, to help limit the moral hazard. Crises are always difficult. You get into a crisis, and the near-term costs are much more palpable than the long-term costs that might be there. So it is always hard to say ""no."" We have said ""no"" in the past on certain circumstances. Drexel is the obvious example. Markets were a little stressed. There was a little disorder. It was fine, but it was a very different circumstance. I think that completes my remarks. Thank you, Mr. Chairman. " FOMC20080130meeting--417 415,MR. PETERS.," I would say we've looked at a lot of that. The one place I would highlight most articulately is the degree of international coordination and cooperation we've had under way. The core firms in the United States are one portion of this system now, with a number of very significant global competitors. So the coordination between us, the OCC, the SEC, the U.K. FSA, and the other senior supervisor groups has been really necessary for everyone to get a good understanding of practices. It's perhaps more valuable to some of the foreign supervisors who have only one or two large firms under their jurisdictions. But even from our vantage point of what our direct supervisory responsibility is, the consolidation within the industry has collapsed the number of firms that we view directly. " CHRG-111shrg53085--211 PREPARED STATEMENT OF RICHARD CHRISTOPHER WHALEN Senior Vice President and Managing Director, Institutional Risk Analytics March 24, 2009 Chairman Dodd, Senator Shelby, and Members of the Committee, My name is Christopher Whalen and I live in the State of New York. \1\ Thank you for requesting my testimony today regarding ``Modernizing Bank Supervision and Regulation.''--------------------------------------------------------------------------- \1\ Mr. Whalen is a co-founder of Institutional Risk Analytics, a Los Angeles unit of Lord, Whalen LLC that publishes risk ratings and provides customized financial analysis and valuation tools.--------------------------------------------------------------------------- Before I address the areas that you have specified, let me suggest some broad themes and questions for further investigation, questions which I believe the Committee should consider before diving into the detail of actual legislative changes to current law and regulation. Simply stated, we need to do some basic diligence about our financial institutions, our markets and our economy, both generally and with respect to the present financial crisis, before we can attack the task of remaking the current supervision and regulation of financial institutions.Financial Institutions Structure What is a financial institution in terms of the reality today in the marketplace vs. the stated intent of law and regulation? What tasks do financial institutions perform that actually require public regulation? What tasks do not? What activities should be permitted for federally insured depositories? What capital is required to support these regulated activities in a safe and sound manner? How much capital must an insured depository institution have in order for (a) markets and (b) the public to have confidence in that institution's ability to function? Are regulatory measures even meaningful to the public today? How do regulatory regimes such as fair-value accounting and Basel II, and market-driven measures such as EBITDA or tangible common equity (``TCE''), affect the real and perceived need for more capital in financial institutions? Is the marketplace a better arbiter of capital adequacy, particularly from a public interest perspective, than the private internal bank models and equally inconsistent, nonpublic regulatory process enshrined in the Basel II accord?Financial Market Structure What is ``systemic risk?'' Is systemic risk a symptom of other risk factors or an independent risk measure in and of itself? If the latter, how is it measured? \2\--------------------------------------------------------------------------- \2\ My personal view is that systemic risk is a political concept akin to fear and not something measurable via scientific methods. See also ``What Is To Be Done With Credit Default Swaps?'' American Enterprise Institute, February 23, 2009. See: http://www.rcwhalen.com/pdf/cds_aei.pdf. How do government policies either increase or decrease systemic risk? For example, has the growth of Over-the-Counter (``OTC'') market structures increased perceived systemic risk hurt investors and negatively affected the safety and soundness --------------------------------------------------------------------------- of financial markets? Does the fact of cash settlement for credit default contracts increase system leverage and therefore risk? Does the rescue of AIG illustrate how OTC cash settlement credit default contracts multiply the systemic risk of a given cash market credit basis? \3\--------------------------------------------------------------------------- \3\ In classical terms, a legal contract recognized as such under common law requires the exchange of value between parties, but a credit default swap (``CDS'') fails this test. Instead, a CDS is better viewed as a ``barrier option'' in insurance industry terms or a gaming instrument like the New York Lottery. Because the buyer of protection does not need to deliver the underlying asset to collect the insurance payment, the parties may settle in cash and there is no limit on the number of open positions written against this basis--save the collateral requirements for such positions, if any. Because the effective collateral posted by dealers of CDS heretofore was low compared to effective end-user collateral requirements, the dealer leverage in the system was almost infinite and thus the systemic risk increased by an order of magnitude. In economic terms, CDS equates renters with owners, risk is increased and regulation is rendered at best irrelevant. Should the Congress mandate SEC registration for all investment instruments that are eligible for investment by smaller banks, insurers, pensions and public agencies? Should the Congress place limits on the ability of securities dealers to sell complex OTC structured assets and derivatives to relatively unsophisticated ``end users'' such as pension funds, --------------------------------------------------------------------------- public agencies and insurance companies? Should the Congress place an effective, absolute limit on size and complexity of banks? What measures ought to be used to gauge market share?Political Economy Does the inability of the Congress to govern its spending behavior and the related monetary policy accommodation by the Federal Reserve Board add to systemic risk for global financial institutions and markets? Does the fact of twin budget and current account deficits by the U.S. add to the market/liquidity risk facing all global financial institutions? That is, is the heavily indebted U.S. economy unstable and thus an engine for creating systemic events?Prudential Regulation Our Nation's Founders tended to favor competition over monopoly, inefficiency and conflict, in the form of checks and balances, over efficiency and short-run practicality. The challenge for the national Congress remains, as it always has been, reconciling the need to be more efficient to achieve current public policy goals while remaining true to the legacy of deliberate inefficiency given to us by the framers of the Constitution. Or to put it another way, the Founders addressed the systemic risk of popular rule by placing deliberately mechanical, inefficient checks and balances in our path. Similar checks are present in any well managed government or enterprise to prevent bad outcomes. In Sarbanes-Oxley risk terms, this is what we call ``systems and controls.'' For example, when the House of Representatives, reflecting current popular anger and indignation, passes tax legislation encouraging the cancelation of state law contracts and the effective confiscating of monies lawfully paid to executives at AIG, it falls to the Senate to withhold its support for the action by the lower chamber and instead counsel a more deliberate approach to advancing the public interest. For example, were the Senate to put aside the House-passed measure and instead pass legislation that forces the Fed and Treasury push AIG into bankruptcy to forestall further public subsidies for this apparently insolvent company, the U.S. Trustee for the Federal Bankruptcy Court arguably could seek to recover the bonuses paid to executives. The Bankruptcy Trustee might also be able to recover the tens of billions of dollars in payments to counterparties such as Goldman Sachs (NYSE:GS), which has so far reportedly received $20 billion in public funds paid and pledged. One might argue that the immediate bankruptcy of AIG is now in the best interest of the public because it provides the only effective way to (a) claw-back bonuses and counterparty payments, and (b) end further subsidies for this insolvent corporation. \4\--------------------------------------------------------------------------- \4\ For a discussion of the true purposes of the AIG rescue by the Fed, See Morgenson, Gretchen, ``A.I.G.'s bailout priorities are in critics' cross hairs,'' The New York Times, March 17, 2009. Also, it must be noted that analysts in the risk management community such as Tim Freestone identified possible instability in the AIG business as early as 2001. AIG threatened to sue Freestone when he published his findings, which were documented at the time by the Economist magazine. Notables such as Henry Kissinger questioned the Economist story and said ``I just want you to know that Hank Greenberg has more integrity than any person I have ever known in my life.''--------------------------------------------------------------------------- In my view, it serves the public interest to have multiple regulators sitting at the table in terms of managing what might be called ``systemic risk,'' including both state and federal regulators. In the same way that the federal government has forced a cooperative relationship between local, state and federal law enforcement when it comes to anti-terrorism efforts, so too the Congress should end the competition between federal and state regulators illustrated by the legal battle over state-law preemption and instead mandate cooperation. In areas from prudential regulation to consumer protection, why cannot the federal government mandate broad standards to achieve policy objectives, then empower/compel state and federal agencies to cooperate in making these goals a reality? What makes no sense about the current system of regulation is having the various federal and state regulators compete amongst themselves over shared portions of the different components of risk as viewed from a public policy perspective, including market and liquidity risk, safety and soundness, and regulatory enforcement and consumer protection. Were I to have the opportunity to rearrange the map of the U.S. regulatory system, here is how I would divide the areas of responsibility: Seen from the perspective of the public, the risks facing the financial system can be divided into three large areas: (a) market and liquidity risk management, (b) regulatory enforcement and consumer protection, and (c) deposit insurance and the resolution of insolvent institutions. Each area has implications for systemic stability. Let me briefly comment on each of these buckets and the agencies I believe should be tasked with responsibility for these areas in a restructured U.S. regulatory system.Market and Liquidity Risk As the bank of issue and the provider of credit to the financial system, the Fed must clearly be given the lead with respect to providing market and liquidity risk management, and general market oversight and surveillance. The Fed's chief area of competency is in the area of monetary policy and financial market supervision. But I strongly urge the Congress to strip the Fed of its current, direct responsibility for financial institution supervision and consumer protection to help the agency better focus on its monetary and economic policy responsibilities, as well as an enhanced market surveillance effort. The United States needs a single safety-and-soundness regulator for all financial institutions, even if they retain diversity in terms of charters and activities. Consider that no other major industrial nation in the world gives its central bank paramount responsibility for bank safety and soundness, and for good reason. Over the past decade, the Fed has demonstrated an inability to manage the internal conflict between its role as monetary authority and its partial responsibility for supervising bank holding companies and their subsidiary banks. While some people claim that the Glass-Steagall Act law dividing banking and commerce has been repealed, I remind you that the Bank Holding Company Act of 1956 is still extant. I urge the Congress to delete this statute in its entirety as part of any new financial services legislation. Indeed, given the size of the capital deficit facing the larger players in the banking industry, AIG, and the GSEs, it seems inevitable that the Congress will be compelled to allow industrial companies to enter the U.S. banking sector. \5\--------------------------------------------------------------------------- \5\ The subsidies for the GSEs, AIG, and Citigroup amounts to a transfer of wealth from American taxpayers to the institutional investors who hold the bonds and derivative obligations tied to these zombie institutions. All of these companies will require continuing cash subsidies if they are not resolved in bankruptcy. My firm estimates that the maximum probable loss for the top U.S. banks with assets above $10 billion, also known as Economic Capital, will be $1.7 trillion through the cycle, of which $1.4 trillion is attributable to the top four money center banks. With the operating loss subsidy required for the GSEs and AIG, the U.S. Treasury could face a collective, worst-case funding requirement of $4 trillion through the cycle.--------------------------------------------------------------------------- The Fed's internal culture, in my view, is dominated by academic economists whose primary focus is monetary policy and who view bank supervision as a troublesome, secondary task. The Fed economists to whom I particularly refer believe that markets are efficient, that investors are rational, and that encouraging products such as subprime securitizations and OTC derivative contracts are consistent with bank safety and soundness. The same Fed economists believe that big is better in the banking industry, even though the overwhelming data and statistical evidence suggests otherwise. \6\--------------------------------------------------------------------------- \6\ Given the magnitude of the losses incurred over the past several years due to financial innovation, it is worth asking if economists or at least those economists involved in the securities industry and financial economics more generally should be licensed and regulated in some way. Several observers have suggested that rating agencies ought to be compelled to publish models used for rating OTC structured asset, thus it seems reasonable to ask economists and analysts to stand behind their work when it is used to create securities. For an excellent discussion of the misuse of mathematics and other quantitative tools expropriated from the physical sciences by economists, regulators, and investment professionals, see ``New Hope for Financial Economics: Interview with Bill Janeway,'' The Institutional Risk Analyst, November 17, 2008.--------------------------------------------------------------------------- Critics of the Fed are right to say that under Alan Greenspan, the central helped cause the subprime mortgage debacle, but not for the reasons most people think. Yes, the expansive monetary policy followed by the Fed earlier this decade was a big factor, but equally important was the active encouragement by Fed staff and other global regulators of over-the-counter derivatives and the use by banks of off-balance-sheet vehicles such as collateralized debt obligations (``CDOs'') for liability management. \7\--------------------------------------------------------------------------- \7\ I recommend that the Committee study Martin Mayer's 2001 book, ``The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets,'' particularly Chapter 13, ``Supervisions,'' on the Fed's role in bank regulation.--------------------------------------------------------------------------- The combination of OTC derivatives, risk-based capital requirements championed by the Fed and authorized by Congress, and favorable accounting rules for off-balance sheet vehicles blessed by the SEC and the FASB, enabled Wall Street to create a de facto assembly line for purchasing, packaging, and selling unregistered, high-risk securities, such as subprime collateralized CDOs, to a wide variety of institutional investors around the world. These illiquid, opaque securities now threaten the solvency of banks in the United States, Europe, and Asia. Observers describe the literally thousands of structured investment vehicles created during the past decade as the ``shadow banking system.'' But few appreciate that this deliberately opaque, unregulated market came into existence and grew with the direct approval and encouragement of the Fed's leadership and the academic research community from which many Fed officials are drawn to this day. For every economist nominated to the Fed Board, the Senate should insist on a noneconomist candidate! Simply stated, in my view monetary economists are not competent to supervise financial institutions nor to set policy for regulating these institutions, yet successive Presidents and Congresses have populated the Fed's board with precisely such skilled professionals. While the more conservative bank supervision personnel at the 12 regional Federal Reserve banks and within agencies such as the OCC, OTS, and FDIC often opposed ill-considered liberalization efforts such as OTC derivatives and the abortive Basel II accord, the Fed's powerful, isolated Washington staff of academic economists almost always had its way--and the Congress supported and encouraged the Fed even as that agency's policies undermined the safety and soundness of our financial markets. The result of our overly generous tolerance for economist dabbling in the real world of banking and finance is a marketplace where some of the largest U.S. banks are in danger of insolvency, because their balance sheets are laden with illiquid, opaque and thus toxic OTC instruments that nobody can value or trade--instruments which the academic economists who populate the Fed actively encouraged for many years. Remember that comments by Fed officials made over the years to the Congress lauding these very same OTC cash and derivative instruments are a matter of public record. Given the Fed's manifest failure to put bank safety and soundness first, I believe that the Congress needs to rethink the role of the Fed and reject any proposal to give the Fed more authority to supervise investment banks and hedge funds, for example, not to mention the latest economist policy infatuation, ``systemic risk.'' We can place considerable blame on the Fed for the subprime crisis, but it must be said that an equally important factor was the tendency of Congress to use financial regulatory and housing policy to raise money and win elections. Members of Congress in both parties have freely used the threat of new regulation to extort contributions from the banking and other financial industries, often with little pretense as to their true agenda. Likewise, the Congress has been generous in providing with new loopholes and opportunities for regulatory arbitrage, enabling the very unsafe and unsound practices in terms of mortgage lending, securitization and the derivatives markets that has pushed the global economy into a deflationary spiral. Let us never forget that the subprime housing bubble that began the present crisis came about with the active support of the Congress, two different political administrations, the GSEs, the mortgage, real estate, banking, securities and homebuilding industries, and many other state and local organizations. It should also be recalled that the 1991 amendment to the Federal Reserve Act which allowed the Fed of New York to make the ill-advised bailout loans to AIG and other companies was added to the FDICIA legislation in the eleventh hour, with no debate, by members of this Committee and at the behest of officials of the Federal Reserve. The FDICIA legislation, let's recall, was intended to protect the taxpayer from loss due to bailouts for large financial institutions. \8\--------------------------------------------------------------------------- \8\ When the amendment to Section 13 of the FRA was adopted by the Senate, Fed Vice Chairman Don Kohn, then a senior Federal Reserve Board staffer, reportedly was present and approved the amendment for the Fed, with the knowledge and support of Gerry Corrigan, who was then President of the Federal Reserve Bank of New York and Vice Chairman of the FOMC. See also ``IndyMac, FDICIA and the Mirrors of Wall Street,'' The Institutional Risk Analyst, January 6, 2009.---------------------------------------------------------------------------Supervision and Consumer Protection A unified federal supervisor should combine the regulatory resources of the Federal Reserve Banks, SEC, the OCC, and the Office of Thrift Supervision, to create a new safety-and-soundness agency explicitly insulated from meddling by the Executive Branch and the Congress. This agency should be responsible for setting broad federal standards for compliance with law and regulation, capital adequacy and consumer protection, and be accountable to both the Congress and the various states whose people it serves. As I mentioned before, the agency should be tasked to form cooperative alliances with state agencies to secure the objectives in each area of regulation. America has neither the time nor the money for regulatory turf battles. As the Congress assembles the unified federal supervisor, it should include enhanced disclosure by all types of financial services entities, including hedge funds, nonbank mortgage origination firms and insurers, to name a few, so that regulators understand the contribution of these entities to the overall risk to the system, even if there is no actual prudential oversight of these entities at the federal level.Insurance and Resolution The Congress does not need to disturb existing state law regulation on insurance or mortgage origination in order to ensure that the unified federal regulator and FDIC have the power to reorganize or even liquidate the parents of insolvent banks. What is needed is a systemic rule so that all participants know what happens to firms that are mismanaged, take imprudent risks and become insolvent. So long as the Congress fashions a clear, unambiguous systemic rule regarding how and when the FDIC can act as the government's fully empowered receiver to resolve financial market insolvency, the markets will be reassured and the systemic stresses to the system reduced in the process. \9\--------------------------------------------------------------------------- \9\ While the commercial banking industry is required to provide extensive disclosure to the public, insurance companies have long dragged their feet when it comes to providing data to the public at a reasonable cost. Whereas members of the public can access machine-readable financial information about banks from portals such as the FDIC and FFIEC, in real time, comparable data on the U.S. insurance industry is available only from private vendors and at great cost, meaning that the public has no effective, direct way to track the soundness of insurers.--------------------------------------------------------------------------- The primary responsibility for insuring deposits and other liabilities of banks, and resolving troubled banks and their affiliates, should be given to the FDIC. Whereas the unified federal regulator will be responsible for oversight and supervision of all institutions, the FDIC should be given authority to (a) publicly rate all financial institutions via the pricing of liability risk insurance, (b) make the determination of insolvency of an insured depository institution, in consultation with the unified regulator and the Fed, and (c) to reorganize any organization or company that is affiliated with an insolvent insured depository. The cost of membership to the financial services club must be to either maintain the safety and soundness of regulated bank depositories or submit unconditionally to prompt corrective action by the FDIC to quickly resolve the insolvency. The Founders placed a federal mechanism for bankruptcy in the U.S. Constitution for many reasons, but chief among them was the overriding need for finality to help society avoid prolonged damage due to insolvencies. By focusing the FDIC on its role as the insurer of deposits and receiver for failed banks, and expanding its legal authority to restructure affiliates of failed banks, the Congress could solve many of the political and jurisdictional issues that now plague the approach to the financial crisis. By giving the FDIC the primary authority to determine insolvency and the legal tools to restructure an entire organization in or out of formal receivership, situations such as the problems at Citigroup or AIG could more easily be resolved or even avoided. And by ending the doubt and ambiguity as to how insolvency is resolved, an enhanced role for the FDIC would reduce perceived systemic risk. For example, if the FDIC had the legal authority to direct the restructuring of all of the units of Citigroup, the agency could collapse the entire Citigroup organization into a single national bank unit, mark the assets to market, wipe out the common and preferred equity, convert all of the parent company debt into new common equity, and contribute new government equity funds as well. The resulting bank would have 40-50 percent TCE vs. assets and would no longer be a source of systemic risk to the markets. Problem solved. While the FDIC probably has the moral and legal authority to compel Citigroup to restructure along these lines (or face a traditional bank resolution), Congress needs to give the FDIC the power as receiver to make these type of changes unilaterally. In the case of a bankruptcy by AIG, FDIC could play a similar role, managing the insolvency process and assisting as the state insurance regulators take control of the company's insurance units. The remaining company would then be placed into bankruptcy. In addition to giving the FDIC paramount authority as the guardian of safety and soundness and thus a key partner in managing the factors that comprise systemic risk, the Congress should give the FDIC the power to impose a fee on all bank liabilities, including foreign deposits and debt issued by companies that own insured depository institutions. All of the liabilities of a regulated depository must support the Deposit Insurance Fund and the Congress should also modify its market share limitations to include liabilities, not merely deposits, for limiting size and thus the ability of a single institutions to destabilize the global financial system.Systemic Risk Regulation As I stated above, systemic risk is a symptom of other factors, a sort of odd political term spawned under the equally dubious rubric of identifying certain banks as being ``Too Big To Fail.'' When issues such as market structure and prudential regulation of institutions are dealt with adequately, the perceived ``problem'' of systemic risk will disappear. \10\--------------------------------------------------------------------------- \10\ For a discussion of the origins of ``Too Big To Fail,'' see ``Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets,'' The Herbert Gold Society, February 1993.---------------------------------------------------------------------------Consumer Protection and Credit Access I believe that the Congress should give the unified federal regulator primary responsibility for enforcement of consumer protection and credit access laws. That said, however, I believe that the Congress should revisit the issue of federal preemption of state consumer fraud and credit laws. While there is no doubt that the federal government should set consistent regulations for all banks, there is no reason why federal and state agencies cannot cooperate to achieve these ends. The notion that consumer regulation must be an either or proposition is wrong. As this Congress looks to reform the larger regulatory framework, a way must be found to allow for cooperation between state and federal agencies tasked with financial regulation and in all areas, including consumer and enforcement. There is no federal tort law, after all, so if consumers are to have effective redress of grievance for bad acts such as fraud or predatory lending, then the agencies and courts of the various states must be part of the solution.Risk Management In terms of risk management priorities, I believe that the Congress must take steps to resolve the market structure and bank activities problems suggested in the questions at the start of my remarks. Specifically, I believe that the Congress should: Require that all OTC derivatives be traded on organized exchanges, that the terms of most contracts be standardized, and that the exchange act as counterparty to all trades and enforce all margin requirements equally on dealers and end users alike. The notion that merely creating automated clearing solutions for CDS contracts, for example, will address the systemic risk issues is mistaken, in my view. \11\--------------------------------------------------------------------------- \11\ See Pirrong, Craig, ``The Clearinghouse Cure,'' Regulation, Winter 2008-2009. Require that all structured assets such as mortgage securitizations be registered with the SEC. It is worth noting that an affiliate of the NASDAQ currently quotes public prices on all of the covered mortgage bonds traded in Denmark. Such a system could be easily adapted for the U.S. markets and almost overnight create a new legal template for private mortgage --------------------------------------------------------------------------- securitization. In terms of ``originate to distribute'' lending, the covered bond model may be the only means to ``distribute'' mortgage paper for some time to come. The idea currently popular inside the Fed and Treasury that now moribund securitization markets will revive is not even worthy of comment. The key issue for the future of securitizations is whether regulators can craft an explicit recognition of the legacy risk involved in ``good sales.'' It may be that, when actually described accurately, the risks involved in securitization outweigh the economic rewards. In terms of mark-to-market accounting, the fact that markets have focused on bank TCE, which like EBITDA is not a defined accounting term, illustrates the folly of trying to define and thereby constrain the preferences of investors and analysts via accounting rules. Using TCE and CDS as valuation indicators, the market concludes that all large banks are insolvent. This is not just a matter of being ``pro-cyclical'' as is fashionable to say in economist circles, but rather of multiplying the already distorted, ``market efficiency'' perspective on value provided by mark-to-market into a short sellers bonanza. The Chicago School is wrong; short-term price is not equal to value. If you make every financial firm on the planet operate under the same rules as a broker-dealer for market risk positions, then capital levels must rise and leverage ratios for all types of financial disintermediation must fall. Everything will be held to maturity, securitization will become exclusively a government activity and the U.S. economy will stagnate. Mark-to-market implies a net reduction in credit to U.S. consumer and the global economy that is causing and will continue to cause asset price deflation and a related political firestorm. While the changes now proposed by the FASB to mark-to- market accounting may give financial institutions some relief in terms of rules-driven losses, falling cash flows behind many assets classes are likely to force additional losses by banks, insurers and other investors. Finally, regarding credit ratings, I urge the Congress to remove from federal law any language suggesting or compelling a bank, agency or other investor to utilize ratings from a particular agency. There is no public policy good to be gained from creating a government monopoly for rating agencies. The best way to keep the rating agencies honest is to let them compete and be sued when their opinions are tainted by conflicts. \12\--------------------------------------------------------------------------- \12\ See ``Reassessing Ratings: What Went Wrong, and How Can We Fix the Problem?,'' GARP Risk Review, October/November 2008.--------------------------------------------------------------------------- ______ CHRG-111hhrg48867--167 Mr. Silvers," Congressman, I think it is a very good point. You know, Angela Merkel, the Chancellor of Germany, came to Hank Paulson in 2007 and suggested that perhaps we ought to have more regulation of hedge funds. The Bush Administration didn't like that idea and thought that we didn't need more transparency. And then they found themselves in the middle of the night thinking about what to do about Bear Stearns without the very transparency that they could have had when Angela Merkel brought it to them. We are now back facing the G20 meeting coming up where, once again, the proposition is going to be put on the table by Europeans, of all people, that we ought to be more serious about transparency and regulation of shadow markets on a routine basis. And we have the opportunity not to be the drag on that process but to lead. It is not necessary to lead to have a global regulator. A global regulator is a thing that may be far in the future, but it is necessary and quite possible to have coordinated action. And if we don't have coordinated action, poor practices in other countries may leak into our markets, and we may be perceived as being the source of poor practices elsewhere, as we were, say, in Norway when our subprime loans blew up their municipal finance. That challenge is right in front of us, and we can lead. And it ought to be a priority of the Administration, and I am hopeful it will be, to do just that. " CHRG-111hhrg48867--33 The Chairman," Next, Terry Jorde, the president and CEO of CountryBank USA. She is here on behalf of the Independent Community Bankers of America. STATEMENT OF TERRY J. JORDE, PRESIDENT AND CHIEF EXECUTIVE OFFICER, COUNTRYBANK USA, ON BEHALF OF INDEPENDENT COMMUNITY BANKERS OF AMERICA (ICBA) Ms. Jorde. Thank you, Mr. Chairman, Ranking Member Bachus, and members of the committee. My name is Terry Jorde. I am president and CEO of CountryBank USA. I am also immediate past chairman of the Independent Community Bankers of America. My bank is located in Cando, North Dakota, a town of 1,300 people, where the motto is, ``You Can Do better in Cando.'' CountryBank has 28 full-time employees and $45 million in assets. ICBA is pleased to have this opportunity to testify today on regulation of systemic risk in the financial services industry. I must admit to you that I am very frustrated today. I have spent many years warning policymakers of the systemic risk that was being created in our Nation by the unbridled growth of the Nation's largest banks and financial firms. But I was told that I didn't get it, that I didn't understand the new global economy, that I was a protectionist, that I was afraid of competition, and that I needed to get with the modern times. Well, sadly, we now know what the modern times look like, and it isn't pretty. Excessive concentration has led to systemic risk and the credit crisis. Banking and antitrust laws are too narrow to prevent these risks. Antitrust laws are supposed to maintain competitive geographic and product markets. So long as the courts and agencies can discern that there are enough competitors in a particular market, that ends the inquiry. This often prevents local banks from merging, but it does nothing to prevent the creation of giant nationwide franchises. Banking regulation is similar. The agencies ask only if a given merger will enhance the safety and soundness of an individual firm. They generally answer bigger is almost necessarily stronger. A bigger firm can, many said, spread its risk across geographic areas and business lines. No one wondered what would happen if one firm or a group of firms jumped off a cliff and made billions in unsound mortgages. Now we know; our economy is in crisis. The four largest banking companies control more than 40 percent of the Nation's deposits and more than 50 percent of U.S. bank assets. This is not in the public interest. A more diverse financial system would reduce risk and promote competition, innovation, and the availability of credit to consumers of various means and businesses of all sizes. We can prove this. Despite the challenges we face, the community bank segment of the financial system is still working and working well. We are open for business, we are making loans, and we are ready to help all Americans weather these difficult times. But I must report that community bankers are angry. Almost every Monday morning, they wake up to news that the government has bailed out yet another too big to fail institution. On many Saturdays, they hear that the FDIC summarily closed one or two too small to save institutions. And just recently, the FDIC proposed a huge special premium to pay for losses imposed by large institutions. This inequity must end, and only Congress can do it. The current situation will damage community banks and the consumers and small businesses that we serve. What can we do? ICBA recommends the following strong measures: Congress should direct a fully staffed interagency task force to immediately identify systemic risk institutions. They should be put immediately under Federal supervision. The Federal systemic risk agency should impose two fees on these institutions that would compensate the agency for the cost of supervision and capitalize a systemic risk fund comparable to the FDIC. The FDIC should impose a systemic risk premium on any insured bank that is affiliated with a systemic risk firm. The systemic risk regulator should impose higher capital charges to provide a cushion against systemic risk. The Congress should direct the systemic risk regulator and the FDIC to develop procedures to resolve the failure of a systemic risk institution. The Congress should direct the interagency systemic risk task force to order the breakup of systemic risk institutions. Congress should direct the systemic risk regulator to block any merger that would result in the creation of a systemic risk institution. And finally, it should direct the systemic risk regulator to block any financial activity that threatens to impose a systemic risk. The current crisis provides you an opportunity to strengthen our Nation's financial system and economy by taking these important steps. They will protect taxpayers and create a vibrant banking system where small and large institutions are able to fairly compete. ICBA urges Congress to quickly seize this opportunity. Thank you, Mr. Chairman. [The prepared statement of Ms. Jorde can be found on page 91 of the appendix.] " CHRG-110hhrg44900--224 Secretary Paulson," I couldn't agree more. I agree totally. This is an example of regulators coming together to transcend some of the issues in the regulatory system. And again, the emphasis that the Fed and the SEC are placing on the investment banks is one that is different from commercial banks, because the issues here are different and the focus has been more on funding and liquidity. I strongly agree with that, and I have been gratified to see some of the improvements that are resulting. " CHRG-111hhrg48873--349 Secretary Geithner," Well, that is large. The total assets of the banking system are roughly the size of the annual GDP, which is roughly $14 trillion now. So that is too big a number. Global financial assets are much larger than those held by U.S. banks. " fcic_final_report_full--71 Indeed, the regulators, including the Fed, would fail to identify excessive risks and unsound practices building up in nonbank subsidiaries of financial holding compa- nies such as Citigroup and Wachovia.  The convergence of banks and securities firms also undermined the supportive relationship between banking and securities markets that Fed Chairman Greenspan had considered a source of stability. He compared it to a “spare tire”: if large commer- cial banks ran into trouble, their large customers could borrow from investment banks and others in the capital markets; if those markets froze, banks could lend us- ing their deposits. After , securitized mortgage lending provided another source of credit to home buyers and other borrowers that softened a steep decline in lending by thrifts and banks. The system’s resilience following the crisis in Asian financial markets in the late s further proved his point, Greenspan said.  The new regime encouraged growth and consolidation within and across bank- ing, securities, and insurance. The bank-centered financial holding companies such as Citigroup, JP Morgan, and Bank of America could compete directly with the “big five” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became major players in investment banking. The strategies of the largest commercial banks and their holding companies came to more closely re- semble the strategies of investment banks. Each had advantages: commercial banks enjoyed greater access to insured deposits, and the investment banks enjoyed less regulation. Both prospered from the late s until the outbreak of the financial cri- sis in . However, Greenspan’s “spare tire” that had helped make the system less vulnerable would be gone when the financial crisis emerged—all the wheels of the system would be spinning on the same axle. LONG TERM CAPITAL MANAGEMENT: “THAT ’S WHAT HISTORY HAD PROVED TO THEM ” In August , Russia defaulted on part of its national debt, panicking markets. Rus- sia announced it would restructure its debt and postpone some payments. In the af- termath, investors dumped higher-risk securities, including those having nothing to do with Russia, and fled to the safety of U.S. Treasury bills and FDIC-insured de- posits. In response, the Federal Reserve cut short-term interest rates three times in seven weeks.  With the commercial paper market in turmoil, it was up to the com- mercial banks to take up the slack by lending to corporations that could not roll over their short-term paper. Banks loaned  billion in September and October of —about . times the usual amount  —and helped prevent a serious disruption from becoming much worse. The economy avoided a slump. Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had devastating losses on its  billion portfolio of high-risk debt securities, including the junk bonds and emerging market debt that investors were dumping.  To buy these securities, the firm had borrowed  for every  of investors’ equity;  lenders included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy had produced magnificent returns: ., ., ., and ., while the S&P  yielded an average .  FOMC20071211meeting--120 118,CHAIRMAN BERNANKE.," But I think I’m in the camp of those who see a fundamental softening going on here. One indicator is the pattern of final demand. This zigzag pattern has been mostly in a situation with basically about 2 percent growth in final demand but with quarter-to- quarter variation in exports and inventories. We see in this case the opposite. Growth in private domestic final demand is projected by the Greenbook to fall to minus 0.2 percent in the fourth quarter and another minus 0.3 percent in the first quarter of next year. It does seem to have been a step-down in economic growth outside of housing. The other issue is the financial markets, which so many people have commented on. I just note that there are several elements to this. First are the losses and the downgrades that have hit capital. These have been only partially offset by new capital issuances. In particular, we’ve seen about $75 billion in write-downs or losses in the financial sector, of which $45 billion has occurred since our last meeting, at a time when we thought things were clearing up. Criticized loans by our supervisors for the top fifty bank holding companies rose from 26 to 28 percent over the last quarter. So we’re seeing continued losses, and I expect to see that to go forward. The second element of this is the pressure on balance sheets. Banks are taking off-balance-sheet assets onto the balance sheet. An example that Governor Kroszner mentioned is the leveraged-loan market, which was open for a while and now seems to be closed, and securitization markets remain closed. Moreover, and I think this is particularly worrisome going forward, supervisors—and you all, of course, talk to your supervisors—are increasingly concerned about credit quality as it looks likely to evolve. Commercial real estate is one area in which we’ve seen essentially no defaults yet, but these things tend to lag, and there’s a lot of expectation both among bankers and among supervisors of that sector weakening. One indicator of banks’ views is that they have been raising their loan-loss provisions at a rapid rate, $17 billion in the third quarter. It was at a twenty-year high, and we are certainly hearing from, for example, the Federal Advisory Council that they expect credit quality to continue to deteriorate. The result of this is that, although I do not expect insolvency or near insolvency among major financial institutions, they are certainly going to become much more cautious, and I think that will affect their lending behavior and their willingness to extend new credit. As has been pointed out, some of the natural substitutes like the so-called shadow banking system are not really there at this point, and I would also be less sanguine than some about regional and community banks, which face their own problems: lack of securitization outlets and a lot of exposure to commercial real estate. So I do think that we’re going to see some tightening of credit and that it could get worse. Experience suggests that, while financial conditions are always different and the financial structure has changed significantly, credit crunches can have a big effect on the economy. The case that’s been cited the most is the 1991-92 crunch, when the capital losses were pretty limited regionally but, nevertheless, there was a national impact. Another smaller, perhaps less relevant, example is the Carter credit controls in March 1980, which were very small in their aspiration yet somehow managed to create a short recession. So I believe that the financial conditions are going to be a significant drag. It is going to go on for a while. Given the low growth expectations, it could lead us into a negative growth area. I see realistically only one way in which we could avoid a drag from the financial system, which would be if, in fact, we get lucky and the housing market begins to stabilize and there’s a sense that we’ve reached bottom there and house prices are stabilizing. I think that would do a tremendous amount of good for the financial system. It might lead to sufficient improvement as to avoid some of these consequences. You know, I do think that we have to take note of the fact that the two-year government yield is down about 75 basis points in real terms since our last meeting and that five-year bond yields are down about 60 basis points in real terms. That’s certainly a market view on what’s happening to growth expectations, and it’s not terribly inconsistent with some of the figures that come out of the Greenbook calculations. So obviously there are mixed views, but I think it is very hard to argue that both the modal growth forecast and the rest of that output forecast have not shifted adversely. With respect to inflation—again, people made these points as well—it is unfortunate that we do have some instability, some risks there. We saw some stabilization of the dollar over the past six weeks. That is obviously not exogenous. It depends on our behavior and our communication. I think oil prices depend also to some extent on our policy, directly or indirectly. We will be seeing some ugly near-term inflation numbers with oil price increases, which we hope will move out of the data shortly, but we’re not sure. So obviously we have to watch that. I think there are a few things that are slightly helpful on that front. One is that, relative to the previous intermeeting period, there’s more conviction now that other countries may be easing monetary policy. In fact, we’ve seen cuts in Canada and the United Kingdom. I think that takes a bit of the risk away from the dollar. I do not know how big the impact of the national intelligence estimate about Iran will be, but it certainly reduces a bit the geopolitical risk that has been around oil over the past couple of years. But, of course, I agree with Governor Mishkin and many others that, whatever we might be tempted to do in terms of trying to get ahead of the financial conditions and what I fully believe will be ultimately a Main Street problem as well as a Wall Street problem, we need to be highly cognizant—this is not a ritual but an honest statement—of those implications for inflation expectations and the dollar as well. So let me stop there, just adding that I think the situation is very difficult and we need to recognize the uncertainty that we’re facing. I believe that in response we will have to make sure that we are sufficiently flexible, open minded, willing to accept new evidence and new information, and willing to respond actively and quickly when we do get that new information. Let me stop there, and let me now ask for volunteers—oh, sorry—before we do that, Brian will introduce the policy go-round." CHRG-111hhrg52400--12 Chairman Kanjorski," Thank you very much, Mrs. Biggert. And now we will hear from the other lady from Illinois, Ms. Bean, for 3 minutes. Ms. Bean. Thank you, Mr. Chairman. Being from Illinois, I would also like to give a shout out to Mike McRaith, but to all of our witnesses, as well, for joining us today, and sharing your expertise. Until this year, the role of Federal involvement in the insurance industry has centered on whether to establish a Federal insurance regulator. I have worked with Congressman Royce on legislation to establish a Federal regulator for the insurance industry. Last Congress, our bill was focused on consumer choice and protections, advantages for agents, and industry efficiencies. But much has changed in our financial system since the last Congress. The collapse of AIG, the world's largest insurer, has proven to be one of the most costly and dangerous corporate disasters in our Nation's financial history. With nearly $180 billion of Federal tax dollars committed to AIG, plus $22 billion to other insurers, the Federal Government has made an unprecedented investment in an industry over which it has no regulatory authority. The need for Federal regulatory oversight has never been greater. And having a Federal insurance commissioner who can work with the expected systemic risk regulator or council is vital to ensure proper oversight of an important pillar of the U.S. financial system. In April, Congressman Royce and I introduced H.R. 1880, the National Insurance Consumer Protection Act. Unlike previous legislation, our bill deals with systemic risk. Recognizing that Congress will create a systemic risk regulator, it subjects all insurance companies, national or State-chartered, to a systemic risk review. The systemic risk regulator would have the ability to gather financial data from insurers and other financial services affiliates within a holding company structure to monitor for systemic risk. Based on that financial data, the systemic risk regulator can make recommendations to appropriate regulators for corrective regulatory action, including the national insurance commissioner. The activities of an insurance company or companies, an affiliate of an insurance company, like an AIG financial products unit, or any product or service of an insurance company, would have serious adverse affects on economic conditions or financial stability. In this instance, the systemic risk regulator can recommend to the Federal or State insurance regulator that an activity, practice, product, or service must be restricted or prohibited. In instances where a functional regulator refuses to take action, the systemic risk regulator would seek approval to override the functional regulator from a coordinating council of financial regulators established in the bill that consists of the current members of the President's Working Group on Capital Markets, plus the Federal banking regulators, the Federal insurance commissioner, and three State financial regulators from the three sectors: insurance; banking; and securities. Finally, if the systemic risk regulator determines an insurance company is systemically significant, it is required to consult with the national insurance commissioner to determine whether the company should be nationally regulated. I believe all financial activity, including that of insurance companies, should be subject to review by a systemic risk regulator. Some suggest the insurance industry does not pose a systemic risk to the financial system. But we know from our experience at AIG that it did pose a systemic risk, and not just through the Financial Products Division, but through the securities lending program, which was regulated by the State insurance commissioners, and has led to over $40 billion in taxpayer money being invested. As we move forward in the next few months to establish a systemic risk regulator or council, we need to provide this regulatory body with all the tools to properly review and evaluate the activities of insurance companies. That should include a Federal regulator for insurance that can work with a system risk regulator in a similar manner as the OCC and SEC do for their respective regulated industries. Thank you, and I yield back the balance of my time. " CHRG-110hhrg46593--112 Mr. Watt," And how does putting money in a bank that didn't ask for it help to stabilize the banking system? " CHRG-111hhrg51698--50 Mr. Gooch," Yes. I think that there is a danger in doing something drastic with a marketplace that exists now that is very liquid, and has actually functioned very well throughout the credit crisis. I would just like to point out that the taxpayer, in any case, in the United States of America, 50 percent of the country doesn't even pay taxes under Obama's tax plans; and so they are not picking up the tab. During the boom, when things were going very well and profits were being made, the government was taking a 35 percent corporate tax, the government was taking 38 percent, 35 percent taxes on incomes, and 15 percent capital gains. So, during the boom times, the government was taking more than 50 percent of the upside. And when you go through a cycle, which this one happens to be extremely severe, the government needs to then become involved in stepping in and paying their fair share in stabilizing the marketplace. But to step in now and kill the credit derivative market at this point in time where we are very delicately trying to get banks to lend, and they won't lend until they get these bad assets off their balance sheets. All this money that is sitting on the sidelines is willing to sell credit derivatives, which reduces cost of borrowing; and they won't be willing to sell them if they can't buy them naked. You will kill the credit derivative market and, in my opinion, extend the recession, possibly even creating a deeper recession for a very, very long period of time. " CHRG-111shrg49488--54 Mr. Green," There is a so-called tripartite committee which brings together the Bank of England--the central bank--the FSA, and the Treasury, which was intended to look at the functioning of the system as a whole. And the Bank of England had a mandate in relation to the stability of the system as a whole. I think there was insufficient clarity about just what that meant in the original drafting and what that meant in terms of the role of the Bank of England--which, in fact, leaves a bit of a question in my mind in relation to the so-called Paulson Blueprint. The central bank has, as the monetary authority, the capacity to lend and to change monetary policy. But then there is an issue about what other tools does it have? Does it have the capacity then to instruct the regulators to take action on grounds of systemic risk? I think, in fact, in the United Kingdom, the Bank of England did not think that it had that authority. And the way the system worked, the lack of clarity of objectives in retrospect proved a bit of a disadvantage. And the Bank of England spent its time talking about the economy, and the FSA spent its time thinking about the individual firms. And one of the main lessons that has been learnt from the crisis is that the regulator needs to think more about what is happening in the wider economy, and the central bank needs to remember that monetary policy only has effect through the financial system. So it is quite a subtle set of links that is difficult to get precisely right. Senator Collins. I think those are excellent points. Mr. Nason, obviously one of the failures of our system was a failure to identify high-risk products that escaped regulation and yet ended up having a cascade of consequences for the entire financial system. And I am thinking in particular of credit default swaps, which in my mind were an insurance product, but they were not regulated as an insurance product. They were not regulated as a securities product. They really were not regulated by anyone. And as long as we have bright financial people, which we always will, we are going to have innovation and the creation of new derivatives, new products. One of my goals is to try to prevent these what I call ``regulatory black holes'' from occurring where a high-risk practice or product can emerge and no one regulator in our system has clear authority over it. Without a council, there is nobody to identify it and figure out who should be regulating it. What are your thoughts on preventing these regulatory gaps? " CHRG-111hhrg56776--10 Mr. Bernanke," The Federal Reserve's involvement in regulation and supervision confers two broad sets of benefits to the country. First, because of its wide range of expertise, the Federal Reserve is uniquely suited to supervise large complex financial organizations and to address both safety and soundness risks and risks to the stability of the financial system as a whole. Second, the Federal Reserve's participation in the oversight of banks of all sizes significantly improves its ability to carry out its central banking functions, including making monetary policy, lending through the discount window, and fostering financial stability. The financial crisis has made it clear that all financial institutions that are so large and interconnected that their failure could threaten the stability of the financial system and the economy must be subject to strong consolidated supervision. Promoting the soundness and safety of individual banking organizations requires the traditional skills of bank supervisors, such as expertise in examination of risk management practices. The Federal Reserve has developed such expertise in its long experience supervising banks of all sizes, including community banks and regional banks. The supervision of large complex financial institutions and the analysis of potential risks to the financial system as a whole requires not only traditional examination skills, but also a number of other forms of expertise, including: macroeconomic analysis and forecasting; insight into sectoral, regional, and global economic developments; knowledge of a range of domestic and international financial markets, including money markets, capital markets, and foreign exchange and derivatives markets; and a close working knowledge of the financial infrastructure, including payment systems and systems for clearing and settlement of financial instruments. In the course of carrying out its central banking duties, the Federal Reserve has developed extensive knowledge and experience in each of these areas critical for effective consolidated supervision. For example, Federal Reserve staff members have expertise in macroeconomic forecasting for the making of monetary policy, which is important for helping to identify economic risks to institutions and to markets. In addition, they acquire in-depth market knowledge through daily participation in financial markets to implement monetary policy and to execute financial transactions on behalf of the U.S. Treasury. Similarly, the Federal Reserve's extensive knowledge of payment and settlement systems has been developed through its operation of some of the world's largest such systems, its supervision of key providers of payment and settlement services, and its long-standing leadership in the International Committee on Payment and Settlement Systems. No other agency can or is likely to be able to replicate the breadth and depth of relevant expertise that the Federal Reserve brings to the supervision of large complex banking organizations and the identification and analysis of systemic risks. Even as the Federal Reserve's central banking functions enhance supervisory expertise, its involvement in supervising banks of all sizes across the country significantly improves the Federal Reserve's ability to effectively carry out its central bank responsibilities. Perhaps most important, as this crisis has once again demonstrated, the Federal Reserve's ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has as both a bank supervisor and a central bank, not only in this crisis, but also in episodes such as the 1987 stock market crash and the terrorist attacks of September 11, 2001. The Federal Reserve's supervisory role was essential for it to contain threats to financial stability. The Federal Reserve making of monetary policy and its management of the discount window also benefit from its supervisory experience. Notably, the Federal Reserve's role as the supervisor of State member banks of all sizes, including community banks, offers insights about conditions and prospects across the full range of financial institutions, not just the very largest, and provides useful information about the economy and financial conditions throughout the Nation. Such information greatly assists in the making of monetary policy. The legislation passed by the House last December would preserve the supervisory authority that the Federal Reserve needs to carry out its central banking functions effectively. The Federal Reserve strongly supports ongoing efforts in the Congress to reform financial regulation and to close existing gaps in the regulatory framework. While we await passage of comprehensive reform legislation, we have been conducting an intensive self-examination of our regulatory and supervisory performance and have been actively implementing improvements. On the regulatory side, we have played a key role in international efforts to ensure that systemically critical financial institutions hold more and higher quality capital, have enough liquidity to survive highly stressed conditions, and meet demanding standards for company wide risk management. We also have been taking the lead in addressing flawed compensation practices by issuing proposed guidance to help ensure that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk-taking. Less formally, but equally important, since 2005, the Federal Reserve has been leading cooperative efforts by market participants and regulators to strengthen the infrastructure of a number of key markets, including the markets for security repurchase agreements and the markets for credit derivatives and other over-the-counter derivative instruments. To improve both our consolidated supervision and our ability to identify potential risks to the financial system, we have made substantial changes to our supervisory framework so that we can better understand the linkages among firms and markets that have the potential to undermine the stability of the financial system. We have adopted a more explicitly multi-disciplinary approach, making use of the Federal Reserve's broad expertise in economics, financial markets, payment systems, and bank supervision, to which I alluded earlier. We are also augmenting our traditional supervisory approach that focuses on firm by firm examinations with greater use of horizontal reviews and to look across a group of firms to identify common sources of risks and best practices for managing those risks. To supplement information from examiners in the field, we are developing an off-site enhanced quantitative surveillance program for large bank holding companies that will use data analysis and formal modeling to help it identify vulnerabilities at both the firm level and for the financial sector as a whole. This analysis will be supported by the collection of more timely detailed and consistent data from regulated firms. Many of these changes draw on the successful experience of the Supervisory Capital Assessment Program (SCAP), also known as the ``banking stress test,'' which the Federal Reserve led last year. As in the SCAP, representatives of primary and functional supervisors will be fully integrated in the process, participating in the planning and execution of horizontal exams and consolidated supervisory activities. Improvements in the supervisory framework will lead to better outcomes only if day-to-day supervision is well executed, with risks identified early and promptly remediated. Our internal reviews have identified a number of directions for improvement. In the future, to facilitate swifter and more effective supervisory responses, the oversight and control of our supervisory function will be more centralized, with shared accountability by senior Board and Reserve Bank supervisory staff and active oversight by the Board of Governors. Supervisory concerns will be communicated to firms promptly and at a high level, with more frequent involvement of senior bank managers and boards of directors and senior Federal Reserve officials. Greater involvement of senior Federal Reserve officials and strong systematic follow-through will facilitate more vigorous remediation by firms. Where necessary, we will increase the use of formal and informal enforcement actions to ensure prompt and effective remediation of serious issues. In summary, the Federal Reserve's wide range of expertise makes it uniquely suited to supervise large complex financial institutions and to help identify risks to the financial system as a whole. Moreover, the insights provided by our role in supervising a range of banks, including community banks, significantly increases our effectiveness in making monetary policy and fostering financial stability. While we await enactment of comprehensive financial reform legislation, we have undertaken an intensive self-examination of our regulatory and supervisory performance. We are strengthening regulations and overhauling our supervisory framework to improve consolidated supervision as well as our ability to identify potential threats to the stability of the financial system. We are taking steps to strengthen the oversight and effectiveness of our supervisory activities. Thank you, and I would be pleased to respond to questions. [The prepared statement of Chairman Bernanke can be found on page 66 of the appendix.] " CHRG-111hhrg56241--96 Mr. Stiglitz," Exactly, for those that represent a risk to our systemic system. But that may be broader than just the big banks. " CHRG-111hhrg51698--300 Mr. Masters," Chairman Peterson and Members of the Committee, thank you for the opportunity to appear before you to discuss this critical piece of legislation. As we witnessed in the last 18 months, what happens on Wall Street can have a huge impact on the average American. There are three critical elements that must be part of any effective regulatory framework. First, transparency. Effective regulation requires complete market transparency. In recent years, the big Wall Street banks have preferred to operate in dark markets where regulators are unable to see what is occurring. This limited transparency has enabled them to take on massive amounts of off-balance-sheet leverage, creating what amounts to a shadow financial system. Regulators cannot regulate if they cannot see the whole picture. Given the speed with which financial markets move, this transparency must be available on a real-time basis. The best way to bring transparency to over-the-counter (OTC) transactions is to make it mandatory for all OTC transactions to clear through an exchange. For that reason, I am very glad to see the sections of this bill that call for exchange clearing. This is a critical prerequisite for effective, regulatory oversight. The second thing that regulators must do is eliminate systemic risk. A lack of transparency was one of the primary factors in the recent financial meltdown. The other primary factor was the liquidity crisis brought on by excessive leverage at the major financial institutions. One of the most dangerous things about OTC derivatives is that they offer virtually unlimited leverage, since typically no margin is required. This is one of the reasons that Warren Buffett famously called them financial weapons of mass destruction. By mandating that OTC transactions clear through an exchange, your bill provides for the exchange to become the counterparty to all transactions. Since the exchange requires the posting of substantial margin, the risk to the financial system as a whole is nearly eliminated. When sufficient margin is posted on a daily basis, then potential losses are greatly contained and will prevent a domino effect from occurring. I do not know the specifics of the clearinghouse that ICE and the major swaps dealers are working to establish, but I would encourage policymakers to look very closely at the amount of margin the swaps dealers were required to post on their trades. If there is a substantial difference between what ICE requires and what CME Group requires, then swaps dealers, in a quest for maximum leverage will flock to the clearing exchange that has the lowest margin requirements. This is exactly opposite of what regulators and policymakers would want to see. The stronger the margin requirements, the greater will be the mitigation of systemic risk. The weaker the margin requirements, the greater chance we face of another systemic meltdown. The third thing that regulators must do is eliminate excessive speculation. Speculative position limits are necessary to eliminate excessive speculation and protect us from price bubbles. In commodities, if they had been in place across all commodity derivatives markets, then we would not have seen last year's spike and crash in commodities prices. The fairest and best way to regulate the commodities derivatives market is to subject all participants to the same regulations and speculative position limits, no matter where they trade. Every speculator should be regulated equally. The over-the-counter markets are dramatically larger than the futures exchanges. If speculative position limits are not imposed on all OTC commodity derivatives, it would be like locking one's doors to prevent a robbery, while leaving the windows wide open. This bill needs to include aggregate speculative position limits. If it does not, there is nothing protecting your constituents from another, more damaging bubble in food and prices. Once OTC commodity derivatives are cleared through an exchange, regulators will be able to easily see every trader's position; and the application of speculative limits will be just as simple for over-the-counter as it is for futures exchanges today. In summary, we have now witnessed how damaging unbridled financial innovation can be. The implosion on Wall Street has destroyed trillions of dollars in retirement savings and has required trillions of dollars in taxpayer money. Fifteen years ago, before the proliferation of OTC derivatives and before regulators become enamored with deregulation, the financial markets stood on a much firmer foundation. It is hard to look back and say that we are better off today than we were then. I think it is clear to everyone in America that this grand experiment, rather than delivering on its great promise, has in fact turned out to be a great disaster. Thank you. [The prepared statement of Mr. Masters follows:] Prepared Statement of Michael W. Masters, Founder and Managing Member/ Portfolio Manager, Masters Capital Management, LLC, St. Croix, U.S. VI Chairman Peterson and Members of the Committee, thank you for the opportunity to appear before you today to discuss this critical piece of legislation. As we have witnessed in the last 18 months, what happens on Wall Street can have a huge impact on Main Street. The implosion of Wall Street has destroyed trillions of dollars in retirement savings, has required trillions of dollars in taxpayer money to rescue the system, has cost our economy millions of jobs, and the devastating aftershocks are still being felt. Worst of all, this crisis was completely avoidable. It can be characterized as nothing less than a complete regulatory failure. The Federal Reserve permitted an alternative, off-balance sheet financial system to form, which allowed money center banks to take on extreme amounts of risky leverage, far beyond the limits of what your typical bank could incur. The Securities and Exchange Commission allowed investment banks to take on the same massive amount of leverage and missed many instances of fraud and abuse, most notably the $50 billion Madoff Ponzi scheme. The Commodities Futures Trading Commission allowed an excessive speculation bubble to occur in commodities that cost Americans more than $110 billion in artificially inflated food and energy prices, which in turn amplified and deepened the housing and banking crises.\1\--------------------------------------------------------------------------- \1\ See our newly released report entitled ``The 2008 Commodities Bubble: Assessing the Damage to the United States and Its Citizens.'' Available at www.accidentalhuntbrothers.com.--------------------------------------------------------------------------- Congress appeared oblivious to the impending storm, relying on regulators who, in turn, relied on Wall Street to alert them to any problems. According to the Center for Responsive Politics ``the financial sector is far and away the biggest source of campaign contributions to Federal candidates and parties, with insurance companies, securities and investment firms, real estate interests and commercial banks providing the bulk of that money.'' \2\ Clearly, Wall Street was pleased with the return on their investment, as regulation after regulation was softened or removed.--------------------------------------------------------------------------- \2\ ``Finance/Insurance/Real Estate: Background,'' OpenSecrets.org, Center for Responsive Politics, July 2, 2007. http://www.opensecrets.org/industries/background.php?cycle=2008&ind=F.--------------------------------------------------------------------------- So I thank you today, Mr. Chairman and Members of this Committee for your courageous stand and your desire to re-regulate Wall Street and put the genie back in the bottle once and for all. I share your desire to focus on solutions and ways that we can work together to ensure that this never happens again. I have included with my written testimony a copy of a report that I am releasing, along with my co-author Adam White, which provides additional evidence and analysis relating to the commodities bubble we experienced in 2008, and the devastating impact it has had on our economy (electronic copies can be downloaded at www.accidentalhuntbrothers.com). I would be happy to take questions on the report, but I want to honor your request to speak specifically on this piece of legislation that you are proposing. I believe that the Derivatives Markets Transparency and Accountability Act of 2009 goes a long way toward rectifying the inherent problems in our current regulatory framework and I commend you for that. While Wall Street will complain that the bill is overreaching, I believe that, on the contrary, there are opportunities to make this bill even stronger in order to achieve the results that this Committee desires. I am not an attorney and I am not an expert on the Commodity Exchange Act, but I can share with you what I see as the critical elements that must be part of any effective regulatory framework, and we can discuss how the aspects of this bill mesh with those critical elements.Transparency Effective regulation requires complete market transparency. Regulators, policymakers, and ultimately the general public must be able to see what is happening in any particular market in order to make informed decisions and in order to carry out their entrusted duties. In recent years, the big Wall Street banks have preferred to operate in dark markets where regulators are unable to fully see what is occurring. This limited transparency has enabled them to take on massive amounts of off-balance-sheet leverage, creating what amounts to a ``shadow financial system.'' Operating in dark markets has also allowed the big Wall Street banks to make markets with wide bid-ask spreads, resulting in outsized financial gains for these banks. When a customer does not know what a fair price is for a transaction, then a swaps dealer can take advantage of informational asymmetry to reap extraordinary profits. Regulators cannot regulate if they cannot see the whole picture. If they are not aware of what is taking place in dark markets, then they cannot do their jobs effectively. Regulators must have complete transparency. Given the speed with which the financial markets move, this transparency, at a minimum, must be available on a daily basis and should ideally be sought on a real-time basis. The American public, which has suffered greatly because of Wall Street's failures, deserves transparency as well. Individuals should be able to see the positions of all the major players in all markets on a delayed basis, similar to the 13-F filing requirements of money managers in the stock market. The best way to bring over-the-counter (OTC) transactions out of the darkness and into the light is to make it mandatory for all OTC transactions to clear through an exchange. Nothing creates transparency better than exchange clearing. All other potential solutions, like self-reporting, are suboptimal for providing necessary real-time information to regulators. For these reasons, I am very glad to see the sections of this bill that call for exchange clearing of all OTC transactions. This is a critical prerequisite for effective regulatory oversight. For that reason, it should be a truly rare exception when any segment of the OTC markets is exempted from exchange clearing requirements. I am further encouraged by sections 3, 4 and 5, which bring transparency to foreign boards of trade and make public reporting of index traders' and swaps dealers' positions a requirement. Lack of transparency was a primary cause of the recent financial system meltdown. Unsure of who owned what, counterparties assumed the worst and were very reluctant to trade with anyone. The aforementioned provisions in this bill will help ensure the necessary transparency to avoid a crisis of confidence like we just experienced. Wall Street would much prefer that the OTC markets remain dark and unregulated. They will push to keep as much of their OTC business as possible from being brought out into the light of exchange clearing. They will argue that we should not make major changes to regulation now that the financial system is so perilously weak. From my perspective this sounds like an intensive care patient that refuses to accept treatment. The system is already on life support. Transparency is the cure that will enable the financial system to recover. Congress must prioritize the health of the financial system and the economy as a whole above the profits of Wall Street. The profits of Wall Street are a pittance when compared with the cost to America from this financial crisis. We must clear all OTC markets through an exchange to ensure that this current crisis does not recur.Systemic Risk Elimination The other primary factor in the meltdown of the financial system was the liquidity crisis, brought on by excessive leverage at the major financial institutions. By mandating that OTC transactions clear through an exchange, the Derivatives Markets Transparency and Accountability Act of 2009 provides for the exchange to become the counterparty to all transactions. Since the exchange requires the posting of substantial margin, the risk to the financial system as a whole is nearly eliminated. When margin is posted on a daily basis, then potential losses are greatly contained and counterparty risk becomes virtually nil. To protect its interests, Wall Street will try to water down these measures. The substantial margin requirements will limit leverage, and limits on leverage, in turn, mean limits on profits, not only for banks, but for traders themselves. Because traders are directly compensated with a fraction of the short-term profits that their trading generates, they have a great deal of incentive to use as much leverage as they can to maximize the size of their trading profits. These incentives also exist for managers and executives, who share in the resulting trading profits. One of the most dangerous things about OTC derivatives is that they offer virtually unlimited leverage, since typically no margin is required. This is one of the reasons that Warren Buffet famously called them ``financial weapons of mass destruction.'' This extreme over-leveraging is essentially what brought down AIG, which at one time was the largest and most respected insurance company in the world. While by law they could not write a standard life insurance contract without allocating proper reserves, they were able, in off-balance-sheet transactions, to write hundreds of billions of dollars worth of credit default swaps and other derivatives without setting aside any significant amount of reserves to cover potential losses. If AIG were clearing its credit default swaps through an exchange requiring substantial margin, it would never have required well over $100 billion dollars in taxpayer money to avoid collapsing. I do not know the specifics of the clearinghouse that the IntercontinentalExchange (ICE) and the major swaps dealers are working to establish but I would encourage policymakers to look very closely at the amount of margin that swaps dealers will be required to post on their trades. If there is a substantial difference between what ICE requires and what CME Group requires then swaps dealers, in a quest for maximum leverage, will flock to the clearing exchange that has lower margin requirements. This is exactly opposite of what regulators and policymakers would want to see. The stronger the margin requirements, the greater will be the mitigation of systemic risk. The weaker the margin requirements, the greater chance we face of having to bail out more financial institutions in the future. I strongly urge Congress to resist all pressure from Wall Street to soften any of the provisions of this bill. We must eliminate the ``domino effect'' in order to protect the system as a whole, and exchange clearing combined with substantial margin requirements is the best way to do that.Excessive Speculation Elimination Speculative position limits are necessary in the commodities derivatives markets to eliminate excessive speculation. When there are no limits on speculators, then commodities markets become like capital markets, and commodity price bubbles can result. If adequate and effective speculative position limits had been in place across commodity derivatives markets, then it is likely we would not have seen the meteoric rise of food and energy prices during the first half of 2008, nor the ensuing crash in prices when the bubble burst. The fairest and best way to regulate the commodities derivatives markets is to subject all participants to the same regulations and speculative position limits regardless of whether they trade on a regulated futures exchange, a foreign board of trade, or in the over-the-counter markets. Every speculator should be regulated equally. If you do not, then you create incentives that will directly favor one trading venue over another. The over-the-counter (OTC) markets are dramatically larger than the futures exchanges. If speculative position limits are not imposed on all OTC commodity derivatives then there is a gaping hole that speculators can exploit. It would be like locking one's doors to prevent a robbery, while leaving one's windows wide open. The best solution is to place a speculative position limit that applies in aggregate across all trading venues. Once OTC commodity derivatives are cleared through an exchange, regulators will be able to see every trader's positions and the application of speculative limits will be just as simple for OTC as it is for futures exchanges today. This type of aggregate speculative position limit is also better than placing individual limits on each venue. For example, placing a 1,000 contract limit on ICE, a 1,000 contract limit on NYMEX and a 1 million barrel (1,000 contract equivalent) limit in the OTC markets will incentivize a trader to spread their trading around to three or more venues, whereas with an aggregate speculative position limit, they can trade in whichever venue fits their needs the best, up to a clear maximum. I applaud the provisions of your bill that call for the creation of a panel of physical commodity producers and consumers to advise the CFTC on the level of position limits. I believe it affirms three fundamental truths about the commodities derivatives markets: (1) these markets exist for no other purpose than to allow physical commodity producers and consumers to hedge their price risk; (2) the price discovery function is strengthened and made efficient by the trading of the physical hedgers and it is weakened by excessive speculation; and (3) speculators should only be allowed to participate to the extent that they provide enough liquidity to keep the markets functioning properly. Physical commodity producers and consumers can be trusted more than the exchanges or even the CFTC to set position limits at the lowest levels possible while still ensuring sufficient liquidity. I understand the legal problem with making this panel's decisions binding upon the CFTC. Still, I hope it is clear that this panel's recommendations should be taken very seriously, and if the CFTC chooses to not implement the recommendations they should be required to give an account for that decision. I further believe that the exchanges and speculators should not be part of the panel because they will always favor eliminating or greatly increasing the limits. CME and ICE may perhaps oppose speculative position limits in general out of a fear that it will hurt their trading volumes and ultimately their profits, but I believe this view is shortsighted. If CME, ICE and OTC markets are all regulated the same, with the same speculative position limits, then trading business will migrate away from the OTC markets and back to the exchanges, because OTC markets will no longer offer an advantage over the exchanges. I am glad that this bill gives the CFTC the legal authority to impose speculative position limits in the OTC markets, but I openly question whether or not the CFTC will exercise that authority. Like the rest of our current financial market regulators, they have been steeped in deregulation ideology. While I hope that our new Administration will bring new leadership and direction to the CFTC, I fear that there will be resistance to change. When Congress passed the Commodity Futures Modernization Act of 2000, they brought about the deregulation that has fostered excessive speculation in commodities derivatives trading. Now Congress must make it clear that they consider excessive speculation in the commodities derivatives markets to be a serious problem in all trading venues. Congress must make it clear to the CFTC that they have an affirmative obligation to regulate, and that a critical part of that is the imposition and enforcement of aggregate position limits to prevent excessive speculation.Summary We have now witnessed how damaging unbridled financial innovation can be. Wherever there is growing innovation there must also be growing regulation. Substantial regulation is needed now just to catch up with the developments on Wall Street over the last fifteen years. This bill is ambitious in its scope and its desire to re-regulate the financial markets, and for that I am encouraged. These drastic times call for bold steps, and I am pleased to support your bill. My sincere wish is that it be strengthened and not weakened by adding a provision for aggregate speculative position limits that covers all speculators in all markets equally. Fifteen years ago, before the proliferation of over-the-counter derivatives and before regulators became enamored with deregulation, the financial markets stood on a much firmer foundation. Today, with all of the financial innovation and the deregulation of the Clinton and Bush years, it is hard to look back and say that the financial markets are better off than they were 15 years ago. I think it is clear to everyone in America that this grand experiment, rather than delivering on its great promise has, in fact, turned out to be a great disaster. Attachment[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] " fcic_final_report_full--187 The OTS approved Countrywide’s application for a thrift charter on March , . LEVERAGED LOANS AND COMMERCIAL REAL ESTATE: “YOU ’VE GOT TO GET UP AND DANCE ” The credit bubble was not confined to the residential mortgage market. The markets for commercial real estate and leveraged loans (typically loans to below-investment- grade companies to aid their business or to finance buyouts) also experienced similar bubble-and-bust dynamics, although the effects were not as large and damaging as in residential real estate. From  to , these other two markets grew tremen- dously, spurred by structured finance products—commercial mortgage–backed se- curities and collateralized loan obligations (CLOs), respectively—which were in many ways similar to residential mortgage-backed securities and CDOs. And just as in the residential mortgage market, underwriting standards loosened, even as the cost of borrowing decreased,  and trading in these securities was bolstered by the development of new credit derivatives products.  Historically, leveraged loans had been made by commercial banks; but a market for institutional investors developed and grew in the mid- to late s.  An “agent” bank would originate a package of loans to only one company and then sell or syndi- cate the loans in the package to other banks and large nonbank investors. The pack- age generally included loans with different maturities. Some were short-term lines of credit, which would be syndicated to banks; the rest were longer-term loans syndi- cated to nonbank, institutional investors. Leveraged loan issuance more than dou- bled from  to , but the rapid growth was in the longer-term institutional loans rather than in short-term lending. By , the longer-term leveraged loans rose to  billion, up from  billion in .  Starting in , the longer-term leveraged loans were packaged in CLOs, which were rated according to methodologies similar to those the rating agencies used for CDOs. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The market was less than  billion annually from  to , but then it started grow- ing dramatically. Annual issuance exceeded  billion in  and peaked above  billion in . From  through the third quarter of , more than  of leveraged loans were packaged into CLOs.  As the market for leveraged loans grew, credit became looser and leverage in- creased as well. The deals became larger and costs of borrowing declined. Loans that in  had paid interest of  percentage points over an interbank lending rate were refinanced in early  into loans paying just  percentage points over that same rate. During the peak of the recent leveraged buyout boom, leveraged loans were fre- quently issued with interest-only, “payment-in-kind,” and “covenant-lite” terms.  Payment-in-kind loans allowed borrowers to defer paying interest by issuing new debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan- dard loan covenants that usually require corporate firms to limit their other debts and to maintain minimum levels of cash. Private equity firms, those that specialized in investing directly in companies, found it easier and cheaper to finance their lever- aged buyouts. Just as home prices rose, so too did the prices of the target companies. One of the largest deals ever made involving leveraged loans was announced on April , , by KKR, a private equity firm. KKR said it intended to purchase First Data Corporation, a processor of electronic data including credit and debit card pay- ments, for about  billion. As part of this transaction, KKR would issue  billion in junk bonds and take out another  billion in leveraged loans from a consortium of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities, Lehman Brothers, and Merrill Lynch.  CHRG-111hhrg55814--193 Secretary Geithner," Well again, the way financial panics work, is that viable institutions face the risk they lose their funding and therefore, have to collapse. That's what financial panic did to define the second half of the 19th Century, the first quarter of this century, help produce the Great Depression, led the Congress, this government to act in the Great Depression to set up some protections for that. What we didn't do is extend those protections to institutions that are very much like banks. Again, the alternative approach, which we would not support, is to say, the taxpayer would be there in the front of the line absorbing the cost of that failure. That, we think, is not necessary and would be a mistake. " FOMC20081216meeting--238 236,MS. DUKE.," Thank you, Mr. Chairman. Yesterday I talked about the income statement of the banks. I would like to talk a bit about the balance sheets now. Up to this point, for the small and medium-sized community banks, it has been pretty much business as usual. But now even those banks are finding it increasingly difficult to lend. Community banks and regional banks are trying, but it is tough. Funding is tight and expensive. It costs 3� percent to keep a CD and 4 percent and up to attract one. The smaller banks are especially bitter about pricing against Citi and those nonbanks that have recently converted to bank holding company and thrift holding company charters. For a bank to qualify for TARP funding, the examiners are raising the bar on noncore funding. One bank reported a meeting with both the OCC and the Fed in which the OCC criticized, and the Fed defended, the bank's use of the discount window. Examiners are raising the bar on capital: 12 is the new 10 on risk-based capital. Borrowers are not in nearly as good shape as they were. The best credits are choosing not to borrow, and they are adjusting their plans so that they get through on their own cash flow. So the requests coming into the banks are more and more likely to be desperation requests--loans to cover operating losses or to meet payroll. Cracks are appearing in C&I loans. Some banks are exiting loans to entire industries, especially auto dealers, marine and construction trades, and retail. The performance of commercial real estate, especially retail properties, is deteriorating. Hospitality is falling off rapidly, and office buildings are expected to be next. Apartments are still okay, and all of this is in addition to problems with construction loans. Lower mortgage rates are helping refinance, but it is not the best time of the year to judge what it is going to happen with purchase activity. There are still issues with jumbos, with down payments, and with requirements for very high credit scores. As we have talked here, it occurs to me that perhaps the traditional tools of monetary policy are all directed at bank credit, and the strongest nontraditional tools that we have are addressed more to the securitization markets--the TALF and the purchase of GSEs. In this instance, most of the problems are not really caused by a cutback in bank lending but a complete collapse of the securitization markets, and so that is why these tools may be more necessary. I asked questions also about the TARP capital and got different reactions. Several bankers said that they didn't need it, they were scared off by the ability of the Congress to change the terms at any time, and they had elected not to take it. Some took it because they thought they could leverage it into good business. Some took it as cheap insurance. Some took it to be in a position to acquire in what they see as the necessary weeding out of weaker players, and they think that should happen sooner rather than later. Several complained about delays in providing terms for smaller banks. Every single bank was adamant about the evils of mark-tomarket accounting and other-than-temporary impairment. There is a big diversion between market losses and credit losses, so that leads to bankers who are afraid to buy securities because they are worried about further marks as the markets go down. But they are also unwilling to sell securities because they don't believe that the current market price adequately reflects the potential credit losses. There is some speculation that the mark-to-market losses will absorb all of the TARP capital that was just injected, and I think that is something we might want to calculate as fourth-quarter reports come out. Then, the next big writedown is on servicing portfolios as lower rates spur refinancing activities. Thank you, Mr. Chairman. " FinancialCrisisReport--58 When Washington Mutual began securitizing its loans, it was dependent upon investment banks to help underwrite and sell its securitizations. In order to have greater control of the securitization process and to keep securitization underwriting fees in house, rather than paying them to investment banks, WaMu acquired a company able to handle securitizations and renamed it Washington Mutual Capital Corporation (WCC), which became a wholly owned subsidiary of the bank. 123 WCC was a registered broker-dealer and began to act as an underwriter of WaMu and Long Beach securitizations. 124 WCC worked with two other bank subsidiaries, Washington Mutual Mortgage Securities Corp. and Washington Mutual Asset Acceptance Corp., that provided warehousing for WaMu loans before they were securitized. WCC helped to assemble RMBS pools and sell the resulting RMBS securities to investors. At first it worked with other investment banks; later it became the sole underwriter of some WaMu securitizations. WCC was initially based in Seattle with 30 to 40 employees. 125 In 2004, it moved its headquarters to Manhattan. 126 At the height of WCC operations, right before the collapse of the securitization market, WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago, with the majority of its personnel in New York. 127 WCC closed its doors in December 2007, after the securitization markets collapsed. (5) Overview of WaMu’s Rise and Fall Washington Mutual Bank (WaMu) was a wholly owned subsidiary of its parent holding company, Washington Mutual Inc. 128 From 1996 to 2002, WaMu acquired over a dozen other financial institutions, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach, expanding to become the nation’s largest thrift and sixth largest bank. WaMu also became one of the largest issuers of home loans in the country. Washington Mutual kept a portion of those loans for its own investment portfolio, and sold the rest either to Wall Street investors, usually after securitizing them, or to Fannie Mae or Freddie Mac. From 2000 to 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, representing more than a quarter of its loan production during those years. 123 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13-47c. 124 Prepared statement of David Beck, April 13, 2010 Subcommittee Hearing at 2. 125 Subcommittee interview of David Beck (3/2/2010). 126 Id. 127 Id. 128 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001, at 002. Washington Mutual Inc. also owned a second, much smaller thrift, Washington Mutual Bank, FSB. Id. FOMC20080310confcall--89 87,MR. LACKER.," Scott, I'd like you to elaborate a bit on this last part. This was a little confusing. This lending apparently is by the New York Bank. How does it relate to the System Open Market Account? Is it by the New York Bank out of the System Open Market Account? " FOMC20081007confcall--10 8,MR. DUDLEY.," Well, a fair point is that the Federal Reserve cannot by its actions solve the balance sheet constraints of the U.S. banking system. The Federal Reserve by its actions cannot create capital for banks, and that's obviously one of the problems at the core of what is going on in the financial system. " CHRG-111shrg54675--41 Mr. Skillern," I would concur with the bankers that, in general, the small banks are well regulated by both their State and primary regulators. I would also disagree, though, that the Federal regulators have done their job well currently. Countrywide, Washington Mutual are both regulated by the OTS. Their subprime predatory lending harmed consumers and collapsed their banks. Wachovia, a national bank regulated by the OCC, crashed itself on exotic mortgage lending. The Federal Reserve has failed to enforce its rules. I am currently in a fight with the OCC to enforce the rules on Santa Barbara Bank and Trust around their refund anticipation loan loss. It is just not happening. So the Federal regulators have lost credibility on their willingness and ability to enforce the existing consumer laws. I do believe that a separate agency with that focus brings standardization of how those rules are applied, can expand it to those agencies that are not covered, and hopefully try to reduce the seemingly conflict of interest that the existing Federal regulators have of enforcing consumer laws. Senator Crapo. Thank you. My time is up. Thank you, Mr. Chairman. " CHRG-111hhrg51698--223 Mr. Slocum," I am not discussing likes and dislikes. I am talking about an unprecedented rise and then collapse of crude oil prices; where any analyst examining it could see a wide disconnect between supply-demand fundamentals. When you have prices rise that quickly, demand does not collapse overnight. There were no new massive oil fields that appeared. This collapse in oil prices was directly the result of the inability of financial players who were betting on these markets---- " CHRG-111shrg51290--63 PREPARED STATEMENT OF PATRICIA A. McCOY George J. and Helen M. England Professor of Law University of Connecticut School of Law March 3, 2009 Chairman Dodd and Members of the Committee: Thank you for inviting me here today to discuss the problem of restructuring the financial regulatory system. I applaud the Committee for exploring bold new approaches to financial regulation on the scale needed to address our nation's economic challenges. In my remarks today, I propose transferring consumer protection responsibilities in the area of consumer credit from Federal banking regulators to a single, dedicated agency whose sole mission is consumer protection. This step is essential for three reasons. First, during the housing bubble, our current system of fragmented regulation drove lenders to shop for the easiest legal regime. Second, the ability of lenders to switch charters put pressure on banking regulators--both State and Federal--to relax credit standards. Finally, banking regulators have routinely sacrificed consumer protection for short-term profitability of banks. Creating one, dedicated consumer credit regulator charged with consumer protection would establish uniform standards and enforcement for all lenders and help eliminate another death spiral in lending. Although I examine this issue through the lens of mortgage regulation, my discussion is equally relevant to other forms of consumer credit, such as credit cards and payday lending. The reasons for the breakdown of the home mortgage market and the private-label market for mortgage-backed securities are well known by now. Today, I wish to focus on lax lending standards for residential mortgages, which were a leading cause of today's credit crisis and recession. Our broken system of mortgage finance and the private actors in that system--ranging from mortgage brokers, lenders, and appraisers to the rating agencies and securitizers--bear direct responsibility for this breakdown in standards. There is more to the story, however. In 2006, depository institutions and their affiliates, which were regulated by Federal banking regulators, originated about 54 percent of all higher-priced home loans. In 2007, that percentage rose to 79.6 percent.\1\ In some states, mortgages originated by State banks and thrifts and independent nonbank lenders were regulated under State anti-predatory lending laws. In other states, however, mortgages were not subject to meaningful regulation at all. Consequently, the credit crisis resulted from regulatory failure as well as broken private risk management. That regulatory failure was not confined to states, moreover, but pervaded Federal banking regulation as well.--------------------------------------------------------------------------- \1\ Robert B. Avery, Kenneth P. Brevoort & Glenn B. Canner, The 2007 HMDA Data, Fed. Res. Bull. A107, A124 (Dec. 2008), available at http://www.federalreserve.gov/pubs/bulletin/2008/pdf/hmda07final.pdf.--------------------------------------------------------------------------- Neither of these phenomena--the collapse in lending criteria and the regulatory failure that accompanied it--was an accident. Rather, they occurred because mortgage originators and regulators became locked in a competitive race to the bottom to relax loan underwriting and risk management. The fragmented U.S. system of financial services regulation exacerbated this race to the bottom by allowing lenders to shop for the easiest regulators and laws. During the housing bubble, consumers could not police originators because too many loan products had hidden risks. As we now know, these risks were ticking time bombs. Lenders did not take reasonable precautions against default because they able to shift that to investors through securitization. Similarly, regulators failed to clamp down on hazardous loans in a myopic attempt to boost the short-term profitability of banks and thrifts. I open by examining why reckless lenders were able to take market share away from good lenders and good products. Next, I describe our fragmented financial regulatory system and how it encouraged lenders to shop for lenient regulators. In part three of my remarks, I document regulatory failure by Federal banking regulators. Finally, I end with a proposal for a separate consumer credit regulator.I. Why Reckless Lenders Were Able To Crowd Out the Good During the housing boom, the residential mortgage market was relatively unconcentrated, with thousands of mortgage originators. Normally, we would expect an unconcentrated market to provide vibrant competition benefiting consumers. To the contrary, however, however, highly risky loan products containing hidden risks--such as hybrid adjustable-rate mortgages (ARMs), interest-only ARMs, and option payment ARMs--gained market share at the expense of safer products such as standard fixed-rate mortgages and FHA-guaranteed loans.\2\--------------------------------------------------------------------------- \2\ A hybrid ARM offers a 2- or 3-year fixed introductory rate followed by a floating rate at the end of the introductory period with substantial increases in the rate and payment (so-called ``2-28'' and ``3-27'' mortgages). Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). An interest-only mortgage allows borrowers to defer principal payments for an initial period. An option payment ARM combines a floating rate feature with a variety of payment options, including the option to pay no principal and less than the interest due every month, for an initial period. Choosing that option results in negative amortization. Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks: Final guidance, 71 Fed. Reg. 58609, 58613 (Oct. 4, 2006).--------------------------------------------------------------------------- These nontraditional mortgages and subprime loans inflicted incalculable harm on borrowers, their neighbors, and ultimately the global economy. As of September 30, 2008, almost 10 percent of U.S. residential mortgages were 1 month past due or more.\3\ By year-end 2008, every sixth borrower owed more than his or her home was worth.\4\ The proliferation of toxic loans was the direct result of the ability to confuse borrowers and to shop for the laxest regulatory regime.\5\--------------------------------------------------------------------------- \3\ See Mortgage Bankers Association, Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey (Dec. 5, 2008), available at www.mbaa.org/NewsandMedia/PressCenter/66626.htm. \4\ Michael Corkery, Mortgage `Cram-Downs' Loom as Foreclosures Mount, Wall St. J., Dec. 31, 2008. \5\ The discussion in this section was drawn, in part, from Patricia A. McCoy, Andrey D. Pavlov, & Susan M. Wachter, Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure,__Conn. L. Rev. __(forthcoming 2009) and Oren Bar-Gill & Elizabeth Warren, Making Credit Safer,__ U. Penn. L. Rev. __ (forthcoming 2009).---------------------------------------------------------------------------A. The Growth in Dangerous Mortgage Products During the housing boom, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs captured a growing part of the market. We can see this from the growth in nonprime mortgages.\6\ Between 2003 and 2005, nonprime loans tripled from 11 percent of all home loans to 33 percent.\7\--------------------------------------------------------------------------- \6\ I use the term ``nonprime'' to refer to subprime loans plus other nontraditional mortgages. Subprime mortgages carry higher interest rates and fees and are designed for borrowers with impaired credit. Nontraditional mortgages encompass a variety of risky mortgage products, including option payment ARMs, interest-only mortgages, and reduced documentation loans. Originally, these nontraditional products were offered primarily in the ``Alt-A'' market to people with near-prime credit scores but intermittent or undocumented income sources. Eventually, interest-only ARMs and reduced documentation loans penetrated the subprime market as well. \7\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. --------------------------------------------------------------------------- If we unpack these numbers, it turns out that hybrid ARMs, interest-only mortgages, and option payment ARMs accounted for a growing share of nonprime loans over this period. Option payment ARMs and interest-only mortgages went from 3 percent of all nonprime originations in 2002 to well over 50 percent by 2005. (See Figure 1). Low- and no-documentation loans increased from 25 percent to slightly over 40 percent of subprime loans over the same period. By 2004 and continuing through 2006, about three-fourths of the loans in subprime securitizations consisted of hybrid ARMs.\8\--------------------------------------------------------------------------- \8\ See generally McCoy, Pavlov & Wachter, supra note 5; FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. --------------------------------------------------------------------------- Figure 1. Growth in Nontraditional Mortgages, 2002-2005\9\--------------------------------------------------------------------------- \9\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. As the product mix of nonprime loans became riskier and riskier, two default indicators for nonprime loans also increased substantially. Loan-to-value ratios went up and so did the percentage of loans with combined loan-to-value ratios of over 80 percent. This occurred even though the credit scores of borrowers with those loans remained relatively unchanged between 2002 and 2006. At the same time, the spreads of rates over the bank cost of capital tightened. To make matters worse, originators layered risk upon risk, with borrowers who were the most at risk obtaining low equity, no-amortization, reduced documentation loans. (See Figure 2). Figure 2. Underwriting Criteria for Adjustable-Rate Mortgages, 2002- 2006 fcic_final_report_full--443 These losses wiped out capital throughout the financial sector. Policymakers were not just dealing with a single insolvent firm that might transmit its failure to others. They were dealing with a scenario in which many large, midsize, and small financial institutions took large losses at roughly the same time. Conclusion: Some financial institutions failed because of a common shock: they made similar failed bets on housing. Unconnected financial firms were failing for the same reason and at roughly the same time because they had the same problem of large housing losses. This common shock meant the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. We examine two frequently debated topics about the events of September . “The government should not have bailed out _____” Some argue that no firm is too big to fail, and that policymakers erred when they “bailed out” Bear Stearns, Fannie and Freddie, AIG, and later Citigroup. In our view, this misses the basic arithmetic of policymaking. Policymakers were presented, for example, with the news that “AIG is about to fail” and counseled that its sudden and disorderly failure might trigger a chain reaction. Given the preceding failures of Fan- nie Mae and Freddie Mac, the Merrill Lynch merger, Lehman’s bankruptcy, and the Reserve Primary Fund breaking the buck, market confidence was on a knife’s edge. A chain reaction could cause a run on the global financial system. They feared not just a run on a bank, but a generalized panic that might crash the entire system–that is, the risk of an event comparable to the Great Depression. For a policymaker, the calculus is simple: if you bail out AIG and you’re wrong, you will have wasted taxpayer money and provoked public outrage. If you don’t bail out AIG and you’re wrong, the global financial system collapses. It should be easy to see why policymakers favored action–there was a chance of being wrong either way, and the costs of being wrong without action were far greater than the costs of being wrong with action. “Bernanke, Geithner, and Paulson should not have chosen to let Lehman fail” This is probably the most frequently discussed element of the financial crisis. To make this case one must argue: • Bernanke, Geithner, and Paulson had a legal and viable option available to them other than Lehman filing bankruptcy. • They knew they had this option, considered it, and rejected it. • They were wrong to do so. • They had a reason for choosing to allow Lehman to fail. CHRG-110hhrg44903--149 Mrs. Maloney," First, I want to welcome all of our witnesses, particularly Tim Geithner from New York. So I have to put that in. Chairman Cox, in your recent op-ed in The Wall Street Journal, you wrote that for financial institutions whose lifeblood is trading, not lending, there is yet no agreement upon apples to apples, comparison of balance sheets and leverage metrics. Regulators must determine whether the different kinds of risks both types of institutions bear within the context of their business models are appropriate for our financial system as a whole. And one of the concerns that I have had that many people have expressed since the collapse of Bear Stearns is that certain entities have become overleveraged. How much is overleveraged? How do you determine to balance that in the future? And as you pointed out in your comments, it is hard to have an apples-to-apples comparison of balance sheets and leverage metrics. Do you think that we need to have a mechanism that allows for an apples-to-apples comparison? And if so, how would you suggest that we do this? Another question connected to this is, as we move forward with reorganization, many of my constituents have expressed concerns of putting too much power into the Federal Reserve, whose primary focus is monetary policy. Will that diminish their ability to be effective on monetary policy and are we putting too much in one area? Thank you. " CHRG-110hhrg46591--47 Mr. Johnson," Thank you, Mr. Chairman. The current state of the U.S. financial regulatory system is a result of an extreme breakdown in confidence by the credit markets in this country and elsewhere so that U.S. regulatory authorities have determined it necessary to practically underwrite the entire process of credit provision to private borrowers. All significant U.S. financial institutions that provide credit have some form of access to Federal Reserve liquidity facilities at this time. All institutional borrowers through the commercial paper market are now supported by the Federal Reserve System. Many of the major institutional players in the U.S. financial system have recently been partially or fully nationalized. While it appears that the Federal Reserve, along with other central banks, have successfully addressed the fear factor regarding access to liquidity, there are lingering fears in the markets about the economic viability of many financial firms due to the poor asset quality of their balance sheets. All of these measures to restore confidence are the result of huge structural and behavioral flaws in the U.S. financial system that led to excessive expansion in subprime mortgage lending and other credit related derivative products. Because these structural problems have encouraged distorted behavior over a long period of time, it will take some time to completely restore confidence in these credit markets. However, over time, as failed financial institutions are resolved through private market mergers or asset acquisitions and government takeovers and restructurings, confidence in the U.S. credit system should be gradually restored. Unfortunately, this will likely be very costly to U.S. taxpayers. Over the longer term, the public, I think, should be very concerned about the implications of the legislative and regulatory efforts to deal with this crisis of confidence. From my perspective, permanent government control over the credit allocation process is economically inefficient and potentially even more unstable. One of the major reasons why excesses developed in housing finance was a failure of Federal regulators to adequately supervise the behavior of bank holding companies. Specifically, the emergence of structured investment vehicles (SIVs), an off-balance sheet innovation by bank holding companies to avoid the capital requirements administered by the Federal Reserve, set in motion a virtual explosion of toxic mortgage financings. While the overall structure of bank capital reserve requirements was sound relative to bank balance sheets, supervisors were simply oblivious to bank exposures off the balance sheet. If bank supervisors could not police the previous and much less pervasive regulatory structure, you can imagine the impossibility of policing a vastly more extensive and complicated structure. Again, while bank capital requirements are reasonably well-designed today, it is supervision that is a problem. The U.S. financial system has been the envy of the world. Its ability to innovate and disburse capital to create wealth in the United States and around the globe is unprecedented. A new book by my colleague, David Smick, entitled, ``The World is Curved,'' documents the astonishing benefits the U.S. financial system has provided in the process of globalization. The book also clearly describes the dangers presented by regulatory and structural weaknesses today. It would be a mistake to roll back the clock on the gains made in U.S. finance over the last several decades. As the current crisis of confidence subsides and stability is restored, U.S. regulators should develop clear transition plans to exit from direct investments in private financial institutions and attempt to roll back extended guarantees to credit markets beyond the U.S. banking system. Successfully supervising the entire U.S. credit allocation process is simply impossible without dramatically contracting the system. More resources and effort should be put into supervision of bank holding companies. Financial regulators should focus on the full transparency of securitization development and clearing systems. Accurate disclosure of risk is the key to effective and sound private sector credit allocation. Reforms following these type principles should help maintain U.S. prominence in global finance and enhance living standards both domestically and internationally. Thank you, Mr. Chairman. [The prepared statement of Mr. Johnson can be found on page 121 of the appendix.] " CHRG-111shrg51290--41 Mr. Bartlett," No. I think both the banks and the other financial institutions create a loyalty to their bank and with customer retention, so I think your proposition of your question is exactly correct. That is not to say that we don't need some more effective regulation to be certain that all of the sides of the bank talk to each other. There were banks that didn't participate in the subprime market because they believed those were bad loans, but their Wall Street affiliates purchased those same bad loans from their competitors so you didn't have the connection between the two, even within the same bank. Senator Shelby. What, Ms. Seidman---- Ms. Seidman. Can I just add that one of the things that we sometimes lose sight of is that there are a lot of different kinds of banks and there are about 8,000 banks that have under a billion dollars in assets. There are Community Development Financial Institution banks, like ShoreBank. And those banks, in general, really did keep contact with their customers, not only their consumer customers, but their small business customers. I do think that one of the things that we need to be a little careful about in this rush to consolidation that we seem to be going through right now is retaining the best of the banking system. Senator Shelby. I hope we will not rush to consolidate all the bank regulatory systems. But I do believe that we need to go down that road and we need to do it right. Senator Dodd alluded to it earlier. We have seen gaps, big gaps out there in the regulation of institutions. We have seen sometimes, and I am going to bring up the Fed again, the Fed is the central bank, supposed to be the lender of last resort. Now it has become the lender of first resort, it seems to me. The big banks that they have regulated, gosh, so many of them are in trouble. So you have to ask from this podium up here, why? Where were they? And so forth. So we have to have, I believe, a comprehensive regulator, and along those same lines, look at AIG. Who were they regulated by basically? Their primary regulator was the New York State Insurance Commission, because under McCarran-Ferguson, there are a lot of things the Fed even to this day doesn't have the power over. It assumed a lot of power over AIG because of systemic risk that Steve talks about. But I believe that whatever we do, we are going to have to be comprehensive and we are going to have to do it right, and I believe we are not going to rush to it, but we are really going to focus on it. We have no other choice. Ms. Seidman. My concern, let me just clarify, is the consolidation of the institutions, of the banking institutions, not the regulatory issue. Senator Shelby. OK. " fcic_final_report_full--44 A basic understanding of these four developments will bring the reader up to speed in grasping where matters stood for the financial system in the year , at the dawn of a decade of promise and peril. COMMERCIAL PAPER AND REPOS: “UNFETTERED MARKETS” For most of the th century, banks and thrifts accepted deposits and loaned that money to home buyers or businesses. Before the Depression, these institutions were vulnerable to runs, when reports or merely rumors that a bank was in trouble spurred depositors to demand their cash. If the run was widespread, the bank might not have enough cash on hand to meet depositors’ demands: runs were common be- fore the Civil War and then occurred in , , , , , and .  To stabilize financial markets, Congress created the Federal Reserve System in , which acted as the lender of last resort to banks. But the creation of the Fed was not enough to avert bank runs and sharp contrac- tions in the financial markets in the s and s. So in  Congress passed the Glass-Steagall Act, which, among other changes, established the Federal Deposit In- surance Corporation. The FDIC insured bank deposits up to ,—an amount that covered the vast majority of deposits at the time; that limit would climb to , by , where it stayed until it was raised to , during the crisis in October . Depositors no longer needed to worry about being first in line at a troubled bank’s door. And if banks were short of cash, they could now borrow from the Federal Re- serve, even when they could borrow nowhere else. The Fed, acting as lender of last re- sort, would ensure that banks would not fail simply from a lack of liquidity. With these backstops in place, Congress restricted banks’ activities to discourage them from taking excessive risks, another move intended to help prevent bank fail- ures, with taxpayer dollars now at risk. Furthermore, Congress let the Federal Reserve cap interest rates that banks and thrifts—also known as savings and loans, or S&Ls— could pay depositors. This rule, known as Regulation Q, was also intended to keep in- stitutions safe by ensuring that competition for deposits did not get out of hand.  The system was stable as long as interest rates remained relatively steady, which they did during the first two decades after World War II. Beginning in the late-s, however, inflation started to increase, pushing up interest rates. For example, the rates that banks paid other banks for overnight loans had rarely exceeded  in the decades before , when it reached . However, thanks to Regulation Q, banks and thrifts were stuck offering roughly less than  on most deposits. Clearly, this was an untenable bind for the depository institutions, which could not compete on the most basic level of the interest rate offered on a deposit. Compete with whom? In the s, Merrill Lynch, Fidelity, Vanguard, and others persuaded consumers and businesses to abandon banks and thrifts for higher returns. These firms—eager to find new businesses, particularly after the Securities and Ex- change Commission (SEC) abolished fixed commissions on stock trades in — created money market mutual funds that invested these depositors’ money in short-term, safe securities such as Treasury bonds and highly rated corporate debt, and the funds paid higher interest rates than banks and thrifts were allowed to pay. The funds functioned like bank accounts, although with a different mechanism: cus- tomers bought shares redeemable daily at a stable value. In , Merrill Lynch in- troduced something even more like a bank account: “cash management accounts” allowed customers to write checks. Other money market mutual funds quickly followed.  CHRG-111hhrg55814--267 Mr. Bowman," Good afternoon, Congressman Moore, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to present the views of the Office of Thrift Supervision on the Financial Stability Improvement Act of 2009. As Acting Director of OTS, I have testified several times about various aspects of financial regulatory reform, including OTS' strong support for maintaining a thrift charter, supervising systemically important financial firms, establishing resolution authority over systemically important financial firms, establishing a strong Financial Services Oversight Council, establishing a Consumer Protection Agency with rule-making authority over all entities offering financial products, and addressing real problems that caused this financial crisis and could cause the next one. I have also testified about OTS' opposition to consolidating bank and thrift regulatory agencies, believing that such an action would not have prevented the current crisis, and that the existence of charter choice was not a cause of the crisis. During this time, I have told OTS employees that based on a review of the Administration's initial proposal, they could take some comfort in assurances that whatever happened, they would be protected, treated fairly, and valued equally with their counterparts at other agencies. After reviewing the draft bill, I can only conclude that this is no longer the case. We know that major changes were made to this portion of the bill recently. Instead of abolishing both OTS and the Office of the Comptroller of the Currency and establishing a new agency called the National Bank Supervisor, the bill would merge the OTS into the OCC. What we do not know is why these changes were made. If Congress concludes that merging agencies would accomplish an important public policy goal, then we believe Congress should build a Federal bank supervisory framework for the 21st Century by establishing a strong, new agency with a name that is recognizable to consumers and accurately reflects its mission. If this bill were to pass as currently drafted, OTS employees would be unfairly singled out and cast under a shadow. The impact of this approach would be particularly onerous for the one third of all OTS employees who are not examiners and who would not work in the OCC's proposed new Division of Thrift Supervision. Instead of having an equal opportunity to obtain a position in the reconstituted agency based on merit and on-the-job performance, they would be folded into current divisions of the OCC. I believe that if all employees had an equal opportunity to compete for positions, then the resulting agency would be more cohesive and would benefit from the most qualified and capable workforce and leadership. It is also critical that the bill include strong protections for all employees of the reconstituted agency, most importantly the same 5-year protection from a reduction in force that is contained in the bill to establish the Consumer Financial Protection Agency. I am concerned that OTS employees could regard the current bill as punitive, and that such an approach would send the wrong signal, not only to the OTS workforce but to all Federal employees about how they would be treated in a similar situation. The timing of such a signal could hardly be worse when a large percentage of Federal employees are nearing retirement age and Federal agencies are redoubling their efforts to attract the workforce of the future to respond to the call of Federal service. In conclusion, Congressman Moore and members of the committee, I strongly urge you to affirm that Congress values the service of all Federal employees and to ensure that this bill would promote a fair, even-handed approach that would result in a harmonious agency with employees hopeful about the future of their agency and their role in it. Thank you, and I would be happy to respond to questions. [The prepared statement of Acting Director Bowman can be found on page 127 of the appendix. ] Mr. Moore of Kansas. Thank you, Mr. Bowman. The Chair next recognizes Commissioner Sullivan for 5 minutes. STATEMENT OF THE HONORABLE THOMAS R. SULLIVAN, INSURANCE COMMISSIONER OF THE STATE OF CONNECTICUT, ON BEHALF OF THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC) " CHRG-111hhrg52406--10 Mr. Royce," Thank you, Mr. Chairman. Well, beyond the problems with bifurcating consumer protection and solvency protection, a fundamental question remains. And that is, would a consumer financial products agency have stopped the issuance of subprime mortgages to consumers or Alt-A mortgages to consumers? I think it is fair to say the regulators we had in place, many of whom were responsible for consumer protection, were assisting in rather than hindering the proliferation of these subprime products, the proliferation of what are now called ``liar loans.'' In fact, it was because of regulators in Congress that these various products came into existence and thrived in the manner that they did. Subprime mortgages came out of CRA regulations, according to a former Fed official. And Fannie Mae and Freddie Mac purchased subprime and Alt-A loans to meet their affordable housing goals set by their regulators and by Congress. They lost $1 trillion doing that. The consumers frequently lost their homes as a result of the collapse of the boom and bust that was thus created. Instead of adding another government agency, and unwisely separating solvency protection from consumer protection, we should take a step back and look at the artificial mandates we place on financial institutions that inevitably distort the market which ends up in the long-term walloping the consumer and creating the kind of housing problem that we have today. Thank you, and I yield back, Mr. Chairman. " FinancialCrisisReport--633 The Dodd-Frank Act contains two conflict of interest prohibitions to restore the ethical bar against investment banks and other financial institutions profiting at the expense of their clients. The first is a broad prohibition that applies in any circumstances in which a firm trades for its own account, as explained above. 2845 The second, in Section 621, imposes a specific, explicit prohibition on any firm that underwrites, sponsors, or acts as a placement agent for an asset backed security, including a synthetic asset backed security, from engaging in a transaction “that would involve or result in any material conflict of interest” with an investor in that security. 2846 Together, these two prohibitions, if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis. Study of Banking Activities. Section 620 of the Dodd-Frank Act directs banking regulators to review what types of banking activities are currently allowed under federal and state law, submit a report to Congress and the Financial Stability Oversight Council on those activities, and offer recommendations to restrict activities that are inappropriate or may have a negative effect on the safety and soundness of a banking entity or the U.S. financial system. This study could evaluate, for example, the use of complex structured finance products that are difficult to understand, have little or no track record on performance, and encourage investors to bet on the failure rather than the success of financial instruments. Structured Finance Guidance. In connection with provisions in the Dodd-Frank Act related to approval of new products and standards of business conduct, 2847 the banking agencies, SEC, and CFTC may update and strengthen existing guidance on new structured finance products. In 2004, after the collapse of the Enron Corporation, the banking regulators and SEC proposed joint guidance to prevent abusive structured finance transactions. 2848 This guidance, which was not finalized until January 2007, was issued in a much weaker form. 2849 The final guidance eliminated, for example, warnings against structured finance products that facilitate deceptive accounting, circumvention of regulatory or financial reporting requirements, or tax evasion, as well as detailed guidance on the roles that should be played by a financial institution's board of directors, senior management, and legal counsel in approving new products and on the documentation they should assemble. (2) Recommendations To prevent investment bank abuses and protect the U.S. financial system from future financial crises, this Report makes the following recommendations. 2845 Section 621 of the Dodd-Frank Act (creating a new § 27B(a) in the Securities Act of 1933). 2846 Id. at § 621. 2847 Section 717 and Title IX of the Dodd-Frank Act. 2848 “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities,” 69 Fed. Reg. 97 (5/19/2004). 2849 “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities,” 72 Fed. Reg. 7 (1/11/2007) (issued by the Office of the Comptroller of the Currency; Office of Thrift Supervision; Federal Reserve System; Federal Deposit Insurance Corporation; and Securities and Exchange Commission). 1. Review Structured Finance Transactions. Federal regulators should review the RMBS, CDO, CDS, and ABX activities described in this Report to identify any violations of law and to examine ways to strengthen existing regulatory prohibitions against abusive practices involving structured finance products. 2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on proprietary trading under Section 619, any exceptions to that ban, such as for market- making or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk. 3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the conflict of interest prohibitions in Sections 619 and 621 should consider the types of conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6) of this Report. 4. Study Bank Use of Structured Finance. Regulators conducting the banking activities study under Section 620 should consider the role of federally insured banks in designing, marketing, and investing in structured finance products with risks that cannot be reliably measured and naked credit default swaps or synthetic financial instruments. # # # CHRG-110hhrg46593--28 Mr. Bachus," Thank you, Mr. Chairman. You have just been told, if you don't give assistance or lend to folks, you will be waxed. It is sort of a continuation of what we have been hearing since the 1970's by Federal policy and the GSEs, is, lend and meet the needs of folks and assist them. I think, as a result of that, the financial system and the economy has been waxed by lending to people who weren't creditworthy. And I hope--and I appreciate that your intergovernment statement stressed creditworthy borrowers. Secretary Paulson, I very much appreciate something that you did in your opening statement. I think you distinguished between the economy and the financial system, because people did question some of the actions by saying, well, the economy is strong. But the financial system, chaos or distress there will affect the economy. It has that effect. I think we have heard good news here. There is stability returning to the financial system. And I think the good news is, just like the instability in the financial system affected the economy, going forward, and it may take a while to do, but the stability that has returned to the system will in the long term strengthen the economy. I think that is good news for all of us. The TARP program, the capital purchase program, all of them had as a design two things. One was restoring the stability to the financial markets. And I think that we are well on our way to achieving that. And as you said, you don't get credit for something that you avoid, and that would be a collapse of the financial system. The second objective was to strengthen the economy by restoring lending to companies and borrowers. And on that score, it hasn't worked as well. Would you comment on, do you think we are on the right track in restoring lending? " CHRG-111shrg55117--25 Mr. Bernanke," If you are referring, Senator, to the fund or the cost of resolving failing financially systemically critical firms, my understanding of the proposal is that assessments would be based on noninsured liabilities. So in principle, any bank holding company or almost any financial company might be subject to assessments to help pay for an intervention when a large systemically critical firm is failing. However, small banks, small community banks, most of their liabilities are insured, their deposits, for example. And so the portion of their liabilities which would be subject to an assessment would be relatively small. So I would imagine that the bulk of the costs would be borne by larger banks, and indeed, you could make the costs progressive and put a heavier weight on the assets or liabilities of larger firms. So I do think that is an important issue and I do think it would be appropriate for larger more systemically critical firms to bear their fair share, obviously, of the costs of resolving any systemically critical firm. Senator Johnson. There has been speculation in recent weeks about the effectiveness of the economic stimulus package that was enacted in February and if enough has been done at the Federal level to bolster our economy. In your judgment, is the stimulus package mitigating some of the effects of the economic crisis, and are there additional fiscal policy responses that Congress can take to help the current economic situation? " fcic_final_report_full--245 EARLY 2007: SPREADING SUBPRIME WORRIES CONTENTS Goldman: “Let’s be aggressive distributing things” .............................................  Bear Stearns’s hedge funds: “Looks pretty damn ugly” .......................................  Rating agencies: “It can’t be . . . all of a sudden” .................................................  AIG: “Well bigger than we ever planned for” ....................................................  Over the course of , the collapse of the housing bubble and the abrupt shutdown of subprime lending led to losses for many financial institutions, runs on money mar- ket funds, tighter credit, and higher interest rates. Unemployment remained rela- tively steady, hovering just below . until the end of the year, and oil prices rose dramatically. By the middle of , home prices had declined almost  from their peak in . Early evidence of the coming storm was the . drop in November  of the ABX Index—a Dow Jones–like index for credit default swaps on BBB- tranches of mortgage-backed securities issued in the first half of .  That drop came after Moody’s and S&P put on negative watch selected tranches in one deal backed by mortgages from one originator: Fremont Investment & Loan.  In December, the same index fell another  after the mortgage companies Ownit Mortgage Solutions and Sebring Capital ceased operations. Senior risk officers of the five largest investment banks told the Securities and Exchange Commission that they expected to see further subprime lender failures in . “There is a broad recogni- tion that, with the refinancing and real estate booms over, the business model of many of the smaller subprime originators is no longer viable,” SEC analysts told Di- rector Erik Sirri in a January , , memorandum.  That became more and more evident. In January, Mortgage Lenders Network an- nounced it had stopped funding mortgages and accepting applications. In February, New Century reported bigger-than-expected mortgage credit losses and HSBC, the largest subprime lender in the United States, announced a . billion increase in its quarterly provision for losses. In March, Fremont stopped originating subprime loans after receiving a cease and desist order from the Federal Deposit Insurance Corporation. In April, New Century filed for bankruptcy.  CHRG-111hhrg54869--38 Mr. Volcker," Two relevant questions. On the first question, I am not recommending anything particularly different so far as banks are concerned that already have lender of last resort, they already have deposit insurance, and we have some history of intervening with Federal Reserve money or government money in the case of failure of very large banking institutions. So that I take is a given. And that is common around the world. There isn't a developed country that doesn't have a similar system to protect banks because banks are, I think, the backbone of the system. Now it is also true in the United States the relevant importance of banks has declined in terms of giving credit because more of the credit creation has been going into securities, which is the province of the capital market. What is different is the situation has changed where some of the benefits anyway, the safety net, has been extended outside the banking system. That is what I want to change. But you can't change it just by saying it is not going to happen because you are going to have problems. You have to develop some other possibilities and arrangements to minimize the chances of a crisis. So that is what we are proposing. " CHRG-111shrg61651--119 Mr. Johnson," Senator, we also have to remember that the ``too big to fail'' is a form of implicit subsidy from the taxpayer, which lowers the cost of funding for these derivative transactions. So one reason the massive banks were able to dominate this market is because they are viewed by the credit markets themselves as too big to fail. That gives them an unfair advantage that enables them to scale up and create even more risk for the taxpayer. The Bank of England financial stability people are calling this entire structure a ``doom loop'' because it is a repeated cycle of boom, bust, bailout, and we are just running through this again. Senator Reed. We have talked about interrelatedness, and I think that is a theme that everyone agrees to. But, Mr. Johnson, in terms of derivative trading, to what extent is that a key factor in this interrelatedness? I know there is no magic one thing, but it strikes me, given the notional size of derivative trading, given the fact that it inherently is staking your future to somebody else's future, would be one of the key drivers in some of these interrelated issues we have. " CHRG-111shrg56376--142 Mr. Carnell," Mr. Chairman and Members of the Committee, our current bank regulatory structure is and remains a source of serious problems. Its defects are significant and longstanding. The system is needlessly complex, needlessly expensive, and imposes needless compliance burdens on banks. It impedes--it blunts regulators' accountability with a tangled web of overlapping jurisdictions and responsibilities, and it gives credence to the old saying, when everyone is responsible, no one is responsible. The system wastes time, wastes energy. It hinders timely action by regulators. It brings policy down to the lowest common denominator that four agencies can agree on. And it takes a particular toll on far-sighted action, action aimed at preventing future problems. That is because so often in policymaking, there is someone who says, if it ain't broke, don't fix it. So it is a lot easier to get agreement when you wait until you are confronted with a problem than when you are trying to look ahead and head off problems to begin with. Now, there is a straightforward solution to the problems we see from our fragmented regulatory system, and that solution is to unify the supervision of FDIC-insured depository institutions, banks and thrifts, in a single agency. Treasury Department Lloyd Bentsen offered that solution here in this room 15 years ago and it made sense at the time. I worked with him in preparing that proposal, and I think the events of the last 15 years bear out the wisdom of that approach. This new agency would take on the existing bank regulatory responsibilities of the OCC, OTS, Federal Reserve, and FDIC. The Federal Reserve would retain all its existing central banking functions, including monetary policy, the discount window, and the payment system. The FDIC would retain all its deposit insurance powers and responsibilities, including back-up examination and enforcement authority. On top of that, under the approach I propose, the Fed and the FDIC would be on the board of the new agency, let us say a five- or seven-member board with those two agencies represented. The Fed and FDIC could have their examiners participate in examinations conducted by the new agency, and they would have full access to supervisory information. So the Fed and FDIC would get all the information they get now and their examiners could be part of teams in all FDIC-insured banks, which is more access than they customarily enjoy now. This straightforward structure would be a major improvement over the current fragmented structure. It would promote clarity, efficiency, accountability, and timely action. Equally important, it would give the bank regulator greater independence from special interest pressure. That is, this new agency would regulate the full spectrum of FDIC-insured institutions. There wouldn't be the sort of subspecialization category like we see with thrift institutions. Now, if you look at the thrift debacle, for example, you see that thrift regulation was better when it was done by agencies that had a broad jurisdiction than when it was done by specialized thrift-only regulators. So, for example, at the Federal level, we had thrifts regulated by both the FDIC, which regulated the traditional savings banks, and we had thrifts regulated by the specialized Federal Home Loan Bank Board. FDIC-regulated thrifts were much less likely to fail and, if they did fail, caused smaller losses than the Home Loan Bank Board-regulate thrifts, and we see the same thing at the State level. At the State level, in about two-thirds, three-quarters of the States, the State Banking Commissioners supervise thrifts, and in those States, the losses to the insurance fund were much lower than we saw in States with specialized thrift regulators, and that is basically because the thrift regulators had no reason for being if there wasn't a thrift industry, and so they looked for every way to keep thrift institutions going, even when, in fact, it was unrealistic at that point. The result was a failure to deal effectively with troubled thrifts, much larger losses to the Deposit Insurance Fund. A unified structure would have another major advantage. It would recognize the reality of how banking organizations actually operate, and Dr. Baily already touched on this, as well. Under the existing system, each agency looks at only part of the organization. But in these organizations, you may, in fact, have the various parts doing business with each other extensively, and to evaluate risk, you need to look at the whole, think about the whole, and it sure helps in doing that to be responsible for the whole. So the fragmented system hinders the agency from getting the full picture. Here is how Secretary Bentsen described the problem. Under our current system, any one regulator may see only a limited piece of a dynamic, integrated banking organization when a larger perspective is crucial, both for effective supervision of the particular organization and for an understanding of broader industry conditions and interests. Mr. Chairman, if I could, I wanted to speak a bit to the question of holding company regulation, which came up earlier. First, I want to note something that may not be widely appreciated, and that is that holding companies as a major subject of regulation, that thing is unique to the United States. In other countries, the regulation focuses on the bank. Regulators look out, reach out, but it is not like we have got people devoting their careers to the Bank Holding Company Act. And here is what two of the leading experts, Pauline Heller and Melanie Fein, say. Bank holding companies have no inherent necessity in a banking system. They developed in the United States only because of our unique banking laws which historically limited geographic location and activities of banks. Their only material purpose has been to serve as vehicles for getting into things banks couldn't get into directly. So this puts it into perspective. There is nothing magical. There is nothing high priestly about bank holding company regulation. There is no need for a separate holding company regulator. A bank regulator can fully handle all the functions of a holding company regulator, policing the banks' transactions with the banks and looking at overall risk. In conclusion, Secretary Bentsen, speaking from this table in 1994, underscored the risk of continuing to rely on what he called ``a dilapidated regulatory system that is ill-defined to prevent future banking crises and ill-equipped to cope with crises when they occur.'' He observed in words eerily applicable to the present that our country had just emerged from its worst financial crisis since the Great Depression, a crisis that our bank regulatory system did not adequately anticipate or resolve. And he issued this warning, which we would yet do well to heed. If we fail to fix the system now, the next financial crisis we face will again reveal its flaws, and who suffers then? Our banking industry, our economy, and potentially the taxpayers. You have the chance to help prevent that result. Thank you, Mr. Chairman. " CHRG-111shrg52619--18 INSURANCE CORPORATION Ms. Bair. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, thank you for the opportunity to testify today. Our current regulatory system has clearly failed in many ways to manage risk properly and to provide market stability. While it is true that there are regulatory gaps which need to be plugged, U.S. regulators already have broad powers to supervise financial institutions. We also have the authority to limit many of the activities that undermined our financial system. The plain truth is that many of the systemically significant companies that have needed unprecedented Federal help were already subject to extensive Federal oversight. Thus, the failure to use existing authorities by regulators casts doubt on whether simply entrusting power in a new systemic risk regulator would be enough. I believe the way to reduce systemic risk is by addressing the size, complexity, and concentration of our financial institutions. In short, we need to end ``too big to fail.'' We need to create regulatory and economic disincentives for systemically important financial firms. For example, we need to impose higher capital requirements on them in recognition of their systemic importance to make sure they have adequate capital buffers in times of stress. We need greater market discipline by creating a clear, legal mechanism for resolving large institutions in an orderly manner that is similar to the one for FDIC-insured banks. The ad hoc response to the current crisis is due in large part to the lack of a legal framework for taking over an entire complex financial organization. As we saw with Lehman Brothers, bankruptcy is a very poor way to resolve large, complex financial organizations. We need a special process that is outside bankruptcy, just as we have for commercial banks and thrifts. To protect taxpayers, a new resolution regime should be funded by fees charged to systemically important firms and would apply to any institution that puts the system at risk. These fees could be imposed on a sliding scale, so the greater the risk the higher the fee. In a new regime, rules and responsibility must be clearly spelled out to prevent conflicts of interest. For example, Congress gave the FDIC back-up supervisory authority and the power to self-appoint as receiver when banks get into trouble. Congress did this to ensure that the entity resolving a bank has the power to effectively exercise its authority even if there is disagreement with the primary supervisor. As Congress has determined for the FDIC, any new resolution authority should also be independent of any new systemic risk regulator. The FDIC's current authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets is a good starting point for designing a new resolution regime. There should be a clearly defined priority structure for settling claims depending on the type of firm. Any resolution should be required to minimize losses to the public. And the claims process should follow an established priority list. Also, no single Government entity should have the power to deviate from the new regime. It should include checks and balances that are similar to the systemic risk exception for the least cost test that now applies to FDIC-insured institutions. Finally, the resolution entity should have the kinds of powers the FDIC has to deal with such things as executive compensation. When we take over a bank, we have the power to hire and fire. We typically get rid of the top executives and the managers who caused the problem. We can terminate compensation agreements, including bonuses. We do whatever it takes to hold down costs. These types of authorities should apply to any institution that gets taken over by the Government. Finally, there can no longer be any doubt about the link between protecting consumers from abusive products and practices and the safety and soundness of America's financial system. It is absolutely essential that we set uniform standards for financial products. It should not matter who the seller is, be it a bank or nonbank. We also need to make sure that whichever Federal agency is overseeing consumer protection, it has the ability to fully leverage the expertise and resources accumulated by the Federal banking agencies. To be effective, consumer policy must be closely coordinated and reflect a deep understanding of financial institutions and the dynamic nature of the industry as a whole. The benefits of capitalism can only be recognized if markets reward the well managed and punish the lax. However, this fundamental principle is now observed only with regard to smaller financial institutions. Because of the lack of a legal mechanism to resolve the so-called systemically important, regardless of past inefficiency or recklessness, nonviable institutions survive with the support of taxpayer funds. History has shown that Government policies should promote, not hamper, the closing and/or restructuring of weak institutions into stronger, more efficient ones. The creation of a systemic risk regulator could be counterproductive if it reinforced the notion that financial behemoths designated as systemic are, in fact, too big to fail. Congress' first priority should be the development of a framework which creates disincentives to size and complexity and establishes a resolution mechanism which makes clear that managers, shareholders, and creditors will bear the consequences of their actions. Thank you. " CHRG-111shrg53822--64 Mr. Rajan," Thank you. Mr. Chairman, Senators, there is, in my view, a more important concern arising from this financial crisis than when private institutions are deemed ``too big to fail.'' Other than the reasons that have already been laid out, let me add one more. When systemically important institutions are bailed out, it is very hard for the authorities to refute allegations of crony capitalism, for the outcomes are observationally equivalent; after all, the difference is only one of intent. In this kind of system, the authorities do not want to bail out the systemically important institutions but are forced to, while in crony capitalism they do so willingly. The collateral damage in this system to public faith and free enterprise is enormous, especially when the public senses two sets of rules, one for the systemically important and another one for the rest of us. I have avoided saying ``too big to fail.'' That is because size, in my view, is neither necessary nor sufficient for an institution to be deemed too systemic to fail. Given my limited time, let me focus on how we can overcome the problems of too systemic to fail institutions in some measure. The three obvious possibilities: one, prevent institutions from becoming too systemic in the first place; second, create additional private sector buffers that keep them from failing; and, third, make it easier for the authorities to fail them when they do become truly distressed. Let me explain each in turn. I personally believe, like Mr. Baily does, that proposals to prevent institutions from expanding beyond a certain size or to significantly limit the activities of some institutions may be very costly without achieving their intent. Consider some economic costs. Some institutions get large not through unwise acquisitions but through organic growth based on superior efficiency. A crude size limit applied across the board will prevent the economy from benefiting from such institutions. Furthermore, size can imply greater diversification, which can reduce risk. Moreover, the threshold size can vary across activities and across time. A trillion dollar mutual fund family may not be a concern, while a $25 billion mortgage guarantor might well be. Finally, size itself is hard to define. Do we mean assets, gross derivative positions, net derivative positions, transactions or profitability? Given these difficulties, any legislation on size limits will have to give regulators substantial discretion. That creates its own problems. Similar issues arise with activity limits. What activities will be prohibited? Some suggest banning banks from proprietary trading, that is trading for their own account. But how would the law distinguish between illegitimate proprietary trading and legitimate risk-reducing hedging? Many of the activities that were prohibited to commercial banks under Glass-Steagall were peripheral to this crisis, and activities that did get banks into trouble, such as holding sub-prime mortgage-backed securities, would have been permissible under Glass-Steagall. Finally, regulating size or activity limits would be a nightmare because the regulator would be strongly tempted to arbitrage the regulations. I would suggest rather than focusing on these limits, we focus on creating stronger private-sector buffers in making institutions easier to fail. Now, the traditional buffer is capital, and I do agree that raising capital might be a good thing, but one should not put too much weight for reasons that have already been stated; in particular, that banks will tend to take more risks when they are asked to hold more capital. In some ways, I would rather advocate a more contingent buffer where systemically important institutions arrange for capital to be infused when the institution or the system is in trouble. And the difference between the two is quite important. As an analogy, additional capital is like keeping buckets full of water ready to douse a potential fire. As the years go by and the fire does not appear, the temptation is to use up the water. My contrast, contingent capital is like installing sprinklers. There is no water to use up, and when the fire threatens, the sprinklers actually turn on. One version of contingent capital, proposed by the nonpartisan Squam Lake Group, is for a portion of a bank's debt to be automatically converted to equity when two conditions are met: one, the system is deemed in crisis either based on regulatory assessments or based on objective indicators like the size of losses of the system; and, second, the bank's capital ratio falls below a certain value. There are other versions of contingent capital, such as requiring banks to purchase fail-safe insurance policies from unlevered institutions that will provide them an insurance payment when they are in trouble, and there are ways of structuring this that I would be happy to go into. Let me turn to the other possible remedy, making them easier to fail. And here I think that there are a number of issues that have been talked about, which makes banks hard to fail. I would suggest we also want to recruit banks in the process of making themselves easier to fail. And this is why I would suggest that banks also be subject to a requirement where they focus on creating a shelf bankruptcy plan, which would focus on how they themselves could be made easier to fail. For example, over time, the amount of time it will take to fail a bank could be reduced to such time as we could actually fail some of these large institutions, over a weekend. By putting this requirement and stress testing it at regular intervals, I think you would give banks an incentive to become less complicated, not to add layers of complexity in the capital structure or in the organization structure, and we could well get easier resolution. Senator Warner. Thank you, sir. The vote has started, I think, about 10:56. I will try to ask two to three minutes worth, and then if Senator Bennett or Senator Merkley want to try to get it in before the vote. If not, we will go into recess. And I am not sure how many votes there are going to be, so we will have to have a little flexibility. Very quickly, without lots of extra commentary, Peter, I would love to hear your comment about not having the need in terms of a non-bank financial systemic risk regulator, where we deal with the AIGs of the world. For all of the panel, perhaps very briefly, Mr. Baily, Mr. Wallison, you both said we do not want to make a line in the sand about ``too big to fail,'' but, in effect, what we want to do is we want to try and stop more institutions from becoming ``too big to fail.'' At some point, if we are going to have additional capital requirements, or if we are going to have added insurance fees or other kinds of resolution fees, we are going to have make some definition. We are still going to be backed into a definition, are we not? Third, questions where we are saying we ought to allow these to grow organically. But some of the actions of, for example, the combination of Merrill and Bank of America, and some of the other things that have taken place in the last six months, I am not sure these would have all have been in the normal course of organic growth. And does that mean because of the crisis, we have to then live with these institutions that were, in effect, created out of the crisis? I know that is a lot. If you could keep your comments or answers fairly short, so, again, my colleagues may get a word in before we go to vote. " CHRG-109shrg30354--111 Chairman Bernanke," It is being allowed for other countries for the appropriate banks, for small banks. The standardized approach is very similar to what we have now. What we are doing is proposing a Basel I-A, that is a modification of the existing system that would be appropriate for the smaller and medium-sized banks in our system. And that is analogous to what foreign countries will be doing when they put smaller banks on the standardized approach. But I do not think you are going to see any large international, sophisticated, complex banks with all these different kinds of derivatives and off-balance sheet activities and operational risks, you are not going to see any of those on the standardized approach because they just do not accommodate the risks that those banks are taking. Senator Sarbanes. So you would not allow that as an option? You would not be prepared to even consider it is an option? " CHRG-111hhrg53245--74 Mr. Wallison," It seems to me if we focus solely on the banking industry, we do not have that problem because all banks are regulated. Right now, the largest banks are regulated much more fully than the smaller institutions. One can assume that a large bank is too big to fail, but it does not have to be true. There is a certain amount of ambiguity when you come to a line between the very largest and the less large institutions. We have no idea what systemic risk is. That is one of the major faults in this legislation. What we ought to do is simply make sure that the banking industry is safe and sound and then we do not have to worry about any of the others. The main fault with what the Administration is doing is attempting to extend regulation which did not work for the banking industry across a broader range of our financial system. There is no need to do that. If we focus solely on banks, we can solve almost all of the problems that we encountered in 2007 and 2008. " CHRG-111shrg52619--186 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM SHEILA C. BAIRQ.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. As I said in my testimony, 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. The FDIC 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. 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.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?A.2. The FDIC did not have supervisory authority over AIG. However, to protect taxpayers the FDIC recommends that a new resolution regime be created to handle the failure of large nonbanks such as AIG. This special receivership process should be outside bankruptcy and be patterned after the process we use for bank and thrift failures.Q.3. Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC?A.3. The FDIC did not have supervisory authority for AIG and did not engage in discussions regarding the entity. However, the need for improved interagency communication demonstrates that 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.Q.4. 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.4. As with other exchange traded instruments, by moving the contracts onto an exchange or central counterparty, the overall risk to any counterparty and to the system as a whole would have been greatly reduced. The posting of daily variance margin and the mutuality of the exchange as the counterparty to market participants would almost certainly have limited the potential losses to any of AIG's counterparties. For exchange traded contracts, counterparty credit risk, that is, the risk of a counterparty not performing on the obligation, would be substantially less than for bilateral OTC contracts. That is because the exchange becomes the counterparty for each trade. The migration to exchanges or central clearinghouses of credit default swaps and OTC derivatives in general should be encouraged and perhaps required. The opacity of CDS risks contributed to significant concerns about the transmission of problems with a single credit across the financial system. Moreover, the customized mark to model values associated with OTC derivatives may encourage managements to be overly optimistic in valuing these products during economic expansions, setting up the potential for abrupt and destabilizing reversals. The FDIC or other regulators could use better information derived from exchanges or clearinghouses to analyze both individual and systemic risk profiles. For those contracts which are not standardized, we urge complete reporting of information to trade repositories so that information would be available to regulators. With additional information, regulators may better analyze and ascertain concentrated risks to the market participants. This is particularly true for large counterparty exposures that may have systemic ramifications if the contracts are not well collateralized among counterparties.Q.5. 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.5. The funding of illiquid assets, whose cash flows are realized over time and with uncertainty, with shorter-maturity volatile or credit sensitive funding, is at the heart of the liquidity problems facing some financial institutions. If a regulator determines that a bank is assuming amounts of liquidity risk that are excessive relative to its capital structure, then the regulator should require the bank to address this issue. In recognition of the significant role that liquidity risks have played during this crisis, regulators the world over are considering ways to enhance supervisory approaches. There is better recognition of the need for banks to have an adequate cushion of liquid assets, supported by pro forma cash flow analysis under stressful scenarios, well diversified and tested funding sources, and a liquidity contingency plan. The FDIC issued supervisory guidance on liquidity risk in August of 2008.Q.6. 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?A.6. 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.Q.7. 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.7. Given the long history of government bailouts for economically and systemically important firms, it will be extremely difficult to convince market participants that current practices have changed. Still, it is critical that we dispel the presumption that some institutions are ``too big to fail.'' As outlined in my testimony, it is imperative that we undertake regulatory and legislative reforms that force TBTF institutions to internalize the social costs of bailouts and put shareholders, creditors, and managers at real risk of loss. Capital and other requirements should be put in place to provide disincentives for institutions to become too large or complex. This must be linked with a legal mechanism for the orderly resolution of systemically important nonbank financial firms--a mechanism similar to that which currently exists for FDIC-insured depository institutions.Q.8. 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?A.8. The FDIC would be supportive of a capital and accounting framework for insured depository institutions that avoids the unintended pro-cyclical outcomes we have experienced in the current crisis. Capital and other appropriate buffers should be built up during more benign parts of the economic cycle so that they are available during more stressed periods. The FDIC firmly believes that financial statements should present an accurate depiction of an institution's capital position, and we strongly advocate robust capital levels during both prosperous and adverse economic cycles. Some features of existing capital regimes, and certainly the Basel II Advanced Approaches, lead to reduced capital requirements during good times and increased capital requirements during more difficult economic periods. Some part of capital should be risk sensitive, but it must serve as a cushion throughout the economic cycle. We believe a minimum leverage capital ratio is a critical aspect of our regulatory process as it provides a buffer against unexpected losses and the vagaries of models-based approaches to assessing capital adequacy. Adoption of banking guidelines that mitigate the effects of pro-cyclicality could potentially lessen the government's financial risk arising from the various federal safety nets. In addition, they would help financial institutions remain sufficiently reserved against loan losses and adequately capitalized during good and bad times. In addition, some believe that counter-cyclical approaches would moderate the severity of swings in the economic cycle as banks would have to set aside more capital and reserves for lending, and thus take on less risk during economic expansions.Q.9. Do you see any circumstances under which your agencies would take a position on the merits of counter-cyclical regulatory policy?A.9. The FDIC would be supportive of a capital and accounting framework for insured depository institutions that avoids the unintended pro-cyclical outcomes we have experienced in the current crisis. Again, we are strongly supportive of robust capital standards for banks and thrifts as well as conservative accounting guidelines which accurately represent the financial position of insured institutions.Q.10. 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?A.10. The G20 summit communique addressed a long list of principles and actions that were originally presented in the so-called Washington Action Plan. The communique provided a full progress report on each of the 47 actions in that plan. The major reforms included expansion and enhancement of the Financial Stability Board (formerly the Financial Stability Forum). The FSB will continue to assess the state of the financial system and promote coordination among the various financial authorities. To promote international cooperation, the G20 countries also agreed to establish supervisory colleges for significant cross-border firms, implement cross-border crisis management, and launch an Early Warning Exercise with the IMF. To strengthen prudent financial regulation, the G20 endorsed a supplemental nonrisk based measure of capital adequacy to complement the risk-based capital measures, incentives for improving risk management of securitizations, stronger liquidity buffers, regulation and oversight of systemically important financial institutions, and a broad range of compensation, tax haven, and accounting provisions.Q.11. Do you see any examples or areas where supranational regulation of financial services would be effective?A.11. If we are to restore financial health across the globe and be better prepared for the next global financial situation, we must develop a sound basis of financial regulation both in the U.S. and internationally. This is particularly important in the area of cross-border resolutions of systemically important financial institutions. Fundamentally, the focus must be on reforms of national policies and laws in each country. Among the important requirements in many laws are on-site examinations, a leverage ratio as part of the capital regime, an early intervention system like prompt corrective action, more flexible resolution powers, and a process for dealing with troubled financial companies. This last reform also is needed in this country. However, we do not see any appetite for supranational financial regulation of financial services among the G20 countries at this time.Q.12. How far do you see your agencies pushing for or against such supranational initiatives?A.12. At this time and until the current financial situation is resolved, I believe the FDIC should focus its efforts on promoting an international leverage ratio, minimizing the pro-cyclicality of the Basel II capital standards, cross-border resolutions, and other initiatives that the Basel Committee is undertaking. In the short run, achieving international cooperation on these issues will require our full attention.Q.13. Regulatory Reform--Chairman Bair, Mr. Tarullo noted in his testimony the difficulty of crafting a workable resolution regime and developing an effective systemic risk regulation scheme. Are you concerned that there could be unintended consequences if we do not proceed with due care?A.13. Once the government formally appoints a systemic risk regulator (SRR), market participants may assume that the likelihood of systemic events will be diminished going forward. By explicitly accepting the task of ensuring financial sector stability and appointing an agency responsible for discharging this duty, the government could create expectations that weaken market discipline. Private sector market participants may incorrectly discount the possibility of sector-wide disturbances. Market participants may avoid expending private resources to safeguard their capital positions or arrive at distorted valuations in part because they assume (correctly or incorrectly) that the SRR will reduce the probability of sector-wide losses or other extreme events. In short, the government may risk increasing moral hazard in the financial system unless an appropriate system of supervision and regulation is in place. Such a system must anticipate and mitigate private sector incentives to attempt to profit from this new form of government oversight and protection at the expense of taxpayers. When establishing a SRR, it is also important for the government to manage expectations. Few if any existing systemic risk monitors were successful in identifying financial sector risks prior to the current crisis. Central banks have, for some time now, acted as systemic risk monitors and few if any institutions anticipated the magnitude of the current crisis or the risk exposure concentrations that have been revealed. Regulators and central banks have mostly had to catch up with unfolding events with very little warning about impending firm and financial market failures. The need for and duties of a SRR can be reduced if we alter supervision and regulation in a manner that discourages firms from forming institutions that are systemically important or too-big-to fail. Instead of relying on a powerful SSR, we need instead to develop a ``fail-safe'' system where the failure of any one large institution will not cause the financial system to break down. In order to move in this direction, we need to create disincentives that limit the size and complexity of institutions whose failure would otherwise pose a systemic risk. In addition, 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. It also is essential that these reforms be time to 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.14. Credit Rating Agencies--Ms. Bair, you note the role of the regulatory framework, including capital requirements, in encouraging blind reliance on credit ratings. You recommend pre-conditioning ratings based capital requirements on wide availability of the underlying data. Wouldn't the most effective approach be to take ratings out of the regulatory framework entirely?A.14. We need to consider a range of options for prospective capital requirements based on the lessons we are learning from the current crisis. Data from credit rating agencies can be a valuable component of a credit risk assessment process, but capital and risk management should not rely on credit ratings. This issue will need to be explored further as regulatory capital guidelines are considered.Q.15. Systemic Regulator--Ms. Bair, you observed that many of the failures in this crisis were failures of regulators to use authority that they had. In light of this, do you believe layering a systemic risk regulator on top of the existing regime is the optimal way to proceed with regulatory restructuring?A.15. 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. ------ CHRG-111shrg50814--114 Mr. Bernanke," Senator, I want to make a very clear distinction between our programs that address broad credit markets--like asset-backed securities and commercial paper--and the rescue efforts we were involved for a couple of large firms. Those rescue efforts make up about 5 percent of our balance sheet. We got involved in them, frankly, because there is no clear resolution authority, in the United States for dealing with systemically critical failing institutions except for banks. But in the case of an investment bank or an insurance company, for example, there is no such regime, and we and the Treasury believe that if we allowed those institutions to fail, it would have done enormous damage to the world financial system and to the world economy. So we did what we had to do. We were very unhappy about doing it. We do not want to do it anymore. We would be delighted if the Congress would pass a substantial resolution regime that would create a set of rules and expectations for how you deal with a firm of this type that is failing and leave the central bank out of it entirely. So I hope very much that it will happen as you---- Senator Warner. And I do not think I am--at least my intent is not to be critical, and I know the Chairman has the intention to pass legislation about it. But you still have these assets that you have got to manage in this ensuing time. " CHRG-110shrg50414--146 Secretary Paulson," You cannot deal with this immediately. This is a huge market that has built up over a long period of time. It has also been extraordinarily useful in avoiding collapses and problems, letting institutions hedge themselves, as we went through--I could just go through situation after situation where, you know, Enron failed at great cost and human suffering, but the markets held up. So these are really valuable tools. It is a case where they grew too quickly, and when I talked earlier about we had a regulatory system that was static and did not change with the marketplace. And so the first work that has been done--and I think it would have to be done before you could regulate anyway--is all the work that Tim Geithner at the New York Fed has been leading with the industry to work out the transparencies and the protocols and the discipline in this market. And so---- " CHRG-110hhrg46593--14 Mr. Bernanke," Thank you. Chairman Frank, Ranking Member Bachus, and other members of the committee, I appreciate having this opportunity to review some of the activities to date of the Treasury's Troubled Asset Relief Program, or TARP, and to discuss recent steps taken by the Federal Reserve and other agencies to support the normalization of credit markets. The legislation that created the TARP put in place a Financial Stability Oversight Board to review the actions of the Treasury in administering the program. That oversight board includes the Secretary of the Treasury, the Secretary of Housing and Urban Development, the Chairman of the Securities and Exchange Commission, the Director of the Federal Housing Finance Agency, and the Chairman of the Federal Reserve Board. We have met 4 times, reviewing the operational plans and policy initiatives for the TARP and discussing possible additional steps that might be taken. Officers for the oversight board have been appointed, and the Federal Reserve and other agencies are providing staff support for the board. Minutes of each meeting are being posted to a special Web site established by the Treasury. In addition, staff members of the agencies whose heads are participating in the oversight board have met with staff from the Government Accountability Office to explore strategies for coordinating the oversight that the two bodies are required to perform under the enabling legislation. The value of the TARP in promoting financial stability has already been demonstrated. The financial crisis intensified greatly in the latter part of September and spread to many countries that had not yet been touched by it, which led to grave concerns about the stability of the global financial system. Failure to prevent the international financial collapse would almost certainly have had dire implications for both the U.S. and world economies. Fortunately, the existence of the TARP allowed the Treasury to act quickly by announcing a plan to inject $250 billion in capital into U.S. financial institutions. Nine large institutions received the first $125 billion, and the remainder is being made available to other banking organizations through an application process. In addition, the Federal Deposit Insurance Corporation announced that it would guarantee non-interest-bearing transaction accounts at depository institutions and certain other liabilities for depository institutions and their holding companies. And the Federal Reserve expanded its provision of backstop liquidity to the financial system. These actions, together with similar actions in many other countries, appeared to stabilize the situation and to improve investor confidence in financial firms. Notably, spreads on credit default swaps for large U.S. banking organizations, which had widened substantially over the previous 2 weeks, declined sharply on the day of the joint announcement. Going forward, the ability of the Treasury to use the TARP to inject capital into financial institutions and to take other steps to stabilize the financial system, including any actions that might be needed to prevent a disorderly failure of a systemically important financial institution, will be critical for restoring confidence and promoting return of credit markets to more normal functioning. As I noted earlier, the Federal Reserve has taken a range of policy actions to provide liquidity to the financial system and thus promote the extension of credit to households and businesses. Our recent actions have focused on the market for commercial paper, which is an important source of short-term financing for many financial and nonfinancial firms. Normally, money market mutual funds are major lenders in commercial paper markets. However, in mid-September, a large fund suffered losses and heavy redemptions, causing it to suspend further redemptions and then close. In the next few weeks, investors withdrew almost $500 billion from prime money market funds. The funds, concerned with their ability to meet further redemptions, began to reduce their purchases of commercial paper and limit the maturity of such paper to only overnight or other very short maturities. As a result, interest rate spreads paid by issuers on longer maturity commercial paper widened significantly, and the issuers were exposed to the costs and risks of having to roll over increasingly large amounts of paper each day. The Federal Reserve has developed three programs to address these problems. The first allows money market mutual funds to sell asset-backed commercial paper to banking organizations which are then permitted to borrow against the paper on a nonrecourse basis from the Federal Reserve Bank of Boston. Usage of that facility peaked at around $150 billion. The facility contributed importantly to the ability of money funds to meet redemption pressures when they were most intense and remains available as a backstop should such pressures re-emerge. The second program involves the funding of a special purpose vehicle that purchases highly rated commercial paper issued by financial and nonfinancial businesses at a term of 3 months. This facility has purchased about $250 billion of commercial paper, allowing many firms to extend significant amounts of funding into next year. A third facility expected to be operational next week will provide a liquidity backstop directly to money market mutual funds. This facility is intended to give funds confidence to extend significantly the maturities of their investments and reduce over time the reliance of issuers on sales to the Federal Reserve special purpose vehicle. All of these programs, which were created under section 13(3) of the Federal Reserve Act, must be terminated when conditions in the financial markets are determined by the Federal Reserve to no longer be unusual and exigent. The primary objective of these and other actions we have taken is to stabilize credit markets and to improve the access of credit to businesses and households. There are some signs that credit markets, while still strained, are improving. Interbank short-term funding rates have fallen notably since mid-October, and we are seeing greater stability in money market mutual funds and in the commercial paper market. Interest rates and higher rated bonds issued by corporations and municipalities have fallen somewhat, and bond issuance for these entities rose a bit in recent weeks. The ongoing capital injections under the TARP are continuing to bring stability to the banking system and have reduced some of the pressure on banks to deleverage, two critical first steps towards restarting flows of new credit. However, overall, credit conditions are still far from normal with risk spreads remaining very elevated and banks reporting that they continued to tighten lending standards through October. There has been little or no bond issuance by lower rated corporations or securitization of consumer loans in recent weeks. To help address the tightness of credit, on November 12th, the Federal banking agencies issued a joint statement on meeting the needs of creditworthy borrowers. The statement took note of the recent strong policy actions designed to promote financial stability and improve banks' access to capital and funding. In light of those actions, which have increased the capacity of banks to lend, it is imperative that all banking organizations and their regulators work together to ensure that the needs of creditworthy borrowers are met in a manner consistent with safety and soundness. As capital adequacy is critical in determining a banking organization's ability and willingness to lend, the joint statement emphasizes the need for careful capital planning, including setting appropriate dividend policies. The statement also notes the agency's expectation that banking organizations should work with existing borrowers to avoid preventable foreclosures which can be costly to all involved: the borrower; the lender; and the communities in which they are located. Steps that should be taken in this area include ensuring adequate funding and staffing of mortgage servicing operations and adopting systematic, proactive, and streamlined mortgage loan modification protocols aimed at providing long-term sustainability for borrowers. Finally, the agencies expect banking organizations to conduct regular reviews of their management compensation policies to ensure that they encourage prudent lending and discourage excessive risk-taking. Thank you. I would be pleased to take your questions. [The prepared statement of Chairman Bernanke can be found on page 139 of the appendix.] " FOMC20080130meeting--369 367,MR. POOLE., And they collapsed? CHRG-111hhrg48874--29 Mr. Long," Congressman, we hear those concerns, too. Over the past several years, beginning in 2003 at the OCC, we began to talk to our banks about a number of excessive risks that we were seeing in the system. The risk has built up. I don't think we have ever gone into an economic downturn with the kind of concentrations in commercial real estate-related credits in the community bank line of business that we have now. And they are in some parts of the country where the asset valuation has grown significantly. There are some very heavy concentrations, so naturally our examiners are focusing on that during examinations. You have a situation in the economy. " CHRG-111hhrg55814--112 Secretary Geithner," I guess we can start with a simple thing. It does make sense to the system in which community banks and regional banks are held to the same standards that are necessary to protect the system from the risk posed by large complicated financial institutions. You need to have a different regime, tougher set of constraints applied to them, because they pose more risk-- " FOMC20071211meeting--148 146,MR. FISHER.," Mr. Chairman, I don’t think I could have said it better than Governor Kohn said it. I am on his wavelength. I would just add a couple of things that I would suggest we consider. First of all, with regard to the financial situation, which is obviously driving this conversation, I appreciate the medical pathology that the Vice Chairman suggested. We have gone now from cardiology, which is my thing, to this fever and the fever breaking, and so on. I combine it with a bit of the strawman that Governor Warsh raised. No one has suggested a panacea. No one has suggested that the existing pool of ersatz money, outside money, or shadow money is fully sufficient to relieve the stress the system is under. What has changed, however, since the August crisis is the process of price discovery. We are beginning to actually get realistic pricing. I spent twenty-one years buying distressed assets on Wall Street. I think I understand the process. It is a patient process, and it takes time. But I think that is the only difference. We have begun the process; it has a long way to go. We have enormous risks, and I fully agree with Vice Chairman Geithner that there is significant risk that might stem from this. But let’s not also understate the fact that some adjustment has begun and that is good news. I would suggest 25 basis points, Mr. Chairman, because I think we have to be very wary of shooting an entire bolt here. If we do 50 basis points plus the TAF plus the swap lines—this is all very subjective—my opinion is that we would scare the hell out of the markets. There is a significant risk if we send a signal, as was previously said—I think Brian may have said this— that we have information that other people do not have. President Lockhart referred to delicate psychology. From a risk-management standpoint, I think the psychology is the opposite of what he stated, which is that we are at risk of interfering with the beginning of the adjustment process that I just described. If people feel that we know more than they do, that we have greater fear of the downside, you are going to see a delay in that adjustment. They are wanting to step up and cherry-pick a little before you start going through the whole orchard. So those would be the two factors that I would suggest. I want to come back to the last point. Our job is to keep inflation at bay. The nominal anchor you mentioned is critical. I heard more people speak around this table about being worried about inflation than did not so speak. And a second-to-the-last point. I agree with President Poole and the suggestion of, I think, Charlie Plosser. I would like to be like the Reserve Bank of Australia and raise the rates despite the political election, if we had to. But I think the scrutiny of this institution will be intense, and my preferred mode is just to stay out of the way. I think it is politically very brave and possibly foolish to say that, well, if we do too much here, we can always pull it back. There will be a lot different circumstances next year, and I worry that we may do too much. I would be against 50 basis points. I would be in favor of 25 basis points, and I would be in favor of alternative B as stated, if I had a vote. Thank you, Mr. Chairman." CHRG-111hhrg48674--279 Mr. Miller," Mr. Chairman, we have heard some pretty dire estimates of how much banks' values are--assets are overvalued. Goldman Sachs economists, just in the past couple of weeks, have said that the total losses to American financial institutions is probably about $2.1 trillion, and about $1 trillion of that had been realized now, had been recognized on the books, and that meant there was another $1.1 trillion of losses yet to be realized. Not surprisingly, Nouriel Roubini, ``Dr. Doom,'' put the number higher; he said $3.6 trillion, and about half of that banks and brokerage houses and that the total capitalization of the American banking system is about $1.4 trillion which, he said, if his own numbers were right, meant the entire American banking system was insolvent. The Federal Reserve is one of the principal safety and soundness regulators. You have responsibility for safety and soundness regulation for most of the Nation's banks one way or the other; and you have been taking hundreds of billions of dollars of assets, trillions of dollars of assets, as collateral for loans. So I assume you have been giving some due diligence to what the value of assets are. You have paid some attention. Do you have a sense of whether American banks are overvaluing their assets and by about how much, if they are? " CHRG-111hhrg55814--531 Mr. Cleaver," Are any of you aware of any other central bank that has the responsibility for supervising systemic banking risk and managing monetary policy? Any other central bank that does--yes, sir, Mr. Wallison? " CHRG-111shrg56376--114 Mr. Tarullo," Senator, I would start by saying, as you noted, the national banks would be supervised by the OCC as well as chartered. State banks that are members of the Federal Reserve System are supervised by the Fed as their Federal supervisors, and if they are nonmember banks, then their primary Federal regulator is the FDIC. I think that there are two answers to the question. One is, as you suggest, history. The Comptroller was started in 1863 to create a new national charter and we have had a dual banking system ever since. I think there is probably some concern on the part of State Banking Commissioners that they not have as their overseer at the Federal level the same entity that charters national banks---- Senator Schumer. That is a little bit of what we would say in Brooklyn is turf. [Laughter.] " fcic_final_report_full--304 MARCH TO AUGUST 2008: SYSTEMIC RISK CONCERNS CONTENTS The Federal Reserve: “When people got scared” ................................................  JP Morgan: “Refusing to unwind . . . would be unforgivable” ...........................  The Fed and the SEC: “Weak liquidity position” ...............................................  Derivatives: “Early stages of assessing the potential systemic risk” .....................  Banks: “The markets were really, really dicey” ..................................................  JP Morgan’s federally assisted acquisition of Bear Stearns averted catastrophe—for the time being. The Federal Reserve had found new ways to lend cash to the financial system, and some investors and lenders believed the Bear episode had set a precedent for extraordinary government intervention. Investors began to worry less about a re- cession and more about inflation, as the price of oil continued to rise (hitting almost  per barrel in July). At the beginning of , the stock market had fallen almost  from its peak in the fall of . Then, in May , the Dow Jones climbed to ,, within  of the record , set in October . The cost of protecting against the risk of default by financial institutions—reflected in the prices of credit default swaps—declined from the highs of March and April. “In hindsight, the mar- kets were surprisingly stable and almost seemed to be neutral a month after Bear Stearns, leading all the way up to September,” said David Wong, Morgan Stanley’s treasurer.  Taking advantage of the brief respite in investor concern, the top ten American banks and the four remaining big investment banks, anticipating losses, raised just under  billion and  billion, respectively, in new equity by the end of June. Despite this good news, bankers and their regulators were haunted by the speed of Bear Stearns’s demise. And they knew that the other investment banks shared Bear’s weaknesses: leverage, reliance on overnight funding, dependence on securitization markets, and concentrations in illiquid mortgage securities and other troubled assets. In particular, the run on Bear had exposed the dangers of tri-party repo agreements and the counterparty risk caused by derivatives contracts. And the word on the street—despite the assurances of Lehman CEO Dick Fuld at  an April shareholder meeting that “the worst is behind us”  —was that Bear would not be the only failure. CHRG-111hhrg48867--87 Mr. Kanjorski," Thank you. No one else? Oh, yes. Ms. Jorde. Thank you. I think one more thing that is important to consider when we look at systemic risk is that it is being exacerbated as we move toward more mixing of banking and commerce. We refer to the auto manufacturers, but the auto manufacturers are also making mortgage loans and financing their own vehicles. We talk about GE Capital and GE. You know, as we have moved towards more mixing of banking and commerce, certainly we are creating more systemic risk. It was what ruined the Japanese financial system back in the 1990's, and it is something that we need to look very closely at as we move forward; close the IOC loophole and keep banking and commerce separate. " CHRG-111hhrg48874--12 OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Ms. Duke. Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and members of the committee, I am pleased to be here today to discuss several issues related to the state of the banking system. As you are all well aware, the Federal Reserve is taking significant steps to improve financial market conditions and has worked with the Treasury and other bank and thrift supervisors to address issues at U.S. banking organizations. We remain attentive to the need for banks to remain in sound financial condition, while at the same time to continue lending prudently to creditworthy borrowers. Indeed, the shutdown of most securitization markets and the evaporation of many types of non-bank credit make it that much important right now for the U.S. banking system to be able to carry out the credit intermediation function. Recent data confirm severe strains on parts of the U.S. banking system. During 2008, profitability measures at U.S. commercial banks and bank holding companies deteriorated dramatically. Indeed, commercial banks posted a substantial, aggregate loss for the fourth quarter of 2008, the first time this has happened since the late 1980's. This loss in large part reflected write-downs on trading assets, high goodwill impairment charges, and, most significantly, increased loan loss provisions. With respect to overall credit conditions, past experience has shown that borrowing by households and nonfinancial businesses has tended to slow during economic downturns. However, in the current case, the slow down in private sector debt growth during the past year has been much more pronounced than in previous downturns, not just for high mortgage debt, but also consumer debt and debt of the business sector. In terms of direct lending by banks, Federal Reserve data show that total bank loans and leases increased modestly in 2008 below the higher pace of growth seen in both 2006 and 2007. Additionally, the Federal Reserve Senior Loan Officer Opinion Survey on Banking Practices has shown that banks have been tightening lending standards over the past 18 months. The most recent survey data also show the demand for loans for businesses and households continue to weaken on balance. Despite the numerous changes to the financial landscape during the past half-century, such as the large increase in the flow of credit coming from non-bank sources, banks remain vital financial intermediaries. In addition to direct lending, banks supply credit indirectly by providing back-up liquidity and credit support to other financial institutions and conduits that also intermediate credit flows. In terms of direct bank lending, much of the increase last year likely reflected households and businesses drawing down existing lines of credit rather than extensions of loans to new customers. Some of these draw-downs by households and businesses were precipitated by the freeze-up of the securitization markets. The Federal Reserve has responded forcefully to the financial and economic crisis on many fronts. In addition to monetary policy easing, the Federal Reserve has initiated a number of lending programs to revive financial markets and to help banks play their important role as financial intermediaries. Among these initiatives are the purchase of large amounts of agency debt and mortgage-backed securities; plans to purchase long-term Treasury securities; other efforts including the Term Asset-backed Securities Loan Facility known as TALF to facilitate the extension of credit to households and small businesses; and, the Federal Reserve's planned involvement in the Treasury's Public-Private Partnership Investment Program, announced on Monday. The Federal Reserve has also been active on the supervisory front to bring about improvements in banks' risk-management practices. Liquidity and capital have been given special attention. That said, we do realize that there must be an appropriate balance between our supervisory actions and the promotion of credit availability to assist in the economic recovery. The Federal Reserve has long-standing policies and procedures in place to help maintain such a balance. We have also reiterated this message of balance in recent interagency statements. We have directed our examiners to be mindful of the procyclical effects of excessive credit tightening and to encourage banks to make economically viable loans, provided that such lending is based on realistic asset valuations and a balanced assessment of borrowers' repayment capacities. The U.S. banking industry is facing serious challenges. The Federal Reserve, working with other banking agencies, has acted and will continue to act to ensure that the banking system remains safe and sound and is able to meet the credit needs of our economy. The challenge for regulators and other authorities is to support prudent bank intermediation that helps restore the health of the financial system and the economy as a whole. As we have communicated, we want banks to deploy capital and liquidity to make credit available, but in a responsible way that avoids past mistakes and does not create new ones. Accordingly, we thank the committee for holding this hearing to help clarify the U.S. banking agencies' message that both safety and soundness and credit availability are important in the current environment. I look forward to your questions. [The prepared statement of Governor Duke can be found on page 82 of the appendix.] " CHRG-111hhrg48873--460 Mr. Bernanke," Well, in terms of the collapse of AIG itself, we didn't see it. Our regulatory system was not adequate, and I believe it was not adequate to find the problem and identify it and stop it in time. I think, going forward, we need a stronger, comprehensive holding company supervision plan, together with resolution authorities that would allow us to wind down a firm like this in this kind of circumstances. So I think there are important financial reforms that need to take place. With respect to getting the money back, again, we have put a lot of money into AIG, it is absolutely true. But speaking at least for the Federal Reserve, we think we have good collateral; we expect to receive that money back. " CHRG-110hhrg46591--164 Mr. Stiglitz," I think the core point is that at the center of the financial system, the commercial banks, our credit system, pension funds, people who are using other people's money they don't have--that has to be ring fenced. Outside of that, if you can ring-fence that core part, if people want to engage in gambling, and we allow them to fail because it won't have systemic consequences, that is fine. Let them gamble. But in that center part, we do have to restrict risk-taking, because we will pick up the pieces when it fails, as we have seen. " CHRG-111shrg53822--23 Chairman Dodd," Thank you, Senator, very much. Senator Bennet. Senator Bennet. Thank you, Mr. Chairman. Thank you for holding the hearing, and thank you for your testimony. Mr. Stern, I wanted to come back to something you said a minute ago; when we think about the systemic risk regulator, that it is important that we think about what we are asking them to do. One of the things that I have been struck by in my conversations with people in the financial industry is not just that this is a leverage problem, a ``too-big-to-fail'' problem, but it may also be a complexity problem, particularly in a rising market, the tendency to create more and more complex instruments that people cannot necessarily keep track of, either in their scope or in their relationships among various financial institutions. I wonder in the context of thinking about--and I guess the other thing I would say is it makes a person somewhat skeptical that an incentive and disincentive regime is ever going to be strong enough to counteract those temptations. I guess my question to you is how do we manage to keep up with that level of complexity without diminishing the innovation that all of us need to see in our financial markets, but at the same time prospectively protect us from the kind of collapse that we have just faced? " FOMC20080625meeting--254 252,MR. ROSENGREN.," For Bear Stearns, we have one side of the transaction looking at the investment banks. On the other side of that transaction, you have companies like Fidelity, Schwab, and Federated. So as we think about who poses systemic risk, we probably want to think about both sides. In terms of a distress scenario, you have tri-party repos that are very illiquid. The clearing bank does not want to provide the cash. As a result they have to liquidate, and you have companies like Fidelity, Schwab, and Federated having to break the buck, and they don't have much capital to infuse. So just as we think about systemic risk, as you're looking at these other organizations, are there other people that you would add to that? I know for Bear Stearns that Fidelity, Schwab, and Federated played a very large role. Were there other organizations that we ought to be thinking about that would have the same kind of nature? " CHRG-111hhrg48868--895 Mr. Liddy," I think the answer to your question is we need a much more hefty systemic risk regulator. So we get a ton of regulation on the insurance side from State regulators, the United States, from other regulators around the globe. What we need is someone who can look at the systemic risk that a large company like AIG represents, pair that with the systemic risk that a large bank or investment bank represents, and decide whether there is too much risk there or not. I don't think that regulation-- " CHRG-111shrg52619--15 Mr. Dugan," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. The financial crisis has raised legitimate questions about whether we need to restructure and reform our financial regulatory system, and I welcome the opportunity to testify on this important subject on behalf of the OCC. Let me summarize the five key recommendations from my written statement which address issues raised in the Committee's letter of invitation. First, we support the establishment of a systemic risk regulator, which probably should be the Federal Reserve Board. In many ways, the Board already serves this role with respect to systemically important banks, but no agency has had similar authority with respect to systemically important financial institutions that are not banks, which created real problems in the last several years as risk increased in many such institutions. It makes sense to provide one agency with authority and accountability for identifying and addressing such risks across the financial system. This authority should be crafted carefully, however, to address the very real concerns of the Board taking on too many functions to do all of them well, while at the same time concentrating too much authority in a single Government agency. Second, we support the establishment of a regime to stabilize resolve and wind down systemically significant firms that are not banks. The lack of such a regime this past year proved to be an enormous problem in dealing with distressed and failing institutions such as Bear Stearns, Lehman Brothers, and AIG. The new regime should provide tools that are similar to those the FDIC currently has for resolving banks, as well as provide a significant funding source, if needed, to facilitate orderly dispositions, such as a significant line of credit from the Treasury. In view of the systemic nature of such resolutions and the likely need for Government funding, the systemic risk regulator and the Treasury Department should be responsible for this new authority. Third, if the Committee decides to move forward with reducing the number of bank regulators--and that would, of course, shorten this hearing--we have two general recommendations. The first may not surprise you. We believe strongly that you should preserve the role of a dedicated prudential banking supervisor that has no job other than bank supervision. Dedicated supervision produces no confusion about the supervisor's goals or mission, no potential conflict with competing objectives; responsibility and accountability are well defined; and the result is a strong culture that fosters the development of the type of seasoned supervisors that we need. But my second recommendation here may sound a little strange coming from the OCC given our normal turf wars. Congress, I believe, should preserve a supervisory role for the Federal Reserve Board, given its substantial experience with respect to capital markets, payment systems, and the discount window. Fourth, Congress should establish a system of national standards that are uniformly implemented for mortgage regulation. While there were problems with mortgage underwriting standards at all mortgage providers, including national banks, they were least pronounced at regulated banks, whether State or nationally chartered. But they were extremely severe at the nonbank mortgage companies and mortgage brokers regulated exclusively by the States, accounting for a disproportionate share of foreclosures. Let me emphasize that this was not the result of national bank preemption, which in no way impeded States from regulating these providers. National mortgage standards with comparable implementation by Federal and State regulators would address this regulatory gap and ensure better mortgages for all consumers. Finally, the OCC believes the best way to implement consumer protection regulation of banks, the best way to protect consumers is to do so through prudential supervision. Supervisors' continual presence in banks through the examination process creates especially effective incentives for consumer protection compliance, as well as allowing examiners to detect compliance failures much earlier than would otherwise be the case. They also have strong enforcement powers and exceptional leverage over bank management to achieve corrective action. That is, when examiners detect consumer compliance weaknesses or failures, they have a broad range of corrective tools from informal comments to formal enforcement action, and banks have strong incentives to move back into compliance as expeditiously as possible. Finally, because examiners are continually exposed to the practical effects of implementing consumer protection rules for bank customers, the prudential supervisory agency is in the best position to formulate and refine consumer protection regulation for banks. Proposals to remove consumer protection regulation and supervision from prudential supervisors, instead consolidating such authority in a new Federal agency, would lose these very real benefits, we believe. If Congress believes that the consumer protection regime needs to be strengthened, the best answer is not to create a new agency that would have none of the benefits of the prudential supervisor. Instead, we believe the better approach is for Congress to reinforce the agency's consumer protection mission and direct them to toughen the applicable standards and close any gaps in regulatory coverage. The OCC and the other prudential bank supervisors will rigorously apply any new standards, and consumers will be better protected. Thank you very much. I would be happy to answer questions. " CHRG-111shrg54533--14 Chairman Dodd," Senator Schumer. Senator Schumer. Thank you, Mr. Chairman, and I want to thank you and congratulate you on the blueprint that you put together, Secretary Geithner, because I do believe it will close many of the most important regulatory gaps in our system. There are a few issues where I think the administration should have pushed a bit farther, but this is an excellent framework and charts a clear course to fix the problems that led us to the crisis. Two places I would like to just give you a pat on the back, I agree with Senator Dodd, a Financial Consumer Product Safety Commission is essential. The Fed failed significantly in this responsibility. So while you have got to be leery of starting over, in this case, you have to start over and a new agency is what is called for. Second, of less noticed but of great importance is the idea that the mortgage issuer and securitizer must hold a piece of the mortgage. That would have stopped Countrywide and others like it in its tracks. It certainly would have greatly lessened the crisis. It might have even avoided it. So that is a great addition, because now they can't issue these junky mortgages and then just not hold them and sell them. On the systemic risk regulator, we need one, there is no question, and the old way is certainly bad. We can criticize any proposal, but keeping the present system is worse. Every agency had a piece of the system to oversee and protect, but nobody had responsibility to mind the whole store rather than just looking after individual aisles. I agree with Senator Shelby, it is really hard to do. But, tackle it we must, or we risk having the same kind of widespread financial crisis that we have just been going through. You cannot let the perfect be the enemy of the good here or we end up with less, and believe me, it is hard to do. Who predicted--you could probably count on your hands and toes the number of people in financial services, the commentators, the press, in government, who predicted 5 years ago that mortgages and this mortgage crisis would bring the whole system down. It is very hard to see around the corner. And my view, I tend to agree--I am not certain, but I tend to agree that the Fed is the best answer. There are no great ones. A council? That is a formula for disaster in something like this. A council, everyone will pass the buck and it will stop nowhere. You must have the buck stop somewhere with systemic risk. So then maybe you should have a new regulator, just someone new. The problem is, you need deep, deep knowledge of how the financial system works and a new council is going to be much slower to start. The Fed has that knowledge. You could argue the reason the Fed failed in the past, and it did, was because of the attitude of some of the people at the top who were for abject deregulation rather than the structure, but to me at least, until shown a better example, I think the Fed, at least tentatively, is the best one. The question I wanted to ask you is about bank responsibility. For years, everybody has said one of the problems of banking regulation is that it is too divided up. The system allowed banks, most recently and notably again Countrywide--that has been a nemesis to me--to game the system for the slightest regulation possible, yet your plan, while consolidating OTS and OCC, leaves significant prudential supervisory authority with the Fed and FDIC. If you count the new consumer watchdog agency, which I am all for, there would be four bodies involved in bank supervision, the same as we started with, no consolidation. A multiplicity of regulators tends to produce less oversight overall. The whole is greater than the sum of its parts when it comes to a symphony orchestra or the New York Giants, but with our patchwork system of banking regulators, the whole is less. So please tell us why you didn't do more consolidation, and particularly with the Fed gaining these powers, why do they have to be the supervisor of State banks, setting up this duplication of systems where you have a Fed regulator, the OCC, for the same exact bank who then shops around to be State chartered? If you want to remove another power from the Fed, which is getting a lot, take it away. Don't have them regulate State banks. Why didn't you consolidate the banking regulators more? " CHRG-111hhrg48674--81 Mr. Watt," The banks. So the ones that you are aimed--and with reference to those banks, whatever regulatory reform might include enhancing those steps. But outside the banks are other entities that do not have regulators that are systemically critical or too big to fail. Is that right? " CHRG-110hhrg46591--258 Mrs. Biggert," In your testimony, you advocated that there be a tiered regulatory system with less stringent and less intrusive regulation of community banks. Do you think that the banks might then be willing to take more risk if they do not have the same regulations as do the larger banks? " CHRG-111hhrg56776--8 Mr. Bernanke," Thank you, Chairman Watt, Ranking Member Bachus, and other members of the committee. I am pleased to have the opportunity to discuss the Federal Reserve's role in bank supervision and the actions that we are taking to strengthen our supervisory oversight. Like many central banks around the world, the Federal Reserve cooperates with other agencies in regulating and supervising the banking system. Our specific responsibilities include the oversight of about 5,000 bank holding companies, including the umbrella supervision of large complex financial firms, the supervision of about 850 banks nationwide that are both State chartered and members of the Federal Reserve System, so-called ``State member banks,'' and the oversight-- " CHRG-110hhrg46591--3 Mr. Kanjorski," Mr. Chairman, we have reached a crossroads. Because our current regulatory regime has failed, we now must design a robust, effective supervisory system for the future. In devising this plan, we each must accept that regulation is needed to prevent systemic collapse. Deregulation, along with the twin notions that markets solve everything while government solves nothing, should be viewed as ideological relics of a bygone era. We also need regulation to rein in the private sector's excesses. In this regard, I must rebuke the greed of some AIG executives and agents who spent freely at California spas and on English hunting trips after the company secured a $123 billion taxpayer loan. Their behavior is shocking. The Federal Reserve must police AIG spending and impose executive pay limits. If it does not, I will do so legislatively. After all, the Federal Reserve's lending money to AIG is no different from the Treasury's investing capital in a bank. Returning to our hearing's main topic, I currently believe that the oversight system of the future must adhere to seven principles: First, regulators must have the resources and flexibility needed to respond to a rapidly evolving global economy full of complexity and innovation. Second, we must recognize the interconnectedness of our global economy when revamping our regulatory system. We must assure that the failure of one company, of one regulator or of one supervisory system does not produce disastrous, ricocheting effects elsewhere. Third, we need genuine transparency in the new regulatory regime. As products, participants, and markets become more complex, we need greater clarity. In this regard, hedge funds and private equity firms must disclose more about their activities. The markets for credit default swaps and for other derivatives must also operate more openly and under regulation. Fourth, we must maintain present firewalls, eliminate current loopholes, and prevent regulatory arbitrage in the new regulatory system. Banking and commerce must continue to remain separate. Financial institutions can neither choose their holding companies' regulators nor evade better regulation with a weaker charter. All financial institutions must also properly manage their risks, rather than shift items off balance sheet to circumvent capital rules. Fifth, we need to consolidate regulation in fewer agencies but maximize the number of cops on the beat to make sure that market participants follow the rules. We must additionally ensure that these agencies cooperate with one another, rather than to engage in turf battles. Sixth, we need to prioritize consumer and investor protection. We must safeguard the savings, homes, rights, and the financial security of average Americans. When done right, strong consumer protection can result in better regulation and more effective markets. Seventh, in focusing financial firms to behave responsibly, we must still foster an entrepreneurial spirit. This innovation goal requires a delicate but achievable balancing act. In sum, we have a challenging task ahead of us. Today's esteemed witnesses will help us to refine our seven regulatory principles and ultimately construct an effective regulatory foundation for the future. I look forward to their thoughts and to this important debate. Thank you, Mr. Chairman. " CHRG-111shrg52619--106 Chairman Dodd," I am sorry, Senator. Senator Menendez. No. Thank you, Senator Dodd. I appreciate it. Just one more line of questioning. You know, we had a witness before the Committee, Professor McCoy of the University of Connecticut School of Law, and she made some statements that were, you know, pretty alarming to me. She said, ``The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alternate-A low-documentation and no-documentation loans during the housing boom.'' ``Unlike OTS, the OCC did promulgate one rule in 2004 prohibiting mortgages to borrowers who could not afford to pay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007.'' ``Despite the 2004 rules, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans.'' ``The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans.'' And so it just seems to me that some of the biggest bank failures have been under your agency's watch, and they, too, involved thrifts heavily into nil documents, low documents, Alternate A, and nontraditionals, and it is hard to make the case that we had an adequate job of oversight given those results. We have heard a lot here about one of our problems is regulatory arbitrage. Don't you think that they chose your agency because they thought they would get a better break? " CHRG-111hhrg48874--37 Mr. Marchant," Thank you, Mr. Chairman. I think one of the big mixed messages that the public is getting is they're picking up the newspaper and they're reading that the Federal Reserve is putting a trillion dollars of liquidity into the system, into the banking system. And they're hearing that there's TARP money going into each of the banks. They're thinking that because of all this money that's going into the banks and the TARP money going into the banks, that there surely must be money available at the bank that they can borrow. I don't think they realize that most of this money is going to the loan loss reserve and to rebuild the capital reserves. And if anything, the TARP money, by paying 5 percent on the TARP money, money that costs 5 percent--5 percent is more than the bank's cost of funds right now. So their best customers, the customers that your examiners like to see when they come in and crack the books, actually are paying 3 to 3.5 percent on their loans. They are prime plus 1 or 2. So any TARP money used to make a loan to their absolute best customer will be made at a loan value that is less than the cost of funds. So obviously the TARP money, while I believe the Congress felt like that is what the money was going to do, to be put in the system to make more liquidity, it hasn't ended up doing that. And when that public reads that the Fed is putting liquidity into the system, I think the message they think is that there is more money available to borrow. But what the customers in my district are finding out is that they are facing rising interest rates. A lot of the prime borrowers are going back in to renegotiate a line of credit that they have done for 20 years, and they're finding out that instead of having a prime plus 1 or 2 now, there's a floor being put on the amount of the loan that can go down. And in most instances, that floor is now 5 percent. They are the best customers of the bank. And the reasons that are being given are: We have this special assessment coming. Our bank is not going to be profitable next year, because of these special assessments. The other thing that has happened is that there is a definite restriction in the amounts that these lines of credits can grow. So de facto, if a business is doing well and can expand, they're not going to be able to expand their credit line. And most bankers are not expanding credit lines. And then, of course, you have the customers who are going in and finding that their HELOC loans they're having, they're getting letters in the mail that say that their line has been cut; they're getting letters from the credit card companies that are saying the same things. I know that this hearing is not about that. And they're getting extra demands on their collateral. So there are mixed signals that are coming out. I believe sincerely that everyone at this panel today is doing exactly what you feel like is the best thing to do for the system. The borrower does not understand the interplay of all of these things. And frankly, this Congressman does not understand the interplay many times, and does not understand what the benefit to the system is if the headline is that a trillion dollars has been put into the system by the Fed, but my constituents don't find that to be of any benefit to them whatsoever, when they go to the bank and want to borrow money. Thank you, Mr. Chairman. " Mrs. Maloney," [presiding] Thank you. The Chair recognizes herself for 5 minutes, and I welcome all the panelists. I would like to ask Governor Duke, whom I understand has experience as an online banker in commercial banking, do you believe that the Federal Government could or should have taken different actions in the fall or more recently to ensure that credit would be more available? I believe all of us are hearing the same story when we go to the caucus meetings, when we talk to our colleagues on both sides of the aisle, that the credit is just not out there; we need to get the liquidity moving. I'm hearing particularly commercial credit has absolutely dried up; it's very hard to get loans. How effective do you believe that the TALF program and the Public-Private Investment Program will be in opening up credit and allowing financial institutions to lend money? And also last night, I was reading a report where banks used to provide 60 percent of the credit in our country, and now are providing roughly 20 percent, and it has been picked up by other forms of credit. Just your comments in general on these questions. Thank you. Ms. Duke. Mrs. Maloney, thank you. As you know, I was a banker and a community banker for nearly 30 years, and so I'm well aware of the tension that exists between bankers and bank examiners, as well as lenders and borrowers. I think, to your first question, I do believe, I honestly believe that the Federal Government has made every response we can think of to make, in particularly the Federal Reserve, in order to ensure that lending is continuing to take place. And I think if we had not done that, that the circumstances would be substantially worse. Provision of liquidity to banks is critically important in order that they have the funds to lend. The capital that we put into the banks not only strengthens the banks, but also strengthens them in the minds of others who would provide liquidity. And it's the liquidity that really gets lent forward on to borrowers. In addition to that, you're right that the banking system percentage of the credit that was extended has dropped. It dropped to about 30-some percent, anyway below 40 percent, although if you add back the securitization that banks did, they were still probably facilitating more than 40 percent of the credit, going into this recent episode. And so the TALF is really designed to restart securitization markets. And what we have found in our Fed facilities, first with those that were directed at commercial paper, was that by creating a facility to support commercial paper, gradually that market improved. Now, the first version of the TALF is directed at consumer loans, student loans, and small business loans. And, we had the first issuance of TALF, which is $8 billion. It may not sound like a lot in the context of trillions and trillions of dollars, but that is more than had been done in the last 4 months. These are difficult times, they're difficult times for bank examiners, they're difficult times for bankers. I think at the end of the day, probably the best thing we can do is everything that we're doing to improve financial conditions. A lot of the reasons lines get cut is because collateral values have dropped. So if we could put a floor under housing, anything we can do to support mortgage lending and housing will tend to put a floor on the value of housing, and then that stops the value of the collateral from dropping. Same thing with commercial real estate, and we're hearing the same things that you hear on commercial real estate. The securitization market for commercial real estate loans has completely shut down. In addition to new commercial real estate, there are also a number of commercial real estate loans that are currently up for renewal. And, we need to provide for the renewal of those. So we are looking at commercial real estate as part of the TALF in the next version. But again, commercial real estate values are tied to the cash flows of the businesses that operate out of that commercial real estate, and so to the extent that business is down, that retail sales are down, that attendance is down in hospitality areas, that's going to tend to reduce the value of that collateral, and reduce the ability of those owners to borrow and to expand their businesses. " CHRG-111hhrg56241--88 Mr. Stiglitz," Yes. Three things very briefly. It is very important to change the incentives, which is the subject of this hearing. If you have incentives for excessive risk-taking, you will do it. These incentives are both at the individual level and the organizational level, which is why the too-big-to-fail bank issue is so critical. Even when we realign incentives, we will never do it perfectly, which is why we need constraints on leverage, on behaviors, and on products like derivatives. Finally, in order for our economic system to work, there has to be transparency. The way the system is set up right now, it is impossible for capital markets to exercise the discipline that is needed to make our system function well. Mr. Moore of Kansas. Thank you, sir. Thank you, Mr. Chairman. " CHRG-111hhrg48873--166 Mrs. Maloney," And, likewise, it had counterparties that were a number of foreign banks. Do you consider bailing out foreign banks systemic risks to the American economy? " CHRG-111shrg51290--3 STATEMENT OF SENATOR SHELBY Senator Shelby. Thank you, Mr. Chairman. There is no question that many home buyers were sold inappropriate mortgages over the past several years. We have heard their stories. We have heard some of those stories right here. There is also no question that many home buyers were willing parties to contracts that stretched them far beyond their financial means. Some of these home buyers were even willing to commit fraud to buy a new home. We have heard their stories, as well. As with any contract, there must be at least two parties to each mortgage. If either party chooses not to participate, there is no agreement. Unfortunately, during the real estate boom, willing participants were in abundance all along the transaction chain, from buyers to bankers, from Fannie and Freddie to investment banks, and from pension funds to international investors. There appeared to be no end to the demand for mortgage-backed securities. Underwriting standards seemed to go from relaxed to nonexistent as the model of lending known as originate to distribute proliferated the mortgage markets. The motto in industry seemed to be risk passed, risk avoided. However, as the risk was then passed around our financial markets like a hot potato, everyone taking their piece along the way, some of the risk was transferred back onto the balance sheets of regulated financial institutions. In many cases, banks were permitted to hold securities backed by loans that they were proscribed from originating. Interesting. How did our regulators allow this to happen? This is just one of the many facets of this crisis that this Committee will be examining over the months ahead. A key issue going forward is how do we establish good consumer protections while also ensuring the safety and soundness of our financial system? In many respects, consumer protection and safety and soundness go hand in hand. Poorly underwritten loans that consumers cannot afford are much more likely to go bad and inflict losses on our banks. In addition, an essential element of consumer protection is making sure that a financial institution has the capital necessary to fulfill its obligations to its customers. This close relationship between consumer protection and safety and soundness argues in favor of a unified approach to financial regulation. Moreover, the ongoing financial crisis has shown that fractured regulation creates loopholes and blind spots that can, over time, pose serious questions to our financial system. It is regulatory loopholes that have also spawned many of the worst consumer abuses. Therefore, we should be cautious about establishing more regulatory agencies just to create the appearance of improving consumer protections. We should also be mindful of the limits of regulation. Our regulators cannot protect consumers better than they can protect themselves. We should be careful not to construct a regulatory regime that gives consumers a false sense of security. The last thing we need to do is lead consumers to believe that they don't have to do their own due diligence. If this crisis teaches us anything, it should be that everyone, from the big banks and pension funds to small community banks and the average consumer, has to do a better job of doing their own due diligence before entering into any financial transactions. At the end of the day, self-reliance may prove to be the best consumer protection. Thank you, Mr. Chairman. " fcic_final_report_full--200 Looking back at how the targeted affordable portfolio performed in comparison with overall losses, the  presentation at Freddie Mac took the analysis of the goals’ costs one step further. While the outstanding  billion of these targeted af- fordable loans was only  of the total portfolio, these were relatively high-risk loans and were expected to account for  of total projected losses. In fact, as of late , they had accounted for only  of losses—meaning that they had performed better than expected in relation to the whole portfolio. The company’s major losses came from loans acquired in the normal course of business. The presentation noted that many of these defaulted loans were Alt-A.  COMMISSION CONCLUSIONS ON CHAPTER 9 The Commission concludes that firms securitizing mortgages failed to perform adequate due diligence on the mortgages they purchased and at times knowingly waived compliance with underwriting standards. Potential investors were not fully informed or were misled about the poor quality of the mortgages contained in some mortgage-related securities. These problems appear to have been signifi- cant. The Securities and Exchange Commission failed to adequately enforce its disclosure requirements governing mortgage securities, exempted some sales of such securities from its review, and preempted states from applying state law to them, thereby failing in its core mission to protect investors. The Federal Reserve failed to recognize the cataclysmic danger posed by the housing bubble to the financial system and refused to take timely action to con- strain its growth, believing that it could contain the damage from the bubble’s collapse. Lax mortgage regulation and collapsing mortgage-lending standards and practices created conditions that were ripe for mortgage fraud. CHRG-110hhrg46596--108 Mr. Kashkari," Not specifically. In some cases, banks offered some indicator. We felt that--a couple of things on this, because it is very important. The overall purpose was to put more capital in the financial system, to increase the strength of the system and, over time, increase lending. By putting more capital in, restricting dividends and restricting share repurchases, the banks have very strong economic incentive to want to put that money to work. If they don't put it to work, their return on equity, their return on assets will go down, so their returns will suffer. So we wanted to put the right economic incentives in there. But, at the same time, thousands of banks across the country in all of our communities--it is very hard for us to try to micromanage and say, ``This is how you should run your business,'' because each bank, and each community, is a little bit different. So we wanted to work with the regulators to identify the healthy banks, put capital in on the same terms, and then create the economic incentives for them to want to go make new loans. " CHRG-110hhrg44903--14 Mr. Cox," Thank you very much, Chairman Frank, Ranking Member Bachus, and members of the committee. It is a pleasure to appear on this panel with my regulatory colleague, Tim Geithner. Under his leadership at the New York Fed, the SEC and the New York Fed have established a very strong and positive working relationship. I want to thank this committee for inviting me to testify on behalf of the SEC about reform of the U.S. financial regulatory system. There is no question, as several of you have just pointed out, that the financial regulatory structure that was forged in the Great Depression has served this Nation well over the intervening 8 decades. Even today in the midst of current strains on the financial sector, the U.S. capital market is larger, deeper, and more liquid than any other market in the world. In large measure, that is due to the world-class protections that investors enjoy in the United States, and those are protections that we should secure. In the decade since our regulatory agencies were chartered, the capital markets and the broader economy have undergone profound changes. The regulatory system in the main has adapted well to some of these changes, but other changes have presented new challenges that are rightly the subject of this committee's review as you consider legislative solutions. I hasten to add that, given the many strengths of the current regulatory system, we don't need to start from scratch. Instead, we can build on what we know has worked. At the same time, we can take lessons from what has not worked and modernize, rather than replace, the current system. One thing that has worked exceptionally well is the regulatory concept of an agency chartered to protect investors, to maintain fair, orderly markets, and to promote capital formation. If the SEC didn't already exist, Congress would have to invent it. Each of the elements of the SEC's mission is mutually reinforcing of the others. The Commission's work to protect investors through our enforcement program has been greatly benefited by the expertise of the SEC staff who specialize in the regulation and supervision of broker dealers and investment advisors. The Commission's regulatory program, including our commitment to ensuring full disclosure of information about public companies, has been informed by the experience, in turn, of the enforcement and examination staffs. But I hasten to add that, given these many strengths, there are many problems as well in the current system. Today when derivatives compete with securities and futures, and insurance products are sold for their investment features, it is no longer true that we can stovepipe regulation. As we approach the end of the first decade of the 21st Century, the growing gaps and crevices in our regulatory system are beginning to show. We all know that the current market crisis began with the deterioration of mortgage origination standards. As a result, it could have been contained to banking and real estate if only our markets weren't so interconnected. But in today's world, these problems quickly spread throughout the capital markets through securitization, and at the same time, the explosive growth of the over-the-counter derivatives markets have drawn the world's major financial institutions into a tangled web of deeper interconnections. This has led to the realization that when a major commercial or investment bank is threatened, so, too, may be the entire marketplace. And it has cast a spotlight on the significant regulatory gap that currently exists when it comes to the regulation of investment banks. When this committee devised the Gramm-Leach-Bliley Act in 1999, you--or perhaps I should say ``I'' because, along with many of you, I served on the conference committee that wrote the legislation--decided that the SEC would serve as the functional regulator with responsibility over broker dealers, investment advisors, and mutual funds. And we decided that the Federal banking regulators similarly would be functional regulators for banking activities. Under this approach, the securities-related activities would be regulated by the SEC, which would also continue to be responsible for regulating broker dealers that are the central entities in investment banks. The Fed would be given consolidated oversight of holding companies that contain broker dealers and also most types of insured depository institutions. And finally, the SEC would retain the authority to regulate that net capital of broker dealers within the financial holding companies. But no explicit arrangement was established for the regular sharing of information between the Fed and the SEC in order to take into account the need to view capital and liquidity on an entity-wide basis. And that is what the memorandum of understanding between the Federal Reserve Board and the SEC is accomplishing today. Likewise, neither the Commission nor the Fed was authorized to exercise mandatory consolidated supervision over investment bank holding companies. As a result, today there is simply no provision in law that requires investment bank holding companies to compute capital measures and maintain liquidity on a consolidated basis. In 2004, the Commission adopted our voluntary program, called the Consolidated Supervised Entities Program, to fill this regulatory gap. But now, recent events have highlighted the need for legislative improvements as well. We need to fill the Gramm-Leach-Bliley regulatory gap by amending the existing statutory authorization for voluntary SEC supervision of investment bank holding companies to make it mandatory for all firms that today are regulated as CSEs. The Commission should be given a statutory mandate to perform this function at the holding company level along with the authority to require compliance. In addition, legislation should prescribe explicitly how the resolution of financial difficulties at investment bank holding companies will be organized and funded. Any regulatory reform that you undertake should recognize the very fundamental business, accounting, and regulatory differences between investment banks and commercial banks. Rather than extend the current approach of commercial bank regulation to investment banks, I believe Congress and regulators must recognize that different regulatory structures are needed for oversight of these industries and, in particular, that investment banks should not be treated like commercial banks by providing them with permanent access to government-provided backstopped liquidity. The added regulation that this would necessitate, following the commercial bank model, would fundamentally alter the role that investment banks play in the economy. In addition, as you weigh other possible reforms, there are five points that should be carefully considered: First, were the Congress to consider addressing the potential for future Bear Stearns-like rescues in statute, any such authority should be reserved for exceptionally rare cases. Second, the securities and bankruptcy laws currently provide an explicit statutory framework for liquidating a failed securities brokerage firm and for protecting customer cash and securities. This framework generally works as well, even in instances of fraud. I would not recommend changing the system. Third, for banks and thrifts, the FDIC has long served as the receiver for failed banks. The FDIC Improvement Act, FDICIA, mandates a least-cost resolution analysis and imposes intentionally onerous restrictions on a bank's ability to receive lender-of-last-resort funding. This is a useful model for resolving investment banks as well. Fourth, FDICIA prescribes a detailed process involving super-majority approvals by the interested regulators and formal approval of the Secretary of the Treasury after consultation with the President. It also requires detailed findings of serious adverse effects on economic conditions or financial stability and a finding that the proposed action would mitigate any adverse effects. These, too, are important constraints. Fifth and finally, OTC derivatives receive special treatment in bankruptcy proceedings. In particular, in the event of insolvency, counterparties can immediately terminate their contracts and seize any collateral related to OTC derivatives. As a result, today, unwinding a significant portfolio in bankruptcy can threaten market disruptions and raise systemic issues. To remedy this problem, the SEC should be given explicit authority to control the liquidation of investment bank holding companies or their unregulated affiliates that generally hold most of the derivative positions. Mr. Chairman, I hope that these observations from the SEC will be of assistance to you and to the committee as you consider the broad questions of whether and, if so, how to reform the existing Federal regulatory system for financial services. Thank you, again, for this opportunity to discuss these important issues. I look forward to taking your questions. [The prepared statement of Chairman Cox can be found on page 46 of the appendix.] " CHRG-111shrg51395--67 Mr. Coffee," Again, it is a perfectly fair question and I am not telling you that every bank should be bailed out, not even every large bank. But if we are going to get the financial system working again, we have to move credit through banks. Senator Shelby. Sure. " FinancialCrisisReport--173 ARMs, 50% of its subprime loans, and 90% of its home equity loans. 621 WaMu also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount exceeded 80% of the value of the underlying property. The Inspectors General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home equity loans had LTV ratios in excess of 80%. 622 Still another problem was that WaMu had high concentrations of its home loans in California and Florida, states that ultimately suffered above-average home value depreciation. 623 WaMu issued loans through its own retail loan offices, through Long Beach, which issued subprime loans initiated by third party mortgage brokers, and through correspondent and conduit programs in which the bank purchased loans from third parties. The Treasury and the FDIC Inspectors General observed that, from 2003 to 2007, 48 to 70% of WaMu’s residential mortgages came from third party mortgage brokers, and that only 14 WaMu employees were responsible for overseeing more than 34,000 third party brokers, 624 requiring each WaMu employee to oversee more than 2,400 third party brokers. When the subprime market collapsed in July 2007, Washington Mutual was left holding a portfolio saturated with high risk, poorly performing loans. Prior to the collapse, WaMu had sold or securitized the majority of the loans it had originated or purchased, undermining the U.S. home loan mortgage market with hundreds of billions of dollars in high risk, poor quality loans. OTS documentation shows that WaMu’s regulators saw what was happening, identified the problems, but then took no enforcement actions to protect either Washington Mutual or the U.S. financial system from the bank’s shoddy lending practices. (2) Overview of Washington Mutual’s Ratings History and Closure An overview of Washington Mutual’s ratings history shows how OTS and the FDIC were required to work together to oversee Washington Mutual, which the two agencies did with varying levels of success. At times, the relationship was productive and useful, while at others they found themselves bitterly at odds over how to proceed. As Washington Mutual’s problems intensified, the working relationship between OTS and the FDIC grew more dysfunctional. From 2004 to 2006, Washington Mutual was a profitable bank and enjoyed a 2 CAMELS rating from both agencies, signifying it was a fundamentally sound institution. In late 2006, as housing prices began to level off for the first time in years, subprime loans began to experience delinquencies and defaults. In part because borrowers were unable to refinance their loans, those delinquencies and defaults accelerated in 2007. The poorly performing loans began to affect the payments supporting subprime mortgage backed securities, which began to incur losses. In July 2007, the subprime market was performing so poorly that the major credit rating agencies suddenly downgraded hundreds of subprime mortgage backed securities, including over 40 issued by Long Beach. The subprime market slowed and then collapsed, and Washington Mutual was suddenly left with billions of dollars in unmarketable subprime loans and securities 621 Id. at 10. 622 Id. 623 Id. at 11. 624 See Thorson prepared statement, at 5, April 16, 2010 Subcommittee Hearing at 105. that were plummeting in value. WaMu stopped issuing subprime loans. In the fourth quarter of 2007, WaMu reported a $1 billion loss. CHRG-111hhrg48867--84 Mr. Wallison," Thank you, Congressman. Your point about auto manufacturers, I think, suggests how plastic and unclear this whole idea of systemic risk really is. We all talk about it as though it is something that we understand. But it is highly theoretical, and we don't really have an example yet of systemic risk being created by anything other than, as I said in my oral testimony, anything other than some kind of external factor affecting the entire market. The market--the financial system around the world, and especially in the United States--is seriously troubled now, but not because of the failure of any particular company; rather, because of all of the bad mortgages that were spread throughout the world. Regulation did not prevent that from happening. We had a very strong regulatory system in place. The banks were subject to it. FDICIA, which I think you would remember well from your service here at the time, was intended to be the end of all bad banking crises. It is a very strong law, and yet we now have the worst banking crisis of all time. So I think before Congress acts on the question of systemic risk, there ought to be some understanding of what we are really talking about. Because if an agency is empowered to regulate systemic risk--it could apply to auto manufacturers as well as anyone else--Congress is handing over a blank check to a government agency, and that would be a very bad precedent. " FOMC20080916meeting--38 36,MR. LACKER.," Note here a sense of discomfort with our lending them dollars that they already have and so our serving as a substitute for their mobilizing their own dollar reserves for this purpose. Obviously, the demand could swamp their own reserves, and at that point I would feel differently about this. But my understanding is that the distribution within the European system of central banks is uneven, and in some sense this just provides them with a way to circumvent negotiating how those dollars would be distributed from different central banks to different private-sector banks within their own system. Broadly, I'm uncomfortable with our playing that role. " CHRG-111hhrg48874--96 Mr. Castle," I think you said this, Governor Duke, but if we had a systemic risk regulator, should we be looking at things like hedge funds and investment banks and even corporations, insurance companies, other entities beyond the banks which are very involved in the credit markets today? Ms. Duke. I'm not certain--I think one of the things about systemic risk is we have to look beyond individual firms. And I think a systemic risk regulator would certainly want to gather information from all participants in the financial markets while they might not necessarily regulate specific firms and specific industries. " fcic_final_report_full--184 CDOs were issued under a different regulatory framework from the one that ap- plied to many mortgage-backed securities, and were not subject even to the minimal shelf registration rules. Underwriters typically issued CDOs under the SEC’s Rule A, which allows the unregistered resale of certain securities to so-called qualified institutional buyers (QIBs); these included investors as diverse as insurance compa- nies like MetLife, pension funds like the California State Teachers’ Retirement Sys- tem, and investment banks like Goldman Sachs.  The SEC created Rule A in , making securities markets more attractive to borrowers and U.S. investment banks more competitive with their foreign counter- parts; at the time, market participants viewed U.S. disclosure requirements as more onerous than those in other countries. The new rule significantly expanded the mar- ket for these securities by declaring that distributions which complied with the rule would no longer be considered “public offerings” and therefore would not be subject to the SEC’s registration requirements. In , Congress reinforced this exemption with the National Securities Markets Improvements Act, legislation that Denise Voigt Crawford, a commissioner on the Texas Securities Board, characterized to the Com- mission “as prohibit[ing] the states from taking preventative actions in areas that we now know have been substantial contributing factors to the current crisis.”  Under this legislation, state securities regulators were preempted from overseeing private placements such as CDOs. In the absence of registration requirements, a new debt market developed quickly under Rule A. This market was liquid, since qualified investors could freely trade Rule A debt securities. But debt securities when Rule A was enacted were mostly corporate bonds, very different from the CDOs that dominated the private placement market more than a decade later.  After the crisis unfolded, investors, arguing that disclosure hadn’t been adequate, filed numerous lawsuits under federal and state securities laws. As we will see, some have already resulted in substantial settlements. REGULATORS: “MARKETS WILL ALWAYS SELF CORRECT ” Where were the regulators? Declining underwriting standards and new mortgage products had been on regulators’ radar screens in the years before the crisis, but dis- agreements among the agencies and their traditional preference for minimal interfer- ence delayed action. Supervisors had, since the s, followed a “risk-focused” approach that relied extensively on banks’ own internal risk management systems.  “As internal systems improve, the basic thrust of the examination process should shift from largely dupli- cating many activities already conducted within the bank to providing constructive feedback that the bank can use to enhance further the quality of its risk-management systems,” Chairman Greenspan had said in .  Across agencies, there was a “his- toric vision, historic approach, that a lighter hand at regulation was the appropriate way to regulate,” Eugene Ludwig, comptroller of the currency from  to , told the FCIC, referring to the Gramm-Leach-Bliley Act in .  The New York Fed, in a “lessons-learned” analysis after the crisis, pointed to the mistaken belief that “markets will always self-correct.” “A deference to the self-correcting property of markets inhib- ited supervisors from imposing prescriptive views on banks,” the report concluded.  The reliance on banks’ own risk management would extend to capital standards. Banks had complained for years that the original  Basel standards did not allow them sufficient latitude to base their capital on the riskiness of particular assets. After years of negotiations, international regulators, with strong support from the Fed, in- troduced the Basel II capital regime in June , which would allow banks to lower their capital charges if they could show they had sophisticated internal models for es- timating the riskiness of their assets. While no U.S. bank fully implemented the more sophisticated approaches that it allowed, Basel II reflected and reinforced the super- visors’ risk-focused approach. Spillenkothen said that one of the regulators’ biggest mistakes was their “acceptance of Basel II premises,” which he described as display- ing “an excessive faith in internal bank risk models, an infatuation with the specious accuracy of complex quantitative risk measurement techniques, and a willingness (at least in the early days of Basel II) to tolerate a reduction in regulatory capital in re- turn for the prospect of better risk management and greater risk-sensitivity.”  Regulators had been taking notice of the mortgage market for several years before the crisis. As early as , they recognized that mortgage products and borrowers had changed during and following the refinancing boom of the previous year, and they began work on providing guidance to banks and thrifts. But too little was done, and too late, because of interagency discord, industry pushback, and a widely held view that market participants had the situation well in hand. “Within the board, people understood that many of these loan types had gotten to an extreme,” Susan Bies, then a Fed governor and chair of the Federal Reserve Board’s subcommittees on both safety and soundness supervision and consumer protection supervision, told the FCIC. “So the main debate within the board was how tightly [should we] rein in the abuses that we were seeing. So it was more of ‘to a degree.’”  Indeed, in the same June  Federal Open Market Committee meeting de- scribed earlier, one FOMC member noted that “some of the newer, more intricate and untested credit default instruments had caused some market turmoil.” Another participant was concerned “that subprime lending was an accident waiting to hap- pen.” A third participant noted the risks in mortgage securities, the rapid growth of subprime lending, and the fact that many lenders had “inadequate information on borrowers,” adding, however, that record profits and high capital levels allayed those concerns. A fourth participant said that “we could be seeing the final gasps of house price appreciation.” The participant expressed concern about “creative financing” and was “worried that piggybacks and other non-traditional loans,” whose risk of default could be higher than suggested by the securities they backed, “could be making the books of GSEs look better than they really were.” Fed staff replied that the GSEs were not large purchasers of private label securities.  CHRG-111hhrg55814--40 Secretary Geithner," No, but this is important. Right now, if you were a globally active bank, the capital requirements you are held to are different from and tougher than if you were a regional or community bank. So that's the system we have today. Now those banks know who they are, they exist, and they're designated as globally active banks. " CHRG-111hhrg48867--107 Mr. Wallison," Let me try to start on that, Congresswoman, and just say that if you were to bail out any U.S. bank of any size, you are going to be bailing out foreign banks, because banks are all interconnected. They make loans to one another. And that is, in fact, the essence of the financial system; banks and others are all intermediaries; they are moving money from one place to another. " CHRG-111shrg50814--107 Mr. Bernanke," That is why the economy is under such pressure. Absolutely. There is--it is useful to think about credit as coming from two places, the banks and then the non-bank sources like asset-backed securities and commercial paper. On the banking side, our objectives, for example, working with the Treasury, are to try to stabilize the banking system, make sure they have enough capital to lend, and make sure they have enough liquidity. In addition, as part of our supervisory oversight, we want to make sure there is an appropriate balance between caution, which is critical--banks need to be cautious in their loans--but on the other hand, we want to make sure that they make loans to credit-worthy borrowers and are not turning down good borrowers because their regulator told them they can't make a loan. We don't want that to happen. We know sometimes it does happen, so we are trying hard to tell our examiners if the bank has a good loan to make and it is a good customer, let them make that loan. We want that to happen. So that is the banking side. On the non-bank side, again, it is a difficult problem, but the Fed is doing its best to work through some of these markets together with the Treasury to try to get credit flowing again through asset-backed securities markets and other types of non-bank markets. Senator Hutchison. My time is up. Thank you, Mr. Chairman. " CHRG-111hhrg56776--17 Mr. Bernanke," Mr. Chairman, we are quite concerned by proposals to make the Fed a regulator only of the biggest banks. It makes us essentially the ``too-big-to-fail'' regulator. We do not want that responsibility. We want to have a connection to Main Street as well as to Wall Street. We need to have insights into what is happening in the entire banking system to understand how regulation affects banks, to understand the status of the assets and credit problems of banks at all levels, all sizes, and smaller and medium-sized banks are very valuable to us and they provide irreplaceable information, both in terms of making monetary policy and in terms of us understanding the economy, but also in terms of financial stability. Let's not forget that small institutions have been part of financial crises in the past, including in the 1930's, in the thrift crisis, and other examples. We think it is very important for the Federal Reserve not to be just the big institution regulator. We need to have exposure to the entire economy and to the broad financial system. " fcic_final_report_full--102 SUBPRIME LOANS:  “BUYERS WILL PAY A HIGH PREMIUM ” The subprime market roared back from its shakeout in the late s. The value of subprime loans originated almost doubled from  through , to  billion. In ,  of these were securitized; in , .  Low interest rates spurred this boom, which would have long-term repercussions, but so did increasingly wide- spread computerized credit scores, the growing statistical history on subprime bor- rowers, and the scale of the firms entering the market. Subprime was dominated by a narrowing field of ever-larger firms; the marginal players from the past decade had merged or vanished. By , the top  subprime lenders made  of all subprime loans, up from  in .  There were now three main kinds of companies in the subprime origination and securitization business: commercial banks and thrifts, Wall Street investment banks, and independent mortgage lenders. Some of the biggest banks and thrifts—Citi- group, National City Bank, HSBC, and Washington Mutual—spent billions on boost- ing subprime lending by creating new units, acquiring firms, or offering financing to other mortgage originators. Almost always, these operations were sequestered in nonbank subsidiaries, leaving them in a regulatory no-man’s-land. When it came to subprime lending, now it was Wall Street investment banks that worried about competition posed by the largest commercial banks and thrifts. For- mer Lehman president Bart McDade told the FCIC that the banks had gained their own securitization skills and didn’t need the investment banks to structure and dis- tribute.  So the investment banks moved into mortgage origination to guarantee a supply of loans they could securitize and sell to the growing legions of investors. For example, Lehman Brothers, the fourth-largest investment bank, purchased six differ- ent domestic lenders between  and , including BNC and Aurora.  Bear Stearns, the fifth-largest, ramped up its subprime lending arm and eventually ac- quired three subprime originators in the United States, including Encore. In , Merrill Lynch acquired First Franklin, and Morgan Stanley bought Saxon Capital; in , Goldman Sachs upped its stake in Senderra Funding, a small subprime lender. Meanwhile, several independent mortgage companies took steps to boost growth. CHRG-111hhrg48873--293 Mr. Bernanke," Congressman, I certainly do not reject capitalism. I don't think this was a failure of capitalism per se. And I also think the free market should be the primary mechanism for allocating capital. Markets have shown over many decades that they can allocate money to new enterprises, to new technologies, very effectively. And so we want to maintain that free capital market structure. It is nevertheless the case that we have seen over the decades and the centuries that financial systems can be prone to panics, runs, booms, and busts. And for better or worse, we have developed mechanisms like deposit insurance and lender of last resort to try to avert those things. Those protections, in turn, require some oversight to avoid the buildup of risk. Dr. Paul. May I interrupt, please? " CHRG-111hhrg56776--120 Mr. Bernanke," We operate the way all the bank regulators do, which is we want to make sure the banks are safe and sound, so to the extent they are taking derivative positions or hedging their risk, we want to make sure they are doing so in a way that is safe, that takes into account counterparty risk, takes into account the full range of risks they face. Clearly, safety and soundness is a big part of our mission. We want to make sure those banks are safe. At the same time, the stability of the entire system depends on the operation of derivatives markets, for example. We saw in the crisis how problems with credit default swaps and other types of derivatives caused broader issues in the economy. As a regulator of the banking system, we will be able to see what is happening and be able to make better decisions about how to address any potential risks to the broad system that those kinds of products might pose. " fcic_final_report_full--545 System and certain of the presidents of the Federal Reserve Banks; oversees market conditions and implements monetary policy through such means as setting interest rates. Federal Reserve Bank of New York One of  regional Federal Reserve Banks, with responsibility for regulating bank holding companies in New York State and nearby areas. Federal Reserve U.S. central banking system created in  in response to financial panics, con- sisting of the Federal Reserve Board in Washington, DC, and  Federal Reserve Banks around the country; its mission is to implement monetary policy through such means as setting inter- est rates, supervising and regulating banking institutions, maintaining the stability of the fi- nancial system, and providing financial services to depository institutions. FHA see Federal Housing Administration . FHFA see Federal Housing Finance Agency. FICO score A measure of a borrower’s creditworthiness based on the borrower’s credit data; de- veloped by the Fair Isaac Corporation. Financial Crimes Enforcement Network Treasury office that collects and analyzes information about financial transactions to combat money laundering, terroristfinancing, and other finan- cial crimes. FinCEN see Financial Crimes Enforcement Network . FOMC see Federal Open Market Committee . foreclosure Legal process whereby a mortgage lender gains ownership of the real property secur- ing a defaulted mortgage. Freddie Mac Nickname for the Federal Home Loan Mortgage Corporation (FHLMC), a govern- ment-sponsored enterprise providing financing for the home mortgage market. Ginnie Mae Nickname for the Government National Mortgage Association (GNMA), a govern- ment-sponsored enterprise ; guarantees pools of VA and FHA mortgages. Glass-Steagall Act Banking Act of  creating the FDIC to insure bank deposits; prohibited commercial banks from underwriting or dealing in most types of securities, barred banks from affiliating with securities firms, and introduced other banking reforms.  In , the Gramm-Leach-Bliley Act repealed the provisions of the Glass-Steagall Act that prohibited affil- iations between banks and securities firms. government-sponsored enterprise A private corporation, such as Fannie Mae and Freddie Mac , created by the federal government to pursue certain public policy goals designated in its charter. Gramm-Leach-Bliley Act  legislation that lifted certain remaining restrictions established by the Glass-Steagall Act . GSE see government-sponsored enterprise . haircut The difference between the value of an asset and the amount borrowed against it. hedge In finance, a way to reduce exposure or risk by taking on a new financial contract. hedge fund A privately offered investment vehicle exempted from most regulation and oversight; generally open only to high-net-worth investors. HOEPA see Home Ownership and Equity Protection Act . Home Ownership and Equity Protection Act  federal law that gave the Federal Reserve new responsibility to address abusive and predatory mortgage lending practices. Housing and Economic Recovery Act  law including measures to reform and regulate the GSEs ; created the Federal Housing Finance Agency . HUD see Department of Housing and Urban Development. hybrid CDO A CDO backed by collateral found in both cash CDOs and synthetic CDOs. illiquid assets Assets that cannot be easily or quickly sold. interest-only loan Loan that allows borrowers to pay interest without repaying principal until the end of the loan term. leverage A measure of how much debt is used to purchase assets; for example, a leverage ratio of : means that  of assets were purchased with  of debt and  of capital . CHRG-111hhrg53248--160 Secretary Geithner," Not all. But in the banking area, that difference between the thrift and the bank charter as it was enforced--now, there are hundreds of well-run thrifts across the country. But there were unfortunately a few very big examples that caused a lot of damage where effectively people would go from one system that was stronger to a weaker system, grow market share, took themselves to the edge of the abyss because of that, and that is something we have to prevent. " CHRG-111shrg56415--83 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System October 14, 2009 Chairman Johnson, Ranking Member Crapo, and members of the Subcommittee, thank you for your invitation to discuss the condition of the U.S. banking industry. First, I will review the current conditions in financial markets and the overall economy and then turn to the performance of the banking system, highlighting particular challenges in commercial real estate (CRE) and other loan portfolios. Finally, I will address the Federal Reserve's regulatory and supervisory responses to these challenges.Conditions in Financial Markets and the Economy Conditions and sentiment in financial markets have continued to improve in recent months. Pressures in short-term funding markets have eased considerably, broad stock price indexes have increased, risk spreads on corporate bonds have narrowed, and credit default swap spreads for many large bank holding companies, a measure of perceived riskiness, have declined. Despite improvements, stresses remain in financial markets. For example, corporate bond spreads remain quite high by historical standards, as both expected losses and risk premiums remain elevated. Economic growth appears to have moved back into positive territory last quarter, in part reflecting a pickup in consumer spending and a slight increase in residential investment--two components of aggregate demand that had dropped to very low levels earlier in the year. However, the unemployment rate has continued to rise, reaching 9.8 percent in September, and is unlikely to improve materially for some time. Against this backdrop, borrowing by households and businesses has been weak. According to the Federal Reserve's Flow of Funds accounts, household and nonfinancial business debt contracted in the first half of the year and appears to have decreased again in the third quarter. For households, residential mortgage debt and consumer credit fell sharply in the first half; the decline in consumer credit continued in July and August. Nonfinancial business debt also decreased modestly in the first half of the year and appears to have contracted further in the third quarter as net decreases in commercial paper, commercial mortgages, and bank loans more than offset a solid pace of corporate bond issuance. At depository institutions, loans outstanding fell in the second quarter of 2009. In addition, the Federal Reserve's weekly bank credit data suggests that bank loans to households and to nonfinancial businesses contracted sharply in the third quarter. These declines reflect the fact that weak economic growth can both damp demand for credit and lead to tighter credit supply conditions. The results from the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices indicate that both the availability and demand for bank loans are well below pre-crisis levels. In July, more banks reported tightening their lending standards on consumer and business loans than reported easing, although the degree of net tightening was well below levels reported last year. Almost all of the banks that tightened standards indicated concerns about a weaker or more uncertain economic outlook, and about one-third of banks surveyed cited concerns about deterioration in their own current or future capital positions. The survey also indicates that demand for consumer and business loans has remained weak. Indeed, decreased loan demand from creditworthy borrowers was the most common explanation given by respondents for the contraction of business loans this year. Taking a longer view of cycles since World War II, changes in debt flows have tended to lag behind changes in economic activity. Thus, it would be unusual to see a return to a robust and sustainable expansion of credit until after the overall economy begins to recover. Credit losses at banking organizations continued to rise through the second quarter of this year, and banks face risks of sizable additional credit losses given the outlook for production and employment. In addition, while the decline in housing prices slowed in the second quarter, continued adjustments in the housing market suggest that foreclosures and mortgage loan loss severities are likely to remain elevated. Moreover, prices for both existing commercial properties and for land, which collateralize commercial and residential development loans, have declined sharply in the first half of this year, suggesting that banks are vulnerable to significant further deterioration in their CRE loans. In sum, banking organizations continue to face significant challenges, and credit markets are far from fully healed.Performance of the Banking System Despite these challenges, the stability of the banking system has improved since last year. Many financial institutions have been able to raise significant amounts of capital and have achieved greater access to funding. Moreover, through the rigorous Supervisory Capital Assessment Program (SCAP) stress test conducted by the banking agencies earlier this year, some institutions demonstrated that they have the capacity to withstand more-adverse macroeconomic conditions than are expected to develop and have repaid the government's Troubled Asset Relief Program (TARP) investments.\1\ Depositors' concerns about the safety of their funds during the immediate crisis last year have also largely abated. As a result, financial institutions have seen their access to core deposit funding improve.--------------------------------------------------------------------------- \1\ For more information about the SCAP, see Ben S. Bernanke (2009), ``The Supervisory Capital Assessment Program,'' speech delivered at the Federal Reserve Bank of Atlanta 2009 Financial Markets Conference, held in Jekyll Island, Ga., May 11, www.Federalreserve.gov/newsevents/speech/bernanke20090511a.htm.--------------------------------------------------------------------------- However, the banking system remains fragile. Nearly 2 years into a substantial recession, loan quality is poor across many asset classes and, as noted earlier, continues to deteriorate as lingering weakness in housing markets affects the performance of residential mortgages and construction loans. Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital ratios are considerably higher than they were at the start of the crisis for many banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions. Diminished loan demand, more-conservative underwriting standards in the wake of the crisis, recessionary economic conditions, and a focus on working out problem loans have also limited the degree to which banks have added high quality loans to their portfolios, an essential step to expanding profitable assets and thus restoring earnings performance. These developments have raised the number of problem banks to the highest level since the early 1990s, and the rate of bank and thrift failures has accelerated throughout the year. Moreover, the estimated loss rates for the deposit insurance fund on bank failures have been very high, generally hovering near 30 percent of assets. This high loss level reflects the rapidity with which loan quality has deteriorated during the crisis and suggests that banking organizations may need to continue their high level of loan loss provisioning for some time. Moreover, some of these institutions, including those with capital above minimum requirements, may need to raise more capital and restrain their dividend payouts for the foreseeable future. Indeed, the buildup in capital ratios at large banking organizations has been essential to reassuring the market of their improving condition. However, we must recognize that capital ratios can be an imperfect indicator of a bank's overall strength, particularly in periods in which credit quality is deteriorating rapidly and loan loss rates are moving higher.Comparative Performance of Banking Institutions by Asset Size Although the broad trends detailed above have affected all financial institutions, there are some differences in how the crisis is affecting large financial institutions and more locally focused community and regional banks. Consider, for example, the 50 largest U.S. bank holding companies, which hold more than three-quarters of bank holding company assets and now include the major investment banks in the United States. While these institutions do engage in traditional lending activities, originating loans and holding them on their balance sheets like their community bank competitors, they also generate considerable revenue from trading and other fee-based activities that are sensitive to conditions in capital markets. These firms reported modest profits during each of the first two quarters of 2009. Second-quarter net income for these companies at $1.6 billion was weaker than that of the first quarter, but was still a great improvement over the $19.8 billion loss reported for the second quarter of last year. Net income was depressed by the payment of a significant share of the Federal Deposit Insurance Corporation's (FDIC) special deposit insurance assessment and a continued high level of loan loss provisioning. Contributing significantly to better performance was the improvement of capital markets activities and increases in related fees and revenues. Community and small regional banks have also benefited from the increased stability in financial markets. However, because they depend largely on revenues from traditional lending activities, as a group they have yet to report any notable improvement in earnings or condition since the crisis took hold. These banks--with assets of $10 billion or less representing almost 7,000 banks and 20 percent of commercial bank assets--reported a $2.7 billion loss in the second quarter. Earnings remained weak at these banks due to a historically narrow net interest margin and high loan loss provisions. More than one in four of these banks reported a net loss. Earnings at these banks were also substantially affected by the FDIC special assessment during the second quarter. Loan quality deteriorated significantly for both large and small institutions during the second quarter. At the largest 50 bank holding companies, nonperforming assets climbed more than 20 percent, raising the ratio of nonperforming assets to 4.3 percent of loans and other real estate owned. Most of the deterioration was concentrated in residential mortgage and construction loans, but commercial, CRE, and credit card loans also experienced rising delinquency rates. Results of the banking agencies' Shared National Credit review, released in September, also document significant deterioration in large syndicated loans, signaling likely further deterioration in commercial loans.\2\ At community and small regional banks, nonperforming assets increased to 4.4 percent of loans at the end of the second quarter, more than six times the level for this ratio at year-end 2006, before the crisis started. Home mortgages and CRE loans accounted for most of the increase, but commercial loans have also shown marked deterioration during recent quarters. Importantly, aggregate equity capital for the top 50 bank holding companies, and thereby for the banking industry, increased for the third consecutive quarter and reached 8.8 percent of consolidated assets as of June 30, 2009. This level was almost 1 percentage point above the year-end 2008 level and exceeded the pre-crisis level of midyear 2007 by more than 2 percentage points. Risk-based capital ratios for the top 50 bank holding companies also remained relatively high: Tier 1 capital ratios were at 10.75 percent, and total risk-based capital ratios were at 14.09 percent. Signaling the recent improvement in financial markets since the crisis began, capital increases during the first half of this year largely reflected common stock issuance, supported also by reductions in dividend payments. However, asset contraction also accounts for part of the improvement in capital ratios. Additionally, of course, the Treasury Capital Purchase Program also contributed to the increase in capital in the time since the crisis emerged.--------------------------------------------------------------------------- \2\ See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2009), ``Credit Quality Declines in Annual Shared National Credits Review,'' joint press release, September 24, www.Federalreserve.gov/newsevents/press/bcreg/20090924a.htm.--------------------------------------------------------------------------- Despite TARP capital investments in some banks and the ability of others to raise equity capital, weak earnings led to modest declines in the average capital ratios of smaller banks over the past year--from 10.7 percent to 10.4 percent of assets as of June 30 of this year. However, risk-based capital ratios remained relatively high for most of these banks, with 96 percent maintaining risk-based capital ratios consistent with a ``well capitalized'' designation under prompt corrective action standards. Funding for the top 50 bank holding companies has improved markedly over the past year. In addition to benefiting from improvement in interbank markets, these companies increased core deposits from 24 percent of total assets at year-end 2008 to 27 percent as of June 30, 2009. The funding profile for community and small regional banks also improved, as core deposit funding rose to 62 percent of assets and reliance on brokered deposits and Federal Home Loan Bank advances edged down from historically high levels. As already noted, substantial financial challenges remain for both large and small banking institutions. In particular, some large regional and community banking firms that have built up unprecedented concentrations in CRE loans will be particularly affected by emerging conditions in real estate markets. I will now discuss the economic conditions and financial market dislocations affecting CRE markets and the implications for banking organizations.Current Conditions in Commercial Real Estate Markets Prices of existing commercial properties are estimated to have declined 35 to 40 percent since their peak in 2007, and market participants expect further declines. Demand for commercial property has declined as job losses have accelerated, and vacancy rates have increased. The higher vacancy levels and significant decline in the value of existing properties have placed particularly heavy pressure on construction and development projects that generate no income until completion. Developers typically depend on the sales of completed projects to repay their outstanding loans, and with the volume of property sales at especially low levels and with prices depressed, the ability to service existing construction loans has been severely impaired. The negative fundamentals in the CRE property markets have caused a sharp deterioration in the credit performance of loans in banks' portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion. Also at the end of the second quarter, about 9 percent of CRE loans on banks' books were considered delinquent, almost double the level of a year earlier.\3\ Loan performance problems were the most striking for construction and development loans, especially for those that finance residential development. More than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter.--------------------------------------------------------------------------- \3\ The CRE loans considered delinquent on banks' books were non-owner occupied CRE loans that were 30 days or more past due.--------------------------------------------------------------------------- Almost $500 billion of CRE loans will mature each year over the next few years. In addition to losses caused by declining property cash-flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will place continued pressure on banks' earnings, especially those of smaller regional and community banks that have high concentrations of CRE loans. The current fundamental weakness in CRE markets is exacerbated by the fact that the CMBS market, which had financed about 30 percent of originations and completed construction projects, has remained virtually inoperative since the start of the crisis. Essentially no CMBS have been issued since mid-2008. New CMBS issuance came to a halt as risk spreads widened to prohibitively high levels in response to the increase in CRE-specific risk and the general lack of liquidity in structured debt markets. Increases in credit risk have significantly softened demand in the secondary trading markets for all but the most highly rated tranches of these securities. Delinquencies of mortgages backing CMBS have increased markedly in recent months. Market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also by borrowers' difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has generated significant stresses on the balance sheets of financial institutions that must mark these securities to market, further limiting their appetite for taking on new CRE exposure.Federal Reserve Activities to Help Revitalize Credit Markets The Federal Reserve, along with other government agencies, has taken a number of actions to strengthen the financial sector and to promote the availability of credit to businesses and households. In addition to aggressively easing monetary policy, the Federal Reserve has established a number of facilities to improve liquidity in financial markets. One such program is the Term Asset-Backed Securities Loan Facility (TALF), begun in November 2008 to facilitate the extension of credit to households and small businesses. Before the crisis, securitization markets were an important conduit of credit to the household and business sectors; some have referred to these markets as the ``shadow banking system.'' Securitization markets (other than those for mortgages guaranteed by the government) have virtually shut down since the onset of the crisis, eliminating an important source of credit. Under the TALF, eligible investors may borrow to finance purchases of the AAA-rated tranches of certain classes of asset-backed securities. The program originally focused on credit for households and small businesses, including auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. More recently, CMBS were added to the program, with the goal of mitigating a severe refinancing problem in that sector. The TALF has had some success. Rate spreads for asset-backed securities have declined substantially, and there is some new issuance that does not use the facility. By improving credit market functioning and adding liquidity to the system, the TALF and other programs have provided critical support to the financial system and the economy.Availability of Credit The Federal Reserve has long-standing policies in place to support sound bank lending and the credit intermediation process. Guidance issued during the CRE downturn in 1991 instructs examiners to ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers.\4\ This guidance also states that examiners should ensure loans are being reviewed in a consistent, prudent, and balanced fashion to prevent inappropriate downgrades of credits. It is consistent with guidance issued in early 2007 addressing risk management of CRE concentrations, which states that institutions that have experienced losses, hold less capital, and are operating in a more risk-sensitive environment are expected to employ appropriate risk-management practices to ensure their viability.\5\--------------------------------------------------------------------------- \4\ See Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (1991), ``Interagency Examination Guidance on Commercial Real Estate Loans,'' Supervision and Regulation Letter SR 91-24 (November 7), www.Federalreserve.gov/BoardDocs/SRLetters/1991/SR9124.htm; and Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of Thrift Supervision (1991), ``Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans,'' joint policy statement, November 7, www.Federalreserve.gov/BoardDocs/SRLetters/1991/SR9124a1.pdf. \5\ See Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (2007), ``Interagency Guidance on Concentrations in Commercial Real Estate,'' Supervision and Regulation Letter SR 07 1 (January 4), www.Federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.--------------------------------------------------------------------------- We are currently in the final stages of developing interagency guidance on CRE loan restructurings and workouts. This guidance supports balanced and prudent decisionmaking with respect to loan restructuring, accurate and timely recognition of losses and appropriate loan classification. The guidance will reiterate that classification of a loan should not be based solely on a decline in collateral value, in the absence of other adverse factors, and that loan restructurings are often in the best interest of both the financial institution and the borrower. The expectation is that banks should restructure CRE loans in a prudent manner, recognizing the associated credit risk, and not simply renew a loan in an effort to delay loss recognition. On one hand, banks have raised concerns that our examiners are not always taking a balanced approach to the assessment of CRE loan restructurings. On the other hand, our examiners have observed incidents where banks have been slow to acknowledge declines in CRE project cash-flows and collateral values in their assessment of the potential loan repayment. This new guidance, which should be finalized shortly, is intended to promote prudent CRE loan workouts as banks work with their creditworthy borrowers and to ensure a balanced and consistent supervisory review of banking organizations. Guidance issued in November 2008 by the Federal Reserve and the other Federal banking agencies encouraged banks to meet the needs of creditworthy borrowers, in a manner consistent with safety and soundness, and to take a balanced approach in assessing borrowers' ability to repay and making realistic assessments of collateral valuations.\6\ In addition, the Federal Reserve has directed examiners to be mindful of the effects of excessive credit tightening in the broader economy and we have implemented training for examiners and outreach to the banking industry to underscore these intentions. We are aware that bankers may become overly conservative in an attempt to ameliorate past weaknesses in lending practices, and are working to emphasize that it is in all parties' best interests to continue making loans to creditworthy borrowers.--------------------------------------------------------------------------- \6\ See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2008), ``Interagency Statement on Meeting the Needs of Creditworthy Borrowers,'' joint press release, November 12, www.Federalreserve.gov/newsevents/press/bcreg/20081112a.htm.---------------------------------------------------------------------------Strengthening the Supervisory Process The recently completed SCAP of the 19 largest U.S. bank holding companies demonstrates the effectiveness of forward-looking horizontal reviews and marked an important evolutionary step in the ability of such reviews to enhance supervision. Clearly, horizontal reviews--reviews of risks, risk-management practices and other issues across multiple financial firms--are very effective vehicles for identifying both common trends and institution-specific weaknesses. The SCAP expanded the scope of horizontal reviews and included the use of a uniform set of stress parameters to apply consistently across firms. An outgrowth of the SCAP was a renewed focus by supervisors on institutions' own ability to assess their capital adequacy--specifically their ability to estimate capital needs and determine available capital resources during very stressful periods. A number of firms have learned hard, but valuable, lessons from the current crisis that they are applying to their internal processes to assess capital adequacy. These lessons include the linkages between liquidity risk and capital adequacy, the dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent assumptions, limitations, and shortcomings. Addressing this uncertainty is one among several reasons that firms should retain substantial capital cushions. Currently, we are conducting a horizontal assessment of internal processes that evaluate capital adequacy at the largest U.S. banking organizations, focusing in particular on how shortcomings in fundamental risk management and governance for these processes could impair firms' abilities to estimate capital needs. Using findings from these reviews, we will work with firms over the next year to bring their processes into conformance with supervisory expectations. Supervisors will use the information provided by firms about their processes as a factor--but by no means the only factor--in the supervisory assessment of the firms' overall capital levels. For instance, if a firm cannot demonstrate a strong ability to estimate capital needs, then supervisors will place less credence on the firm's own internal capital results and demand higher capital cushions, among other things. Moreover, we have already required some firms to raise capital given their higher risk profiles. In general, we believe that if firms develop more-rigorous internal processes for assessing capital adequacy that capture all the risks facing those firms--including under stress scenarios--and maintain adequate capital based on those processes, they will be in a better position to weather financial and economic shocks and thereby perform their role in the credit intermediation process. We also are expanding our quantitative surveillance program for large, complex financial organizations to include supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses across large firms will enhance our understanding of the potential impact of adverse changes in the operating environment on individual firms and on the system as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and accounting and legal experts. This program will be distinct from the activities of onsite examination teams so as to provide an independent supervisory perspective, as well as to complement the work of those teams. As we adapt our internal organization of supervisory activities to build on lessons learned from the current crisis, we are using all of the information and insight that the analytic abilities the Federal Reserve can bring to bear in financial supervision.Conclusion A year ago, the world financial system was profoundly shaken by the failures and other serious problems at large financial institutions here and abroad. Significant credit and liquidity problems that had been building since early 2007 turned into a full-blown panic with adverse consequences for the real economy. The deterioration in production and employment, in turn, exacerbated problems for the financial sector. It will take time for the banking industry to work through these challenges and to fully recover and serve as a source of strength for the real economy. While there have been some positive signals of late, the financial system remains fragile and key trouble spots remain, such as CRE. We are working with financial institutions to ensure that they improve their risk management and capital planning practices, and we are also improving our own supervisory processes in light of key lessons learned. Of course, we are also committed to working with the other banking agencies and the Congress to ensure a strong and stable financial system. ______ CHRG-111shrg57709--42 Mr. Volcker," That is very important. " Chairman Dodd,"----see that, as well. Senator Shelby? Senator Shelby. Thank you, Mr. Chairman. Chairman Volcker, commercial banks did engage in activities considered to be investment banking prior to the repeal, including some proprietary trading. But there does not seem to be evidence that I have seen that proprietary trading created the losses that resulted in the rate need and race for bailouts. Some argue it is questionable how curtailment of proprietary trading will protect the financial system from future instabilities, what we are going after. In addition, there are notable examples of failed institutions, such as Bear Stearns, Lehman Brothers, among others, that were at the root of the recent crisis but did not engage in commercial banking and were more dangerous by being interconnected than by being large. And while AIG did have a small thrift--it was a very small thrift--the systemic threat from AIG did not emerge from that thrift. Would you just share with us what you believe are the top three institutions that were engaged in proprietary trading and discuss what it was about these institutions that contributed to the financial crisis that we are confronting now? " CHRG-111hhrg56767--114 Mr. Royce," Again, I raise this issue not because this $6.3 million is going to make Fannie and Freddie solvent again, but because as we look at the housing boom and bust, which caused the financial collapse, one of the roads leads to Fannie Mae and Freddie Mac. Some of us were raising alarms about these institutions long before their failure and well before their accounting scandals, and we understood the fundamentally flawed structure of socialized losses and privatized profits. We saw the overleveraging and the build-up in junk loans there. Frankly, the Federal Reserve came and warned us about it. We had an obligation to the taxpayers to prevent their failure, but we failed, largely because of Chuck Hagel's bill the Fed had requested which passed out of committee on the Senate side and was blocked by the lobbying of Fannie and Freddie. Fannie and Freddie executives leaned in and said no, in terms of those portfolios, in terms of the issue of the overleveraging and the arbitrage which the Fed was trying to get a handle on, we want to block that, and that legislation was blocked. Now, because of that failure, the taxpayers own 80 percent of those companies. We now have an obligation, I think, to see that those most responsible for this failure are held accountable. If the FHFA fails to take action to: first, get the money back from the legal defense fees; and second, curb these executive payouts, then I hope Congress would intervene. These are wards of the state. In my view, at the end of the day, they should be treated as wards of the state. I will yield back, Mr. Chairman. " CHRG-111hhrg53245--31 The Chairman," All right. That's a very important issue. By the way, it divides the banking community up. You see the smaller banks, the community banks who feel they have been victimized by the trash talking--the American Banking Association not so much. Mr. Wallison, on the Systemic Risk Council that you talk about? " CHRG-111hhrg48867--239 Mr. Ryan," I do have views on this. I think this issue of rules applying to specific activities or products within bank holding companies or within systemically important institutions is within the domain of the existing regulator today, so the Fed has authority to deal with this, from a bank-holding-company standpoint. And, under our proposal, the systemic regulator, who we think is a more appropriate entity, with all of the information, should be making those determinations. " CHRG-111hhrg56766--185 Mr. Hensarling," Thank you. Chairman Bernanke, I want to follow up on a question that one of my colleagues had that I am not sure I heard a precise answer to. I think the question was a variant of, what is the level of desirable or necessary leverage within the banking system on a macroeconomic level to hopefully ensure we don't repeat what we have just been through? Clearly, there are those within Congress who believe in artificial limits to the size of financial institutions, who believe that Federal regulators should have power to prohibit certain credit offerings. But some of us believe that hopefully out there is a proper application of risk-based application of capital and liquidity standards that would hopefully, perhaps, lead to a more prudent leveraging within our economy. But the question is, from your perspective, on a macroeconomic level, what is the amount of leverage the system can handle a cyclical downturn? " CHRG-111hhrg48674--273 Mr. Miller," So you agree that if the result of an asset purchase program that established an active market and had realistic values might be that many banks would be revealed to be insolvent, that actually would be a healthy development because it would increase confidence in the financial system? It might attract private capital because they know that the banks--that the books were honest? " CHRG-110hhrg46591--371 Mr. Washburn," I think we have always been big proponents of SBA lending, and that is what we do. We are, again, a community bank in Hoover, Alabama, with probably almost 20 percent of our portfolio concentrated in small- to medium-sized business loans. We have worked with the SBA and hopefully will continue to do so. That is a way to get money back out. As I mentioned earlier in my testimony as well, our loan demand is big, and is great as it has ever been, but capital is holding us back. And so any way to get capital injected into the community bank system, the healthy community bank system will only benefit your area as well as ours and any other area who has a community bank. " CHRG-111shrg57923--8 Mr. Tarullo," So that varies considerably, Senator, from data stream to data stream, and I think the subject--let me be clear just that when some people say ``realtime,'' some people mean ``immediate'' by that; that as a trade happens, the data, the information about the trade is immediately available to regulators and possibly the public. For most of our supervisory purposes, that kind of literally realtime data is not critical to achieving those supervisory purposes. And, of course, as you all know, true realtime data is a very expensive thing to put together. But timely, meaning in many instances daily or end-of-the-day trading, is very important for making an assessment on a regular basis as to the stability of a firm that may be under stress. One of the things that became clear, I think, during the crisis--and for me became particularly evident during the stress tests last spring--was the substantial divergence in the capacities of firms to amass, to get a hold of their own data, to know what their own trades were, to know what their own counterparty risk exposures were. So one of the things that we have actually been doing in the wake of the Special Capital Assessment Program is placing particular emphasis on the management information systems of the firms, requiring that they themselves be able to get a hold of the data on trades or counterparty exposures or certain kinds of instrument--certain kinds of involvement with certain kinds of instruments, because if they can get a hold of it for their own internal purposes, we will be able to get a hold of it pretty quickly. So right now it is actually not so much a question of our telling them, ``Send us something you have on a daily basis.'' It is in many instances as much a matter of making sure they have the capacity to derive that information from their raw computer records and then to send it to us. Senator Corker. May I ask another question, Mr. Chairman? Senator Reed. Yes, sure. Senator Corker. You know, of course, we all tend to try to find a solution that is unique and maybe alleviates a lot of just the daily work it takes to be good regulators, right? And a lot of what happened this last time could have been prevented with the tools we had if we just maybe had been a little more effective in regulating the way that we should have and Congress overseeing the way that it should have. But there were certainly lots of issues that caused this last crisis, if you will, to unfold. So we have had this wonderful presentation that we are going to hear next, and, you know, we envision having all this, at the end of the day, realtime type of data so we know positions throughout our country, so that regulators have the ability to know if something that is putting our country in systemic risk is occurring. What should we be concerned about there from the standpoint of having this thing that sounds really neat and costs money, how do we prevent it from being something that really is not that useful but is collecting a lot of data that I imagine takes place throughout this city that is not utilized? And then, second, I would imagine that data like that collected in one place could be used for pretty nefarious purposes if it got into the wrong hands. If we actually have it and collect it, what should be our concerns in that regard? " Mr. Tarullo," OK, so with respect to your first question, I mean, I do think that the efforts of the group of academics and others who have been promoting the NIF and certainly the efforts of the National Academy of Sciences in convening that workshop have been very valuable in drawing attention to and moving the debate forward on the data needs that we really do have. And I think, Senator, just to underscore something I said earlier, the absence of data from the shadow banking system was certainly problematic in retrospect. I think that the degree to which the tightly wound, very rapid shadow banking system was channeling liquidity around the financial system and, thus, the rapidity with which it came to a screeching halt once things began to break down, is something that was at least underappreciated by even those who foresaw problems ahead. So I do think that there is--and I do not think it is a coincidence, by the way, that some of the names I saw on the list of participants in that workshop that the NAS held were the names of scholars who have written, quite insightfully, I think, on the substantive causes of the crisis and of the way in which adverse feedback loops began when things moved into reverse. So I do think we need additional data sources. Now, how to make sure that every dollar of governmental funds spent on this are spent most wisely and how to make sure that we do not demand a lot of private expenditures that are not going to useful purposes is the kind of question that I think we all confront all the time in any Government regulatory or data collection effort. And I guess I would say that that is where some of the principles that we suggested in my written testimony I hope will be of some help. Keeping the regulator and supervisory agencies closely involved and, I would hope, the prime movers of these data collection efforts I think will help because whether it is the SEC or us or the CFTC, we are going to be most concerned in the first instance with achieving our statutory missions. And so for us that would be the consolidated supervision of the largest financial holding companies and also, obviously, our monetary policy and financial stability functions. That I think is one way to do it. I think a second way would be to make sure that there is some thought about new requirements coming forward. This is why OMB has the rules they have. And as you know, we think maybe some of the Paperwork Reduction Act features need to be changed around the edges. But there is a good reason why that act exists because you do want to put the brakes on people just willy nilly saying we would like new data sources. I think actually the council, if a council of regulators were created or the President's working group could formalize such an effort, I think it would be useful to have different agencies actually thinking about what new data sources may be important and having a debate precisely to guard against any one maybe going a bit too far afield from its own regulatory mission. On the protection issue, obviously there are, as I mentioned, these important interests, proprietary interests, IP interests in some cases where vendors are involved, privacy interests where individuals are involved, a little bit less, obviously, with some of the things we are talking about. We ought to continue to have those protections. But it is also the case that our country I think wants to be protected from financial instability, and my conclusion at least is that the efforts to identify potential sources of financial stress and risk throughout the economy is not something that one or even a whole group of Government agencies should be the sole actors in. I think we do need to enable analysts, private analysts, finance professors, people who have expertise but are not in the Government, to look at what is going on in the economy to offer their views to you, to us, to the American people, and let us all filter through how much of that may be well grounded and where we might disagree. If we are going to do that, we have to figure out how to get this data into a sufficiently aggregated form so as to protect proprietary information, but to make sure that it is really useful to somebody out there who is trying to do an analysis and have some insight into what is going on in the subprime mortgage market or over-the-counter derivatives or anywhere else. Senator Reed. Well, thank you, Governor Tarullo, and you have reminded me, I have to thank also the National Academy of Sciences because we asked them to convene that meeting and I am pleased that it produced positive results in your view and other people's view, but thank you very much. Senator Corker. I thought maybe you were going to ask another round. If I could just ask one more question---- Senator Reed. Yes, and I might have one, but go ahead. You go first. Senator Corker. No, go ahead. Absolutely. Senator Reed. Well, it sort of--no, why don't you go, because this is not Abbott and Costello, but you are ready. Senator Corker. So a number of us have been looking at speed bumps, ways for us not to be faced with resolution. We obviously, if we have resolution, want to ensure that this whole notion of too big to fail is not part of the American vocabulary. But we have had numbers of entities in recently--today, yesterday, the day before--talking about contingent capital and the ability to take unsecured debt in an institution that is moving into problem areas and converting that immediately to common equity. I know that is a little bit off topic, but there is a lot happening. We are going on recess next week. I just wondered if you might have some comments regarding that. It is something that I think is gaining more and more attention. " CHRG-111shrg57322--763 Mr. Viniar," I have not read any of it. Senator Ensign. Because I think this goes to one of the--when you said you had responsibility, I am glad you said that Goldman Sachs actually does have some responsibility. This is kind of an explanation of some of what was happening in the financial markets. According to Steve Eisman, Goldman Sachs and Deutsche Bank, on the fate of the BBB tranche of subprime mortgage-backed bonds without fully understanding why those firms were so eager to accept them. He didn't know at the time. Later, he figured, at least he thinks he figured it out. The credit default swaps filtered through the CDOs were used to replicate bonds backed by actual home loans. ``There weren't enough Americans,'' and I am quoting here, so excuse the language, ``there weren't enough Americans with shi**y credit ratings taking out loans to satisfy investors' appetite for the end product. Wall Street needed his bets in order to synthesize more of them. `They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford,' said Eisman. They were creating them out of whole cloth, 100 times over. That is why the losses in the financial system are so much greater than the subprime loans.'' The premise that, or at least what his analysis was of the reason that it became--even though the subprime market itself was bad, the collapse of that market wouldn't have been nearly as bad for the entire rest of the economy if it wasn't for a lot of the synthetic instruments that were created by firms like Goldman Sachs and others. Would you agree with that statement? " CHRG-111shrg50814--150 Mr. Bernanke," In the private sector, that will be a major indicator that we are moving in the right direction. Senator Shelby. And how do you do that with transparency, with closing some banks, consolidating some banks, letting the market know or believe in the banking system? " CHRG-111shrg54675--64 Mr. Hopkins," We believe in a strong dual banking system, so we do believe that the competition amongst the regulators, just as it does with competition amongst banks, does make for stronger banks and stronger regulators. Senator Tester. We are going to maintain the dual charters? " CHRG-111shrg52619--39 Chairman Dodd," Yes. Chairman Bair. Ms. Bair. Yes. I think the problems with regulatory arbitrage have been more severe regarding banks than nonbanks, especially on capital constraints--leverage constraints--certainly with regard to investment banks versus commercial banks, and bank mortgage lenders versus nonbank mortgage lenders with regard to lending standards. So I think there needs to be some baseline standards that apply to all types of financial institutions, especially with consumer protection and basic prudential requirements, such as capital standards. I think there are still some problems within the category of banks. We have four different primary regulators now and I think there have been some issues. There have been issues we have seen with banks converting charters because they fear perhaps the regulatory approach by one regulator. We have seen banks convert charters in order to get preemption, which is not always a good thing. So I think there is more work to be done here. Part of that may be Congress's call in terms of whether they want to establish basic consumer protections that cannot be preempted--whether you want Federal protection to be a floor or a ceiling for consumer protection. I think among us as regulators, we could do more to formalize agreements among ourselves that we will respect each other's CAMELS ratings and enforcement actions even if a charter is converted to remove the bad incentives for charter conversion. So I think there are some steps to be taken, but I do agree with what Joe said, we need both State and Federal charters. There is a long history of the dual banking system in the United States and I think that should be preserved. " CHRG-111hhrg48875--192 Secretary Geithner," You are exactly right. These are very complicated situations, and we have to be very careful that what we are doing is not going to add to moral hazard in the system. So the regime has to come with clearly established rules for prompt corrective action, like what exists for banks, so you constrain the discretion of the supervisor to let an institution slip towards the edge of the cliff without intervention. You have to have very high thresholds for judgment that would allow the government to put in capital. It requires, you know, elaborate checks and balances to limit discretion there, too. And you have to look at this alongside what we are proposing, to raise, fundamentally, capital requirements and leverage constraints on the system as a whole. But you are right that you have to be very careful that this mechanism does not add to moral hazard. And I think that--but the virtues of this is exactly that, that we are reducing moral hazard in the system because we are giving ourselves more choices. The system we have today has the opposite risk because today, people fear that with no resolution authority, our only choice if it is systemic is to come in and guarantee. " CHRG-111shrg55278--115 RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED FROM SHEILA C. BAIRQ.1. You discussed regulatory arbitrage in your written statements and emphasized the benefits of a Council to minimize such opportunities. Can you elaborate on this? Should standards be set by individual regulators, the Council, or both? Can a Council operate effectively in emergency situations?A.1. One type of regulatory arbitrage is regulatory capital arbitrage. It is made possible when there are different capital requirements for organizations that have similar risks. For instance, banks must hold 10 percent total risk-based capital and a 5 percent leverage ratio to be considered well-capitalized, while large broker-dealers (investment banks) were allowed to operate with as little as 3 percent risk-based capital. Thus for similar assets, a bank would have to hold $5 for every $100 of assets, a broker dealer would only be required to hold $3 of capital for every $100 of the same assets. Obviously, it would be more advantageous for broker dealers to accumulate these assets, as their capital requirement was 40 percent smaller than for a comparable bank. The creation of a Systemic Risk Council with authority to harmonize capital requirements across all financial firms would mitigate this type of regulatory capital arbitrage. Although the capital rules would vary somewhat according to industry, the authority vested in the Council would prevent the types of disparities in capital requirements we have recently witnessed. Some have suggested that a council approach would be less effective than having this authority vested in a single agency because of the perception that a deliberative council such as this would need additional time to address emergency situations that might arise from time to time. Certainly, some additional thought and effort will be needed to address any dissenting views in council deliberations, but a vote by Council members would achieve a final decision. A Council will provide for an appropriate system of checks and balances to ensure that appropriate decisions are made that reflect the various interests of public and private stakeholders. In this regard, it should be noted that the board structure at the FDIC, with the participation of outside directors, is not very different than the way the council would operate. In the case of the FDIC, quick decisions have been made with respect to systemic issues and emergency bank resolutions on many occasions. Based on our experience with a board structure, we believe that decisions could be made quickly by a deliberative council while still providing the benefit of arriving at consensus decisions.Q.2. What do you see as the key differences in viewpoints with respect to the role and authority of a Systemic Risk Council? For example, it seems like one key question is whether the Council or the Federal Reserve will set capital, liquidity, and risk management standards. Another key question seems to be who should be the Chair of the Council: the Secretary of the Treasury or a different Senate-appointed Chair. Please share your views on these issues.A.2. The Systemic Risk Council should have the authority to impose higher capital and other standards on financial firms notwithstanding existing Federal or State law and it should be able to overrule or force actions on behalf of other regulatory entities to raise capital or other requirements. Primary regulators would be charged with enforcing the requirements set by the Council. However, if the primary regulators fail to act, the Council should have the authority to do so. The standards set by the Council 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 Council would be uniquely positioned to provide the critical linkage between the primary Federal regulators and the need to take a macroprudential view and focus on emerging systemic risk across the financial system. The Council would assimilate information on economic conditions and the condition of supervised financial companies to assess potential risk to the entire financial system. The Council could then direct specific regulatory agencies to undertake systemic risk monitoring activities or impose recommended regulatory measures to mitigate systemic risk. The Administration proposal includes eight members on the Council: the Secretary of the Treasury (as Chairman); the Chairman of the Federal Reserve Board; the Director of the National Bank Supervisor; the Director of the Consumer Financial Protection Agency; the Chairman of the Securities and Exchange Commission; the Chairman of the Commodities Futures Trading Commission; the Chairman of the FDIC; and the Director of the Federal Housing Finance Agency. In designing the role of the Council, it will be important to preserve the longstanding principle that bank regulation and supervision are best conducted by independent agencies. For example, while the OCC is an organization within the Treasury Department, there are statutory safeguards to prevent undue involvement of the Treasury in regulation and supervision of National Banks. Given the role of the Treasury in the Council contemplated in the Administration's plan, careful attention should be given to the establishment of appropriate safeguards to preserve the political independence of financial regulation. Moreover, while the FDIC does not have a specific recommendation regarding what agencies should compose the Council, we would suggest that the Council include an odd number of members in order to avoid deadlocks. One way to address this issue that would be consistent with the importance of preserving the political independence of the regulatory process would be for the Treasury Chair to be a nonvoting member, or the Council could be headed by someone appointed by the President and confirmed by the Senate.Q.3. What are the other unresolved aspects of establishing a framework for systemic risk regulation?A.3. With an enhanced Council with decision-making powers to raise capital and other key standards for systemically related firms or activities, we are in general agreement with the Treasury plan for systemic risk regulation, or the Council could be headed by a Presidential appointee.Q.4. How should Tier 1 firms be identified? Which regulator(s) should have this responsibility?A.4. 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. 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 oversee 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. The Council could establish what practices, instruments, or characteristics (concentrations of risk or size) that might be considered risky, but would not identify any set of firms as systemic. We have concerns about formally designating certain institutions as a special class. 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 why, most importantly, a robust resolution mechanism, in addition to enhanced supervision, is important for very large financial organizations.Q.5. One key part of the discussion at the hearing is whether the Federal Reserve, or any agency, can effectively operate with two or more goals or missions. Can the Federal Reserve effectively conduct monetary policy, macroprudential regulation, and consumer protection?A.5. The Federal Reserve has been the primary Federal regulator for State chartered member institutions since its inception and has been the bank holding company supervisor since 1956. With the creation of the Consumer Financial Protection Agency and the Systemic Risk Council, the Federal Reserve should be able to continue its monetary policy role as well as remain the prudential primary Federal regulator for State chartered member institutions and bank holding companies.Q.6. Under the Administration's plan, there would be heightened supervision and consolidation of all large, interconnected financial firms, including likely requiring more firms to become financial holding companies. Can you comment on whether this plan adequately addresses the ``too-big-to-fail'' problem? Is it problematic, as some say, to identify specific firms that are systemically significant, even if you provide disincentives to becoming so large, as the Administration's plan does?A.6. The creation of a systemic risk regulatory framework for bank holding companies and systemically important firms will address some of the problems posed by ``too-big-to-fail'' firms. In addition, we should develop incentives to reduce the size of very large financial firms. However, even if risk-management practices improve dramatically and we introduce effective macroprudential supervision, the odds are that a large systemically significant firm will become troubled or fail at some time in the future. The current crisis has clearly demonstrated the need for a single resolution mechanism for financial firms that will preserve stability while imposing the losses on shareholders and creditors and replacing senior management to encourage market discipline. A timely, orderly resolution process that could be applied to both banks and nonbank financial institutions, and their holding companies, would prevent instability and contagion and promote fairness. It would enable the financial markets to continue to function smoothly, while providing for an orderly transfer or unwinding of the firm's operations. The resolution process would ensure that there is the necessary liquidity to complete transactions that are in process at the time of failure, thus addressing the potential for systemic risk without creating the expectation of a bailout. Under a new resolution regime, Congress should raise the bar higher than existing law and eliminate the possibility of open assistance for individual failing entities. The new resolution powers should result in the shareholders and unsecured creditors taking losses prior to the Government, and consideration also should be given to imposing some haircut on secured creditors to promote market discipline and limit costs potentially borne by the Government. ------ CHRG-111shrg56376--201 Mr. Carnell," Yes. A couple of things, Senator Merkley, if I could. First, the Federal Reserve argument that it needs to be a primary Federal bank regulator to do its monetary policy responsibilities are just not credible, based on facts at several levels. First, right now, the Federal Reserve only has supervisory responsibility for 13 percent of FDIC-insured assets and 10 percent of FDIC-insured institutions, so it is not a significant proportion at all. And then on top of that, our whole commercial banking system only accounts for 18 percent of credit market assets. Gone are the days when banks held 50 percent of those assets, as would have been true when I was born. There is just a big change in the growth of other financial markets and it is just out of touch with reality for someone to suggest that that Fed connection to being a primary Federal bank regulator is essential. Senator Merkley. I want to get into some other questions before I run out of time here, but Mr. Carnell, to follow up, you made a comment in regard to bank holding companies, that they exist to allow banks to get into businesses that are, and I am not sure if I caught this quite right, but incompatible with banking or very distinct from banking. Should we be eliminating bank holding companies? I mean, do they serve a--what purpose do they serve---- " CHRG-111shrg50564--167 Mr. Dodaro," I mentioned, alluded to one in my opening statement. The Bank Insurance Fund, I think, is the model that we have in mind going forward here extended across the system whereby the banks pay fees into the system. The fund is then capitalized. There is a statutory ratio that is set, and if the fund falls below that ratio, FDIC has a number of years in order to recapitalize the fund---- " FOMC20071206confcall--39 37,MR. DUDLEY.," Yes, I am happy to address that, Mr. Chairman. Absolutely. If we put $20 billion in this way, we have to take $20 billion out. But this would change the composition of the banking system’s balance sheet, and that’s how it is going to have its potential effect. We cannot change the amount of reserves in the system if we want to keep the federal funds rate anchored at the target. But we can change the composition of our balance sheet—and of the banking system’s balance sheet by extension—and that may have some beneficial effect." CHRG-111shrg62643--85 Mr. Bernanke," I am not quite sure what you mean by stress test issues, but we did do stress tests of 19 of the largest banks---- Senator Gregg. I am talking about the largest banks. " Mr. Bernanke," ----in the United States, and some of them were required to raise additional capital, all of which did. Since then, large banks have become increasingly profitable. Their losses on most categories of loans seem to have peaked, and in some cases they are reducing their reserves against loan losses. So the overall capital levels and the quality of the capital of large banks is certainly much improved over the last couple of years. Senator Gregg. The Chairman referred to an extraordinary quantity of excess reserves, which would imply that the banking system is fairly aggressively capitalized right now. Do you see that as being true? I mean the major banking system. " CHRG-111shrg56376--123 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System August 4, 2009 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, thank you for your invitation to testify this morning. The financial crisis had many causes, including global imbalances in savings and capital flows, the rapid integration of lending activities with the issuance, trading, and financing of securities, the existence of gaps in the regulatory structure for the financial system, and widespread failures of risk management across a range of financial institutions. Just as the crisis had many causes, the response of policymakers must be broad in scope and multifaceted. Improved prudential supervision--the topic of today's hearing--is a necessary component of the policy response. The crisis revealed supervisory shortcomings among all financial regulators, to be sure. But it also demonstrated that the framework for prudential supervision and regulation had not kept pace with changes in the structure, activities, and growing interrelationships of the financial sector. Accordingly, it is essential both to refocus the regulation and supervision of banking institutions under existing authorities and to augment those authorities in certain respects. In my testimony today, I will begin by suggesting the elements of an effective framework for prudential supervision. Then I will review actions taken by the Federal Reserve within its existing statutory authorities to strengthen supervision of banks and bank holding companies in light of developments in the banking system and the lessons of the financial crisis. Finally, I will identify some gaps and weaknesses in the system of prudential supervision. One potential gap has already been addressed through the cooperative effort of Federal and State banking agencies to prevent insured depository institutions from engaging in ``regulatory arbitrage'' through charter conversions. Others, however, will require congressional action.Elements of an Effective Framework for Prudential Supervision An effective framework for the prudential regulation and supervision of banking institutions includes four basic elements. First, of course, there must be sound regulation and supervision of each insured depository institution. Applicable regulations must be well-designed to promote the safety and soundness of the institution. Less obvious, perhaps, but of considerable importance, is the usefulness of establishing regulatory requirements that make use of market discipline to help confine undue risk taking in banking institutions. Supervisory policies and techniques also must be up to the task of enforcing and supplementing regulatory requirements. Second, there must be effective supervision of the companies that own insured depository institutions. The scope and intensity of this supervision should vary with the extent and complexity of activities conducted by the parent company or its nonbank subsidiaries. When a bank holding company is essentially a shell, with negligible activities or ownership stakes outside the bank itself, holding company regulation can be less intensive and more modest in scope. But when material activities or funding are conducted at the holding company level, or when the parent owns nonbank entities, the intensity of scrutiny must increase in order to protect the bank from both the direct and indirect risks of such activities or affiliations and to ensure that the holding company is able to serve as a source of strength to the bank on a continuing basis. The task of holding company supervision thus involves an examination of the relationships between the bank and its affiliates as well as an evaluation of risks associated with those nonbank affiliates. Consolidated capital requirements also play a key role, by helping ensure that a holding company maintains adequate capital to support its groupwide activities and does not become excessively leveraged. Third, there cannot be significant gaps or exceptions in the supervisory and regulatory coverage of insured depository institutions and the firms that own them. Obviously, the goals of prudential supervision will be defeated if some institutions are able to escape the rules and requirements designed to achieve those goals. There is a less obvious kind of gap, however, where supervisors are restricted from obtaining relevant information or reaching activities that could pose risks to banking organizations. Fourth, prudential supervision--especially of larger institutions--must complement and support regulatory measures designed to contain systemic risk and the too-big-to-fail problem, topics that I have discussed in previous appearances before this Committee. \1\ One clear lesson of the financial crisis is that important financial risks may not be readily apparent if supervision focuses only on the exposures and activities of individual institutions. For example, the liquidity strategy of a banking organization may appear sound when viewed in isolation but, when examined alongside parallel strategies of other institutions, may be found to be inadequate to withstand periods of financial stress.--------------------------------------------------------------------------- \1\ See, Daniel K. Tarullo (2009), ``Regulatory Restructuring'', statement before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 23, www.federalreserve.gov/newsevents/testimony/tarullo20090723a.htm; and Daniel K. Tarullo (2009), ``Modernizing Bank Supervision and Regulation'', statement before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 19, www.federalreserve.gov/newsevents/testimony/tarullo20090319a.htm.---------------------------------------------------------------------------Strengthening Prudential Supervision and Regulation The crisis has revealed significant risk-management deficiencies at a wide range of financial institutions, including banking organizations. It also has challenged some of the assumptions and analysis on which conventional supervisory wisdom has been based. For example, the collapse of Bear Stearns, which at the end was unable to borrow privately even with U.S. Government securities as collateral, has undermined the widely held belief that a company can readily borrow against high-quality collateral, even in stressed environments. Moreover, the growing codependency between financial institutions and markets--evidenced by the significant role that investor and counterparty runs played in the crisis--implies that supervisors must pay closer attention to the potential for financial markets to influence the safety and soundness of banking organizations. These and other lessons of the financial crisis have led to changes in regulatory and supervisory practices in order to improve prudential oversight of banks and bank holding companies, as well as to advance a macroprudential, or systemic, regulatory agenda. Working with other domestic and foreign supervisors, the Federal Reserve has taken steps to require the strengthening of capital, liquidity, and risk management at banking organizations. There is little doubt that, in the period before the crisis, capital levels were insufficient to serve as a needed buffer against loss, particularly at some of the largest financial institutions, both in the United States and elsewhere. Measures to strengthen the capital requirements for trading activities and securitization exposures--two areas where banking organizations have experienced greater losses than anticipated--were recently announced by the Basel Committee on Banking Supervision. Additional efforts are under way to improve the quality of the capital used to satisfy minimum capital ratios, to strengthen the capital requirements for other types of on- and off-balance-sheet exposures, and to establish capital buffers in good times that can be drawn down as economic and financial conditions deteriorate. Capital buffers, though not easy to design or implement in an efficacious fashion, could be an especially important step in reducing the procyclical effects of the current capital rules. Further review of accounting standards governing valuation and loss provisioning also would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. The Federal Reserve also helped lead the Basel Committee's development of enhanced principles of liquidity risk management, which were issued last year. \2\ Following up on that initiative, on June 30, 2009, the Federal banking agencies requested public comment on new Interagency Guidance on Funding and Liquidity Risk Management, which is designed to incorporate the Basel Committee's principles and clearly articulate consistent supervisory expectations on liquidity risk management. \3\ The guidance reemphasizes the importance of cash flow forecasting, adequate buffers of contingent liquidity, rigorous stress testing, and robust contingent funding planning processes. It also highlights the need for institutions to better incorporate liquidity costs, benefits, and risks in their internal product pricing, performance measurement, and new product approval process for all material business lines, products, and activities.--------------------------------------------------------------------------- \2\ See, Basel Committee on Banking Supervision (2008), ``Principles for Sound Liquidity Risk Management and Supervision'' (Basel, Switzerland: Bank for International Settlements, September), www.bis.org/publ/bcbs144.htm. \3\ See, Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and National Credit Union Administration (2009), ``Agencies Seek Comment on Proposed Interagency Guidance on Funding and Liquidity Risk Management'', joint press release, June 30, www.federalreserve.gov/newsevents/press/bcreg/20090630a.htm.--------------------------------------------------------------------------- With respect to bank holding companies specifically, the supervisory program of the Federal Reserve has undergone some basic changes. As everyone is aware, many of the financial firms that lay at the center of the crisis were not bank holding companies; some were not subject to mandatory prudential supervision of any sort. During the crisis a number of very large firms became bank holding companies--in part to reassure markets that they were subject to prudential oversight and, in some cases, to qualify for participation in various Government liquidity support programs. The extension of holding company status to these firms, many of which are not primarily composed of a commercial bank, highlights the degree to which the traditional approach to holding company supervision must evolve. Recent experience also reinforces the value of holding company supervision in addition to, and distinct from, bank supervision. Large organizations increasingly operate and manage their businesses on an integrated basis with little regard for the corporate boundaries that typically define the jurisdictions of individual functional supervisors. Indeed, the crisis has highlighted the financial, managerial, operational, and reputational linkages among the bank, securities, commodity, and other units of financial firms. The customary focus on protecting the bank within a holding company, while necessary, is clearly not sufficient in an era in which systemic risk can arise wholly outside of insured depository institutions. Similarly, the premise of functional regulation that risks within a diversified organization can be evaluated and managed properly through supervision focused on individual subsidiaries within the firm has been undermined further; the need for greater attention to the potential for damage to the bank, the organization within which it operates, and, in some cases, the financial system generally, requires a more comprehensive and integrated assessment of activities throughout the holding company. Appropriate enhancements of both prudential and consolidated supervision will only increase the need for supervisors to be able to draw on a broad foundation of economic and financial knowledge and experience. That is why we are incorporating economists and other experts from nonsupervisory divisions of the Federal Reserve more completely into the process of supervisory oversight. The insights gained from the macroeconomic analyses associated with the formulation of monetary policy and from the familiarity with financial markets derived from our open market operations and payments systems responsibilities can add enormous value to holding company supervision. The recently completed Supervisory Capital Assessment Program (SCAP) heralds some of the changes in the Federal Reserve's approach to prudential supervision of the largest banking organizations. This unprecedented process involved, at its core, forward-looking, cross-firm, and aggregate analyses of the 19 largest bank holding companies, which together control a majority of the assets and loans within the financial system. Bank supervisors in the SCAP defined a uniform set of parameters to apply to each firm being evaluated, which allowed us to evaluate on a consistent basis the expected performance of the firms under both a baseline and more-adverse-than-expected scenario, drawing on individual firm information and independently estimated outcomes using supervisory models. Drawing on this experience, we are prioritizing and expanding our program of horizontal examinations to assess key operations, risks, and risk-management activities of large institutions. For the largest and most complex firms, we are creating an enhanced quantitative surveillance program that will use supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses across large firms will enhance our understanding of the potential impact of adverse changes in the operating environment on individual firms and on the system as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and accounting and legal experts. This program will be distinct from the activities of on-site examination teams so as to provide an independent supervisory perspective as well as to complement the work of those teams. Capital serves as an important bulwark against potential unexpected losses for banking organizations of all sizes, not just the largest ones. Accordingly, internal capital analyses of banking organizations must reflect a wide range of scenarios and capture stress environments that could impair solvency. Earlier this year, we issued supervisory guidance for all bank holding companies regarding dividends, capital repurchases, and capital redemptions. \4\ That guidance also reemphasized the Federal Reserve's long-standing position that bank holding companies must serve as a source of strength for their subsidiary banks.--------------------------------------------------------------------------- \4\ See, Board of Governors of the Federal Reserve System (2009), Supervision and Regulation Letter SR 09-4, ``Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies'', February 24 (as revised on March 27, 2009), www.federalreserve.gov/boarddocs/srletters/2009/SR0904.htm.--------------------------------------------------------------------------- Commercial real estate (CRE) is one area of risk exposure that has gained much attention recently. We began to observe rising CRE concentrations earlier this decade and, in light of the central role that CRE lending played in the banking problems of the late 1980s and early 1990s, led an interagency effort to issue supervisory guidance directed at the risks posed by CRE concentrations. This guidance, which generated significant controversy at the time it was proposed, was finalized in 2006 and emphasized the need for banking organizations to incorporate realistic risk estimates for CRE exposures into their strategic- and capital-planning processes, and encouraged institutions to conduct stress tests or similar exercises to identify the impact of potential CRE shocks on earnings and capital. Now that weaker housing markets and deteriorating economic conditions have, in fact, impaired the quality of CRE loans at many banking organizations, we are monitoring carefully the effect that declining collateral values may have on CRE exposures and assessing the extent to which banking organizations have been complying with the CRE guidance. At the same time, we have taken actions to ensure that supervisory and regulatory policies and practices do not inadvertently curtail the availability of credit to sound borrowers. While CRE exposures represent perhaps an ``old'' problem, the crisis has newly highlighted the potential for compensation practices at financial institutions to encourage excessive risk taking and unsafe and unsound behavior--not just by senior executives, but also by other managers or employees who have the ability, individually or collectively, to materially alter the risk profile of the institution. Bonuses and other compensation arrangements should not provide incentives for employees at any level to behave in ways that imprudently increase risks to the institution, and potentially to the financial system as a whole. The Federal Reserve worked closely with other supervisors represented on the Financial Stability Board to develop principles for sound compensation practices, which were released earlier this year. \5\ The Federal Reserve expects to issue soon our own guidance on this important subject to promote compensation practices that are consistent with sound risk-management principles and safe and sound banking.--------------------------------------------------------------------------- \5\ See, Financial Stability Forum (2009), FSF Principles for Sound Compensation Practices, April 2, www.financialstabilityboard.org/publications/r_0904b.pdf. The Financial Stability Forum has subsequently been renamed the Financial Stability Board.--------------------------------------------------------------------------- Finally, I would note the importance of continuing to analyze the practices of financial firms and supervisors that preceded the crisis, with the aim of fashioning additional regulatory tools that will make prudential supervision more effective and efficient. One area that warrants particular attention is the potential for supervisory agencies to enlist market discipline in pursuit of regulatory ends. For example, supervisors might require that large financial firms maintain specific forms of capital so as to increase their ability to absorb losses outside of a bankruptcy or formal resolution procedure. Such capital could be in contingent form, converting to common equity only when necessary because of extraordinary losses. While the costs, benefits, and feasibility of this type of capital requires further study, policymakers should actively seek ways of motivating the private owners of banking organizations to monitor the financial positions of the issuing firms more effectively.Addressing Gaps and Weaknesses in the Regulatory Framework While the actions that I have just discussed should help make banking organizations and the financial system stronger and more resilient, the crisis also has highlighted gaps and weaknesses in the underlying framework for prudential supervision of financial institutions that no regulatory agency can rectify on its own. One, which I will mention in a moment, has been addressed by the banking agencies working together. Others require congressional attention.Charter Conversions and Regulatory Arbitrage The dual banking system and the existence of different Federal supervisors create the opportunity for insured depository institutions to change charters or Federal supervisors. While institutions may engage in charter conversions for a variety of sound business reasons, conversions that are motivated by a hope of escaping current or prospective supervisory actions by the institution's existing supervisor undermine the efficacy of the prudential supervisory framework. Accordingly, the Federal Reserve welcomed and immediately supported an initiative led by the Federal Deposit Insurance Corporation (FDIC) to address such regulatory arbitrage. This initiative resulted in a recent statement of the Federal Financial Institutions Examination Council reaffirming that charter conversions or other actions by an insured depository institution that would result in a change in its primary supervisor should occur only for legitimate business and strategic reasons. \6\ Importantly, this statement also provides that conversion requests should not be entertained by the proposed new chartering authority or supervisor while serious or material enforcement actions are pending with the institution's current chartering authority or primary Federal supervisor. In addition, it provides that the examination rating of an institution and any outstanding corrective action programs should remain in place when a valid conversion or supervisory change does occur.--------------------------------------------------------------------------- \6\ See, Federal Financial Institutions Examination Council (2009), ``FFIEC Issues Statement on Regulatory Conversions'', press release, July 1, www.ffiec.gov/press/pr070109.htm.---------------------------------------------------------------------------Systemically Important Financial Institutions The Lehman experience clearly demonstrates that the financial system and the broader economy can be placed at risk by the failure of financial firms that traditionally have not been subject to the type of consolidated supervision applied to bank holding companies. As I discussed in my most recent testimony before this Committee, the Federal Reserve believes that all systemically important financial firms--not just those affiliated with a bank--should be subject to, and robustly supervised under, a statutory framework for consolidated supervision like the one embodied in the Bank Holding Company Act (BHC Act). Doing so would help promote the safety and soundness of these firms individually and the stability of the financial system generally. Indeed, given the significant adverse effects that the failure of such a firm may have on the financial system and the broader economy, the goals and implementation of prudential supervision and systemic risk reduction are inextricably intertwined in the case of these organizations. For example, while the strict capital, liquidity, and risk-management requirements that are needed for these organizations are traditional tools of prudential supervision, the supervisor of such firms will need to calibrate these standards appropriately to account for the firms' systemic importance.Industrial Loan Companies and Thrifts Another gap in existing law involves industrial loan companies (ILCs). ILCs are State-chartered banks that have full access to the Federal safety net, including FDIC deposit insurance and the Federal Reserve's discount window and payments systems; have virtually all of the deposit-taking powers of commercial banks; and may engage in the full range of other banking services, including commercial, mortgage, credit card, and consumer lending activities, as well as cash management services, trust services, and payment-related services, such as Fedwire, automated clearinghouse, and check-clearing services. A loophole in current law, however, permits any type of firm--including a commercial company or foreign bank--to acquire an FDIC-insured ILC chartered in a handful of States without becoming subject to the prudential framework that the Congress has established for the corporate owners of other full-service insured banks. Prior to the crisis, several large firms-including Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley, GMAC, and General Electric--took advantage of this opportunity by acquiring ILCs while avoiding consolidated supervision under the BHC Act. The Federal Reserve has long supported closing this loophole, subject to appropriate ``grandfather'' provisions for the existing owners of ILCs. Such an approach would prevent additional firms from acquiring a full-service bank and escaping the consolidated supervision framework and activity restrictions that apply to bank holding companies. It also would require that all firms controlling an ILC, including a grandfathered firm, be subject to consolidated supervision. For reasons of fairness, the Board believes that the limited number of firms that currently own an ILC and are not otherwise subject to the BHC Act should be permitted to retain their nonbanking or commercial affiliations, subject to appropriate restrictions to protect the Federal safety net and prevent abuses. Corporate owners of savings associations should also be subject to the same regulation and examination as corporate owners of insured banks. In addition, grandfathered commercial owners of savings associations should, like we advocate for corporate owners of ILCs, be subject to appropriate restrictions to protect the Federal safety net and prevent abuses.Strengthening the Framework for Consolidated Supervision Consolidated supervision is intended to provide a supervisor the tools necessary to understand, monitor, and, when appropriate, restrain the risks associated with an organization's consolidated or groupwide activities. Risks that cross legal entities and that are managed on a consolidated basis cannot be monitored properly through supervision directed at any one, or even several, of the legal entity subdivisions within the overall organization. To be fully effective, consolidated supervisors need the information and ability to identify and address risks throughout an organization. However, the BHC Act, as amended by the so-called ``Fed-lite'' provisions of the Gramm-Leach-Bliley Act, places material limitations on the ability of the Federal Reserve to examine, obtain reports from, or take actions to identify or address risks with respect to both nonbank and depository institution subsidiaries of a bank holding company that are supervised by other agencies. Consistent with these provisions, we have worked with other regulators and, wherever possible, sought to make good use of the information and analysis they provide. In the process, we have built cooperative relationships with other regulators--relationships that we expect to continue and strengthen further. Nevertheless, the restrictions in current law still can present challenges to timely and effective consolidated supervision in light of, among other things, differences in supervisory models--for example, between the safety and soundness approach favored by bank supervisors and the approaches used by regulators of insurance and securities subsidiaries--and differences in supervisory timetables, resources, and priorities. Moreover, the growing linkages among the bank, securities, insurance, and other entities within a single organization that I mentioned earlier heighten the potential for these restrictions to hinder effective groupwide supervision of firms, particularly large and complex organizations. To ensure that consolidated supervisors have the necessary tools and authorities to monitor and address safety and soundness concerns in all parts of an organization on a timely basis, we would urge statutory modifications to the Fed-lite provisions of the Gramm-Leach-Bliley Act. Such changes, for example, should remove the limits first imposed in 1999 on the scope and type of information that the Federal Reserve may obtain from subsidiaries of bank holding companies in furtherance of its consolidated supervision responsibilities, and on the ability of the Federal Reserve to take action against subsidiaries to address unsafe and unsound practices and enforce compliance with applicable law.Limiting the Costs of Bank Failures The timely closing and resolution of failing insured depository institutions is critical to limiting the costs of a failure to the deposit insurance fund. \7\ The conditions governing when the Federal Reserve may close a failing State member bank, however, are significantly more restrictive than those under which the Office of the Comptroller of the Currency may close a national bank, and are even more restrictive than those governing the FDIC's backup authority to close an insured depository institution after consultation with the appropriate primary Federal and, if applicable, state banking supervisor. The Federal Reserve generally may close a state member bank only for capital-related reasons. The grounds for which the OCC or FDIC may close a bank include a variety of non-capital-related conditions, such as if the institution is facing liquidity pressures that make it likely to be unable to pay its obligations in the normal course of business or if the institution is otherwise in an unsafe or unsound condition to transact business. We hope that the Congress will consider providing the Federal Reserve powers to close a state member bank that are similar to those possessed by other Federal banking agencies.--------------------------------------------------------------------------- \7\ Similarly, the creation of a resolution regime that would provide the Government the tools it needs to wind down a systemically important nonbank financial firm in an orderly way and impose losses on shareholders and creditors where possible would help the Government protect the financial system and economy while reducing the potential cost to taxpayers and mitigating moral hazard.--------------------------------------------------------------------------- In view of the number of bank failures that have occurred over the past 18 months and the resulting costs to the deposit insurance fund, policymakers also should explore whether additional triggers--beyond the capital ratios in the current Prompt Corrective Action framework--may be more effective in promoting the timely resolution of troubled institutions at lower cost to the insurance fund. Capital is a lagging indicator of financial difficulties in most instances, and one or more additional measures, perhaps based on asset quality, may be worthy of analysis and consideration.Conclusion Thank you for the opportunity to testify on these important matters. We look forward to working with the Congress, the Administration, and the other banking agencies to ensure that the framework for prudential supervision of banking organizations and other financial institutions adjusts, as it must, to meet the challenges our dynamic and increasingly interconnected financial system. ______ CHRG-111shrg50564--44 Mr. Volcker," Well, we do a lot of talking about the importance of risk management and so forth, but, in essence, the conclusion that we have is that some of these innovations and some of these very risky activities are almost inevitably going to get ahead of the regulators, and these basic institutions--the big commercial banks, in particular--are of systemic importance, therefore should not get involved in those activities. They are too risky, and I think it is clearly demonstrable they involve conflicts of interest that add to the uncertainty and risk. Senator Warner. So you would see some system whereby there might be bright-line prohibitions---- " CHRG-111hhrg53248--178 The Chairman," Ms. Bair. STATEMENT OF THE HONORABLE SHEILA C. BAIR, CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) Ms. Bair. Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for holding this hearing and for the opportunity to give our views on reforming financial regulation. The issues before the committee are as challenging as any that we face since the days of the Great Depression. We are emerging from a credit crisis that has greatly harmed the American economy. Homes have been lost, jobs have been lost, retirement and investment accounts have plummeted in value. The proposals by the Administration to fix the problems that caused this crisis are both thoughtful and comprehensive. Regulatory gaps within the financial system were a major cause of the crisis. Differences in regulating capital, leverage, and complex financial instruments as well as in protecting consumers allowed rampant regulatory arbitrage. Reforms are urgently needed to close these gaps. At the same time, we must recognize that many of the problems involve financial firms that were already subject to extensive regulation. Therefore, we need robust and credible mechanisms to ensure that all market players actively monitor and control risk taking. We must find ways to impose greater market discipline on systemically important institutions. In a properly functioning market and economy, there will always be winners and losers. And when firms, through their own mismanagement and excessive risk taking, are no longer viable, they should fail. Efforts to prevent them from failing ultimately distort market mechanisms, including the incentive to compete and to allocate resources to the most efficient players. Unfortunately, the actions taken during the past year have reinforced the idea that some financial organizations are simply too-big-to-fail. To end too-big-to-fail, we need a practical, effective, and highly credible mechanism for the orderly resolution of large and complex institutions that is similar to the process for FDIC insured banks. When the FDIC closes a bank, shareholders and creditors take the first loss. We are talking about a process where the failed bank is closed, where the shareholders and creditors typically suffer severe loss, where management is replaced, and where the assets of the failed institution are sold off. The process is harsh, as it should be. It is not a bailout. It quickly reallocates assets back into the private sector and into the hands of better management. It also sends a strong message to the market that investors and creditors face losses when an institution fails, as they should. We also believe potentially systemic institutions should be subject to assessments that provide disincentives for complexity and high risk behavior and reduce taxpayer exposure. I am very pleased that President Obama, earlier this week, said he supports the idea of assessments. Funds raised through an assessment should be kept in reserve to provide working capital for the resolution of large financial organizations to further insulate taxpayers from losses. In addition to a credible resolution process, we need a better structure for supervising systemically important institutions, and we need a framework that proactively identifies risks to the financial system. The new structure, featuring a strong oversight council, should address such issues as excessive leverage, inadequate capital, and overreliance on short-term funding. A regulatory council would give the necessary perspective and expertise to look at our financial system holistically. Finally, the FDIC strongly supports creating a new Consumer Financial Protection Agency. This would help eliminate regulatory gaps between bank and nonbank providers of financial products and services by setting strong, consistent, across-the-board standards. Since most of the consumer products and practices that gave rise to the current crisis originated outside of traditional banking, focusing on nonbank examination and enforcement is essential for dealing with the most abusive lending practices that consumers face. The Administration's proposal would be even more effective if it included tougher oversight for all financial services providers and assured strict consumer compliance oversight for banks. As both the bank regulator and deposit insurer, I am very concerned about taking examination and enforcement responsibility away from bank regulators. It would disrupt consumer protection oversight of banks and would fail to adequately address the current lack of nonbank supervision. Consumer protection and risk supervision are actually two sides of the same coin. Splitting the two would impair access to critical information and staff expertise and likely create unintended consequences. Combining the unequivocal prospect of an orderly closing, a stronger supervisory structure, and tougher consumer protections will go a very long way to fixing the problems of the last several years and to assuring that any future problems can be handled without cost to the taxpayer. Thank you very much. [The prepared statement of Chairman Bair can be found on page 56 of the appendix.] " Mr. Kanjorski," [presiding] Thank you very much, Ms. Bair. Our next presenter will be the Honorable John C. Dugan, Comptroller, Office of the Comptroller of the Currency. STATEMENT OF THE HONORABLE JOHN C. DUGAN, COMPTROLLER, OFFICE OF THE COMPTROLLER OF THE CURRENCY (OCC) " fcic_final_report_full--159 Through May , Goldman received  million from IKB, Wachovia, and TCW as a result of the credit default swaps against the A tranche. As was common, some of the tranches of Abacus - found their way into other funds and CDOs; for example, TCW put tranches of Abacus - into three of its own CDOs. In total, between July , , and May , , Goldman packaged and sold  synthetic CDOs, with an aggregate face value of  billion.  Its underwriting fee was . to . of the deal totals, Dan Sparks, the former head of Goldman’s mortgage desk, told the FCIC.  Goldman would earn profits from shorting many of these deals; on others, it would profit by facilitating the transaction between the buyer and the seller of credit default swap protection. As we will see, these new instruments would yield substantial profits for investors that held a short position in the synthetic CDOs—that is, investors betting that the housing boom was a bubble about to burst. They also would multiply losses when housing prices collapsed. When borrowers defaulted on their mortgages, the in- vestors expecting cash from the mortgage payments lost. And investors betting on these mortgage-backed securities via synthetic CDOs also lost (while those betting against the mortgages would gain).  As a result, the losses from the housing collapse were multiplied exponentially. To see this play out, we can return to our illustrative Citigroup mortgage-backed securities deal, CMLTI -NC. Credit default swaps made it possible for new market participants to bet for or against the performance of these securities. Syn- thetic CDOs significantly increased the demand for such bets. For example, there were about  million worth of bonds in the M (BBB-rated) tranche—one of the mezzanine tranches of the security. Synthetic CDOs such as Auriga, Volans, and Neptune CDO IV all contained credit default swaps in which the M tranche was ref- erenced. As long as the M bonds performed, investors betting that the tranche would fail (short investors) would make regular payments into the CDO, which would be paid out to other investors banking on it to succeed (long investors). If the M bonds defaulted, then the long investors would make large payments to the short investors. That is the bet—and there were more than  million in such bets in early  on the M tranche of this deal. Thus, on the basis of the performance of  million in bonds, more than  million could potentially change hands. Goldman’s Sparks put it succinctly to the FCIC: if there’s a problem with a product, synthetics increase the impact.  The amplification of the M tranche was not unique. A  million tranche of the Glacier Funding CDO -A, rated A, was referenced in  million worth of syn- thetic CDOs. A  million tranche of the Soundview Home Equity Loan Trust -EQ, also rated A, was referenced in  million worth of synthetic CDOs. A  million tranche of the Soundview Home Equity Loan Trust -EQ, rated BBB, was referenced in  million worth of synthetic CDOs.  In total, synthetic CDOs created by Goldman referenced , mortgage securities, some of them multiple times. For example,  securities were referenced twice. In- deed, one single mortgage-backed security was referenced in nine different synthetic CHRG-111shrg55278--120 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM MARY L. SCHAPIROQ.1. Identify Systemic Risk in Advance?--I believe we can all agree that very few if anyone was able to effectively identify where the systemic risk resided in our economy prior to our current financial difficulties. While we had regulatory efforts in effect to combat these risks in commercial bank and thrift institutions, the real risk was shown to be outside of this area. Chairman Schapiro, what about the structure proposed by the Obama administration gives you confidence that this new regulatory body will succeed where so many others failed?A.1. While there is no guarantee, the one proposed by the Administration represents a number of improvements over the current regulatory landscape in terms addressing gaps in regulatory oversight and minimizing incentives for regulatory arbitrage. For example, the Administration's proposal seeks to address the importance of and strengthen consolidated supervision of large financial conglomerates, including supervision of previously unregulated subsidiaries. Critical elements of a successful systemic risk regulation program also include strong support of functional regulators. The Council and SRR should complement and augment the role of functional regulators by leveraging their specialized knowledge and expertise and should take action in contravention of functional regulators' standards if necessary when those standards are less stringent than those advocated by the Council or SRR. Indeed, functional regulators' standards are the first line of defense, as functional regulators understand the markets, products and activities of their regulated entities. The effective implementation of a systemic risk regulation program is critical to its success. Because the process of identifying emerging risks heavily relies on the analysis of significant amounts of information and reporting gathered from firms and regulators, a successful program must be appropriately resourced, employing an adequate number of staff with appropriate skill sets. It is important that the competencies of monitoring and inspection staff are equal to those of the firm's personnel regarding the relevant topic. Having a staff that is multidisciplinary and equipped with the proper skill sets to review and analyze the information obtained is critical. Generalists with substantial experience across the breadth of issues and firm relationships should complement their skills with those of experts in relevant quantitative specialties.Q.2. SEC as Systemic Risk Regulator--Chairman Schapiro, the SEC's Consolidated Supervised Entity program, a program that existed without the benefit of statutory authorization, collapsed as its firms failed, were taken over, or shifted to regulation as bank holding companies. How does the SEC's experience with the CSE program inform the model for regulation of systemic risk that you are advocating today?A.2. Between 2004 and 2008, the SEC was recognized as the consolidated supervisor for the five large independent investment banks under its Consolidated Supervised Entity or ``CSE'' program. The CSE program was created as a way for U.S. global investment banks that lacked a consolidated holding company supervisor to voluntarily submit to consolidated regulation by the SEC. In connection with the establishment of the CSE program, the largest U.S. broker-dealer subsidiaries of these entities were permitted to utilize an alternate net capital computation (ANC). \1\ Other large broker-dealers, whose holding companies are subject to consolidated supervision by banking authorities, were also permitted to use this ANC approach. \2\--------------------------------------------------------------------------- \1\ In 2004, the SEC amended its net capital rule to permit certain broker-dealers subject to consolidated supervision to use their internal mathematical models to calculate net capital requirements for the market risks of certain positions and the credit risk for OTC derivatives-related positions rather than the prescribed charges in the net capital rule, subject to specified conditions. These models were thought to more accurately reflect the risks posed by these activities, but were expected to reduce the capital charges and therefore permit greater leverage by the broker-dealer subsidiaries. Accordingly, the SEC required that these broker-dealers have, at the time of their ANC approval, at least $5 billion in tentative net capital (i.e., ``net liquid assets''), and thereafter to provide an early warning notice to the SEC if that capital fell below $5 billion. This level was considered an effective minimum capital requirement. \2\ Currently six broker-dealers utilize the ANC regime and all are subject to consolidated supervision by banking authorities.--------------------------------------------------------------------------- Under the CSE regime, the holding company had to provide the Commission with information concerning its activities and exposures on a consolidated basis; submit its nonregulated affiliates to SEC examinations; compute on a monthly basis, risk-based consolidated holding company capital in general accordance with the Basel Capital Accord, an internationally recognized method for computing regulatory capital at the holding company level; and provide the Commission with additional information regarding its capital and risk exposures, including market, credit and liquidity risks. It is important to note that prior to the CSE regime, the SEC had no jurisdiction to regulate these holding companies. \3\ Accordingly, these holding companies previously had not been subject to any consolidated capital requirements. This program was viewed as an effort to fill a significant gap in the U.S. regulatory structure. \4\--------------------------------------------------------------------------- \3\ The Gramm-Leach-Bliley Act had created a voluntary program for the oversight of certain investment bank holding companies (i.e., those that did not have a U.S. insured depository institution affiliate). The firms participating in the CSE program did not qualify for that program or did not opt into that program. Only one firm (Lazard) has ever opted for this program. \4\ See, e.g., Testimony by Erik Sirri, Director of the Division of Trading and Markets, Before the Senate Subcommittee on Securities, Insurance and Investment, Senate Banking Committee, March 18, 2009. http://www.sec.gov/news/testimony/2009/ts031809es.htm.--------------------------------------------------------------------------- During the financial crisis many of these institutions lacked sufficient liquidity to operate effectively. During 2008, these CSE institutions failed, were acquired, or converted to bank holding companies which enabled them to access Government support. The CSE program was discontinued in September 2008. Some of the lessons learned are as follows: Capital Adequacy Rules Were Flawed and Assumptions Regarding Liquidity Risk Proved Overly Optimistic. The applicable Basel capital adequacy standards depended heavily on the models developed by the financial institutions themselves. All models depend on assumptions. Assumptions about such matters as correlations, volatility, and market behavior developed during the years before the financial crisis were not necessarily applicable for the market conditions leading up to the crisis, nor during the crisis itself. The capital adequacy rules did not sufficiently consider the possibility or impact of modeling failures or the limits of such models. Indeed, regulators worldwide are reconsidering how to address such issues in the context of strengthening the Basel regime. Going forward, risk managers and regulators must recognize the inherent limitations of these (and any) models and assumptions--and regularly challenge models and their underlying assumptions to consider more fully low probability, extreme events. While capital adequacy is important, it was the related, but distinct, matter of liquidity that proved especially troublesome with respect to CSE holding companies. Prior to the crisis, the SEC recognized that liquidity and liquidity risk management were critically important for investment banks because of their reliance on private sources of short-term funding. To address these liquidity concerns, the SEC imposed two requirements: First, a CSE holding company was expected to maintain funding procedures designed to ensure that it had sufficient liquidity to withstand the complete loss of all short term sources of unsecured funding for at least 1 year. In addition, with respect to secured funding, these procedures incorporated a stress test that estimated what a prudent lender would lend on an asset under stressed market conditions (a ``haircut''). Second, each CSE holding company was expected to maintain a substantial ``liquidity pool'' that was composed of unencumbered highly liquid and creditworthy assets that could be used by the holding company or moved to any subsidiary experiencing financial stress. The SEC assumed that these institutions, even in stressed environments, would continue to be able to finance their high-quality assets in the secured funding markets (albeit perhaps on less favorable terms than normal). In times of stress, if the business were sound, there might be a number of possible outcomes: For example, the firm might simply suffer a loss in capital or profitability, receive new investment injections, or be acquired by another firm. If not, the sale of high quality assets would at least slow the path to bankruptcy or allow for self-liquidation. As we now know, these assumptions proved much too optimistic. Some assets that were considered liquid prior to the crisis proved not to be so under duress, hampering their ability to be financed in the repo markets. Moreover, during the height of the crisis, it was very difficult for some firms to obtain secured funding even when using assets that had been considered highly liquid. Thus, the financial institutions, the Basel regime, and the CSE regulatory approach did not sufficiently recognize the willingness of counterparties to simply stop doing business with well-capitalized institutions or to refuse to lend to CSE holding companies even against high-quality collateral. Runs could sometimes be stopped only with significant Government intervention, such as through institutions agreeing to become bank holding companies and obtaining access to Government liquidity facilities or through other forms of support. Consolidated Supervision Is Necessary but Not a Panacea. Although large interconnected institutions should be supervised on a consolidated basis, policy makers should remain aware of the limits of such oversight and regulation. This is particularly the case for institutions with many subsidiaries engaging in different, often unregulated, businesses in multiple countries. Before the crisis, there were many different types of large interconnected institutions subject to consolidated supervision by different regulators. During the crisis, many consolidated supervisors, including the SEC, saw large interconnected, supervised entities seek Government liquidity or direct assistance. Systemic Risk Management Requires Meaningful Functional Regulation, Active Enforcement, and Transparent Markets. While a consolidated regulator of large interconnected firms is an essential component to identifying and addressing systemic risk, a number of other tools must also be employed. These include more effective capital requirements, strong enforcement, functional regulation, and transparent markets that enable investors and other counterparties to better understand the risks associated with particular investment decisions. Given the complexity of modern financial institutions, it is essential to have strong, consistent functional regulation of individual types of institutions, along with a broader view of the risks building within the financial system.Q.3. SEC's Endorsement of Treasury's Approach--Chairman Schapiro, you chose to testify today on your own behalf. I suspect that if you had submitted your testimony for a Commission vote, you might have met some resistance since you endorse an approach that envisions the creation of a systemic risk regulator that will have authority over firms within the SEC's jurisdiction. Although cast as a second set of eyes to back up the front line financial regulators, the systemic risk regulator could complicate the SEC's job. Are you concerned that the addition of a new regulatory body will water down your regulatory authority over firms that you oversee?A.3. While a SRR should play a critical role in assessing emerging systemic risks by setting standards for liquidity, capital and risk management practices, in my view it is vital that its role be complemented by the creation of a strong and robust Council. I believe the Council should have authority to identify institutions, practices, and markets that create potential systemic risks, and also should be authorized to set policies for liquidity, capital and other risk management practices at firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness. The Council also would provide a forum for analyzing and recommending harmonization of certain standards at other significant financial institutions. In most times, I would expect the Council and SRR to work with and through primary regulators of systemically important institutions. The primary regulators understand the markets, products and activities of their regulated entities. The SRR, however, can provide a second layer of review from a macroprudential perspective. If differences arise between the SRR/Council and the primary regulator regarding the capital or risk management standards of systemically important institutions, I strongly believe that the higher (more conservative) standard should govern. The systemic risk regulatory structure should serve as a ``brake'' on a systemically important institution's riskiness; it should never be an ``accelerator.'' In emergency situations, the SRR/Council may need to overrule a primary regulator (for example, to impose higher standards or to stop or limit potentially risky activities). However, to ensure that authority is checked and decisions are not arbitrary, the Council should be where general policy is set, and only then to implement a more rigorous policy than that of a primary regulator. This should reduce the ability of any single regulator to ``compete'' with other regulators by lowering standards, driving a race to the bottom.Q.4. SEC as Systemic Risk Regulator--Chairman Schapiro, under the plan the Administration set forth, a so-called ``Tier 1 Financial Holding Company'' (Tier 1 FHC) and its subsidiaries would be subject to examination by the Federal Reserve. Thus, a broker-dealer subsidiary of a Tier 1 FHC would be subject to examination by the Fed and the SEC. Should we be concerned that, rather than clarifying regulatory responsibility, this arrangement could blur lines of regulatory responsibility?A.4. A similar arrangement exists today for broker-dealers subsidiaries within a Bank Holding Company. At its core, the mission of the SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Accordingly, rigorous financial responsibility requirements apply to all U.S. broker-dealers, which are designed to ensure that broker-dealers operate in a manner that permits them to meet all obligations to customers and counterparties. The first of these requirements is the net capital rule, which, among other things, requires the broker-dealer to maintain a level of liquid assets in excess of all unsubordinated liabilities to enable the firm to absorb business losses and, if necessary, finance an orderly self-liquidation. The second is the customer protection rule, which requires the firm to safeguard customer cash and securities by segregating these assets from its proprietary business activities. The third prong is comprised of recordkeeping and financial reporting requirements that require the broker-dealer to make and maintain records and file reports that detail its net capital positions and document the segregation of customer assets. To ensure an equal playing field among the large and small, all broker-dealers should be subject to the same regulation, but additional review and holding company supervision can also take place. The SRR/Council could serve as a second set of eyes upon those larger institutions whose failure might put the system at risk, with the mandate of monitoring the entire financial system for systemwide risks and forestalling emergencies.Q.5. Too-Big-To-Fail--Chairman Schapiro, your testimony correctly recognizes that one type of systemic risk is that we create a system that favors large institutions over their ``smaller, more nimble competitors.'' Your testimony also suggests that a Financial Stability Oversight Council could prevent the formation of institutions that are too-big-to-fail. How would this work in practice?A.5. The Council, SRR, and primary regulators all should have a role in addressing the risks posed by large interconnected financial institutions. One of most important regulatory arbitrage risks is the potential perception that large interconnected financial institutions are too-big-to-fail and will therefore benefit from Government intervention in times of crisis. This perception can lead market participants to favor large interconnected firms over smaller firms of equivalent creditworthiness, fueling greater risk. To address these issues, policy makers should consider the following: Strengthen Regulation and Market Transparency. Given the financial crisis and the Government's unprecedented response, it is clear that large, interconnected firms present unique and additional risks to the system. To minimize the systemic risks posed by these institutions, policy makers should consider using all regulatory tools available--including supplemental capital, transparency and activities restrictions--to reduce risks and ensure a level playing field for large and small institutions. A strong Council could provide a forum for examining regulatory standards across markets, ensuring that capital and liquidity standards are in place and being enforced and that those standards are adequate and appropriate for systemically important institutions and the activities they conduct. The Council and SRR would be primarily responsible for setting standards at the holding company level. Establish a Resolution Regime. In times of crisis when a systemically important institution may be teetering on the brink of failure, policy makers have to immediately choose between two highly unappealing options: (1) providing Government assistance to a failing institution (or an acquirer of a failing institution), thereby allowing markets to continue functioning but creating moral hazard; or (2) not providing Government assistance but running the risk of market collapses and greater costs in the future. Markets recognize this dilemma and can fuel more systemic risk by ``pricing in'' the possibility of a Government backstop of large interconnected institutions. This can give such institutions an advantage over their smaller competitors and make them even larger and more interconnected. A credible resolution regime can help address these risks by giving policy makers a third option: a controlled unwinding of a large, interconnected institution over time. Structured correctly, such a regime could force market participants to realize the full costs of their decisions and help reduce the ``too-big-to-fail'' dilemma. Structured poorly, such a regime could strengthen market expectations of Government support, thereby fueling ``too-big-to-fail'' risks. ------ CHRG-111hhrg56776--116 Mr. Bernanke," Both to monetary policy, but also to financial stability because we need to see what is happening in the entire banking system, and indeed, small banks can be part of a financial crisis. " CHRG-111hhrg54867--104 Secretary Geithner," Absolutely. Toxic assets are a problem for any financial system if banks don't hold enough capital against those losses and if they are unable to raise capital because the market doesn't understand the risk in those banks. And if you measured against that, you have seen dramatic amounts of new capital coming into the financial system because of disclosure in some sense we force in the system. The markets for those kind of real-estate-related loans and securities are beginning to improve. The prices have increased. There is more liquidity in part because of the programs we have set in motion. But we are just on the verge now of making the initial allocations of capital to the fund managers, and we have some authority to come in and buy those securities. But, again, the suite of these programs has already had a pretty important impact on liquidity and price in those markets, and things are starting to improve. But the best measure of this is, again, the amount of private capital that has come back into the financial system because of the disclosure we forced on the major institutions. " CHRG-111shrg57709--243 HOW TO REFORM OUR FINANCIAL SYSTEM The New York Times, January 30, 2010 By Paul Volcker, Op-Ed Contributor President Obama 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international. Aggressive action by governments and central banks--really unprecedented in both magnitude and scope--has been necessary to revive and maintain market functions. Some of that support has continued to this day. Here in the United States as elsewhere, some of the largest and proudest financial institutions--including both investment and commercial banks--have been rescued or merged with the help of massive official funds. Those actions were taken out of well-justified concern that their outright failure would irreparably impair market functioning and further damage the real economy already in recession. Now the economy is recovering, if at a still modest pace. Funds are flowing more readily in financial markets, but still far from normally. Discussion is underway here and abroad about specific reforms, many of which have been set out by the United States administration: appropriate capital and liquidity requirements for banks; better official supervision on the one hand and on the other improved risk management and board oversight for private institutions; a review of accounting approaches toward financial institutions; and others. As President Obama has emphasized, some central structural issues have not yet been satisfactorily addressed. A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established ``safety net'' undergirding the stability of commercial banks--deposit insurance and lender of last resort facilities--has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world's largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected. The phrase ``too big to fail'' has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks. As things stand, the consequence will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. We need to find more effective fail-safe arrangements. In approaching that challenge, we need to recognize that the basic operations of commercial banks are integral to a well-functioning private financial system. It is those institutions, after all, that manage and protect the basic payments systems upon which we all depend. More broadly, they provide the essential intermediating function of matching the need for safe and readily available depositories for liquid funds with the need for reliable sources of credit for businesses, individuals and governments. Combining those essential functions unavoidably entails risk, sometimes substantial risk. That is why Adam Smith more than 200 years ago advocated keeping banks small. Then an individual failure would not be so destructive for the economy. That approach does not really seem feasible in today's world, not given the size of businesses, the substantial investment required in technology and the national and international reach required. Instead, governments have long provided commercial banks with the public ``safety net.'' The implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration in international forums as a key element of reform. The further proposal set out by the president recently to limit the proprietary activities of banks approaches the problem from a complementary direction. The point of departure is that adding further layers of risk to the inherent risks of essential commercial bank functions doesn't make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets. The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading--that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally. Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution. The further point is that the three activities at issue--which in themselves are legitimate and useful parts of our capital markets--are in no way dependent on commercial banks' ownership. These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets. Individually, such independent capital market institutions, typically financed privately, are heavily dependent like other businesses upon commercial bank services, including in their case prime brokerage. Commercial bank ownership only tilts a ``level playing field'' without clear value added. Very few of those capital market institutions, both because of their typically more limited size and more stable sources of finance, could present a credible claim to be ``too big'' or ``too interconnected'' to fail. In fact, sizable numbers of such institutions fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets. What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed. To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new ``resolution authority.'' Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization. To help facilitate that process, the concept of a ``living will'' has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts. To put it simply, in no sense would these capital market institutions be deemed ``too big to fail.'' What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital--and as ordinary businesses in a capitalist economy, to fail. I do not deal here with other key issues of structural reform. Surely, effective arrangements for clearing and settlement and other restrictions in the now enormous market for derivatives should be agreed to as part of the present reform program. So should the need for a designated agency--preferably the Federal Reserve--charged with reviewing and appraising market developments, identifying sources of weakness and recommending action to deal with the emerging problems. Those and other matters are part of the Administration's program and now under international consideration. In this country, I believe regulation of large insurance companies operating over many states needs to be reviewed. We also face a large challenge in rebuilding an efficient, competitive private mortgage market, an area in which commercial bank participation is needed. Those are matters for another day. What is essential now is that we work with other nations hosting large financial markets to reach a broad consensus on an outline for the needed structural reforms, certainly including those that the president has recently set out. My clear sense is that relevant international and foreign authorities are prepared to engage in that effort. In the process, significant points of operational detail will need to be resolved, including clarifying the range of trading activity appropriate for commercial banks in support of customer relationships. I am well aware that there are interested parties that long to return to ``business as usual,'' even while retaining the comfort of remaining within the confines of the official safety net. They will argue that they themselves and intelligent regulators and supervisors, armed with recent experience, can maintain the needed surveillance, foresee the dangers and manage the risks. In contrast, I tell you that is no substitute for structural change, the point the president himself has set out so strongly. I've been there--as regulator, as central banker, as commercial bank official and director--for almost 60 years. I have observed how memories dim. Individuals change. Institutional and political pressures to ``lay off'' tough regulation will remain--most notably in the fair weather that inevitably precedes the storm. The implication is clear. We need to face up to needed structural changes, and place them into law. To do less will simply mean ultimate failure--failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future. ______ CHRG-111hhrg74090--91 Mr. Barr," I think that the better judgment, sir, again, with respect, is that the current system we have had, the status quo on consumer protection was a dismal failure and I think we have evidence all around us of that, and our view was, both for banks and for non-banks, for consumers and for households, the system failed. If you talk to, and I am sure you do, the community bankers in your community who had to compete against unregulated providers who were sucked into offering products---- " CHRG-111shrg53085--32 Mr. Whalen," Chairman Dodd, Senator Shelby, Members of the Committee, I am going to summarize my written comments and go down a list in bullet fashion, if you will, to respond to some of your comments and some of the other testimony. Systemic risk--does it exist? I am not sure. I used to work for Gerry Corrigan. I watched it in its early formations. Read the paper on my Web site called ``Gone Fishing,'' by the way. It is an allusion to his pastime with Chairman Volcker. What I would urge you to do is talk about systemic risks, make it plural, because then you are going to focus everybody on what we need to focus on, which are what the components that cause people to talk about systemic risk. A synonym for ``system risk'' is ``fear.'' If you go back to the Corrigan Group's work, you will see they differentiate between market disturbances and systemic events. Market disturbances are when people are upset, unsure about pricing, stop answering the phone. Systemic risk is when you are not getting paid. That is the difference. And if the Congress would focus on what are the components that cause us to talk about systemic risk, then I think we will make progress. The role of the Fed: I have great admiration and respect for every one of my colleagues in the Federal Reserve System, especially for the people in bank supervision. But the Congress has to accept and understand that monetary economists are entirely unsuited to supervise financial institutions. In fact, they cannot even work in the financial services industry unless they work as economists. So when you understand their prejudices, when you understand their love and their devotion to monetary policy and economic thought, economic theory, you understand why it is hard for them to take apart large banks. They recoil in horror at the notion that we are not going to have lots of big dealer banks in New York City. Well, folks, they are gone. They are gone. We cannot put Humpty-Dumpty back together again. So my sense is we have to excuse the people at the Fed from all direct responsibility for bank supervision. We give them a seat at the table by giving them responsibility for the things they do well, which is market liquidity risk management, market surveillance, et cetera. Do not ask them to do too many things. In my opinion--I worked on the Hill for Democrats and Republicans, and the thing you constantly do over and over again is give agencies too much to do. Let us give each one of these agencies ownership of the specific area: market liquidity risk for the Fed; supervision and even consumer protection in terms of the unified regulator; and then, finally, resolution and insurance for the FDIC separate from the supervisory activities. Why? Well, really, if I had my druthers--and I loved the comments from the community bankers before--I would like to see the FDIC evolve into a rating agency where we could look at the premium they charge banks not just for their deposits but for all of their liabilities, and use that rating, use that premium charge as a basis for the public to understand the risks that that bank takes. I am delighted to hear people talk about small banks. My company rates little banks. Most little banks are just fine. We have got 3,000-plus institutions in our rating system that are A or A-plus. The problem is we have got 2,000, as of the end of 2008, that we rate F. Half of those are victims of mark-to-market accounting; about a quarter of those banks have stopped lending entirely. You can tell because they are running off. They are shrinking. Their revenue is falling. They just are not in a position to lend. So I think what we have to do is ask ourselves a basic question: What do we want to achieve with the future regulatory framework? And who are going to be the owners of each piece? I have provided a little graphic here, and the one thing I would urge you to consider both with respect to consumer protection and all other areas is let us see if we cannot partner with the States. Why can't the Federal Government set consistent rules for all of the banking markets in the U.S.? Leave different types of charters in place, let us have diversity in terms of charts, but then we have to come up with a way of unifying capital requirements, unifying safety and soundness, and having a level playing field. I would love, by the way, to have better data on credit unions. I get calls about credit unions every day, but I cannot rate them because the data they put through the National Credit Union Administration is not organized properly. You guys have to go spend some time with the FDIC. Copy their methodology. I can get a bank call report off their Web site in real time now. It comes out at the same time as the EDGAR filing for public banks. That is what investors need. Finally, let me just make one other comment, and I look forward to your questions. The reason little banks are not in trouble as much as big banks is because the State and FDIC regulatory personnel did not let them get in trouble. They did not let them build a financial market that is based on notional, fanciful, speculative contracts that have no connection to the real economy. The biggest indictment of the Federal Reserve Board is that they have countenanced and encouraged renters to become equal with owners. That is what we have with AIG. The speculators, the dealers in New York, have leveraged the real world with these speculative ``gaming contracts.'' That is the only thing you can call them. If I want home insurance, do I go to the corner grocery store and pay him a premium every month? No. I go to a reputable insurance company. Everybody on the street knew that AIG was the dumbest guy in the room. They all knew, and they sucked that firm's blood for almost 7 years. Now we have to pay for it? No. I disagree. I will be happy to answer your questions. " CHRG-111hhrg56241--109 Mr. Stiglitz," You might say ``missteps.'' They were very much taken into the view that at that point, they had to give money to the banks; because they thought it was imperative so that the banks could return to the usual role that they had had. But the government officials were captured in an intellectual sense by the banking system. It was a very big mistake. " CHRG-111shrg56415--5 Mr. Tarullo," Thank you, Mr. Chairman, Senator Crapo, members of the Subcommittee. Let me begin by echoing a few points that my colleagues made in either their written or oral statements. First, compared to the situation of 8 to 12 months ago, the financial system has been significantly stabilized. The largest banking institutions, each of whose financial conditions was evaluated in our stress tests and then announced to markets and the public, have raised $60 billion in capital since last spring. We continue to see a narrowing of spreads in some parts of the market, such as corporate bonds, and in short-term funding markets. Second, however, important segments of our credit system are still not functioning effectively. Many securitization markets have had trouble restarting without Government involvement. Lending by commercial banks has declined through much of 2009. This decline reflects both weaker demand and tighter supply conditions, with particularly severe consequences for small and medium-sized businesses, which are much more dependent on banks than on the public capital markets that can be accessed by larger corporations. Banks will continue to suffer significant losses in coming quarters as residential mortgage markets continue to adjust. Losses on CRE loans, which represent a disproportionate share of the assets of some small and medium-sized banks, are likely to climb. The strains on these banks, when added to the more cautious underwriting typical of recessions, compound the problems of small businesses that rely on community banks for their borrowing. Third, it is important that bank supervisors take an even-handed approach in examining banks during these stressful times. We certainly do not want examiners to exacerbate the problems of declining CRE prices and restricted availability of credit by reflexively criticizing loans solely because, for example, the underlying collateral has declined in value. At the same time, we do not want supervisory forbearance that will put off inevitable losses, which may well increase over time, with attendant implications for the Federal Deposit Insurance Fund. So it is relatively easy to summarize the situation and state the problem. The question on everyone's mind is when and how it can be ameliorated. There are no easy answers, but let me offer a few observations. We as banking regulators should certainly redouble our efforts to ensure that the even-handed guidance we are issuing in Washington will be implemented faithfully by our examiners throughout the country. But we should not fool ourselves that even the best implementation of this policy will come close to solving the problems caused by significantly reduced demand for commercial properties that were in many cases highly leveraged on the assumption of rising asset prices. The problems lie deeper. In a weak economy that has, in turn, weakened many of our banks, supervisory guidance is neither appropriate for, nor effective as, an economic stimulus measure. At the most basic level, the strengthening of CRE markets and a return to a fully healthy banking system depend on growth in the economy as a whole, and particularly on a reduction in unemployment. I believe that the most important Federal Reserve action to promote CRE recovery is through our monetary policy. Our actions to date have helped return the Nation to growth sooner than many have expected. Nonetheless, because economic performance remains relatively weak, the Federal Open Market Committee indicated after our last meeting that conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. The Federal Reserve has also taken a series of steps to increase liquidity for financing capital of interest to consumers and small businesses, including the TALF program, which we recently extended through March, with a longer extension for commercial mortgage-backed securities. I suspect, though, that more direct efforts may be needed to make credit available to some creditworthy small businesses. Congress and the Administration may wish to consider temporary targeted programs while conditions in the banking industry normalize. Thank you very much, Mr. Chairman. Senator Johnson. Thank you. Ms. Matz. STATEMENT OF DEBORAH MATZ, CHAIRMAN, NATIONAL CREDIT UNION CHRG-110hhrg46591--96 Mr. Watt," All right. We have a system regulator and we have a bank holding company regulator. " CHRG-110hhrg46596--369 Mr. Scott," But can we not use the banking system to do that, for example? And you are saying, yes, we can. " CHRG-110shrg50410--124 Secretary Paulson," This is obviously your decision, and this is a major decision. And again, in terms of the U.K., we suggested it. I believe they are moving to adopt it. OK. I do not say they have this now. I think the thing you need to ask yourself, and you need to ask yourself long and hard, is when we have a system that was developed when commercial banks were not only the dominant, the predominant financial institution. And now we have a system where we have got the GSEs. We have got hedge funds. We have got investment banks. And it is going to be a long time, no matter how many hearings you hold, before the regulatory structure of this country is changed in a way in which it meets up with the world in which we live in. And so, as we have noted, that if people look increasingly to the Fed to play a clean up role, to me we need to put ourselves in a responsibility where we minimize the likelihood that we get into situations like this. And one way to do that is to have one regulator across the whole economy--not to supplant the other regulators. But to be able to look at risks to the system. And when they see risks to the system, be able to get the information, see the risks, and play a role. But as you rightfully point out, which is very fair, we have presented this idea and presented the idea. And what we are doing is bootstrapping it onto something which we felt would be the right move and would inspire market confidence and is an obvious step. But you may choose not to do that now, but that is---- " CHRG-110hhrg41184--52 Mr. Bernanke," Well, as you point out, the money remittances are currently regulated by States, by the FTC and so on. And I think, as in some other areas, the State regulation varies in terms of its aggressiveness and quality. I am not sure the Federal Reserve is the right agency. Our expertise is in banking. This is quite a different industry, with many small operators. We have taken a somewhat different approach, which is to encourage banks and other federally-regulated institutions to offer remittance services and to try to attract people interested in that to come into the banking system. The advantage of doing that is, first, banks can often offer better, cheaper services. But, in addition, people who are ``unbanked''--that is, they are not part of the regular banking system--through this particular service may become more comfortable with banks, may begin to have a checking account, a savings account, credit and so on. So that has been our approach. It is to encourage banks in their own interest, and also through CRA motivation and other ways, to try to reach out and bring remittances into their operations. " CHRG-111shrg54533--93 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM TIMOTHY GEITHNERQ.1. Role of the Fed--Secretary Geithner, the Administration proposes to expand the Fed's powers by giving it authority to regulate systemically significant nonbank financial institutions. This would mean that the Chairman of the Fed would not only have to be an expert in monetary policy and banking regulation, but also would have to be an expert in systemic risk regulation. Is it reasonable to expect that any one person can possibly acquire the expertise in so many highly technical fields? Do you think that one person could possibly oversee a complex institution like Citigroup and still have time to be fully prepared to make decisions on monetary policy?A.1. As the supervisor of bank holding companies and financial holding companies, the Federal Reserve already supervises all large U.S. commercial and investment banking firms. As stated elsewhere in my responses to these questions for the record, we propose modestly expanding the Federal Reserve's regulatory authority over the largest and most interconnected financial institutions in large part because we believe that the Federal Reserve is the only agency with the depth of expertise in financial institutions and markets that such regulation would require. The role of banking supervision is closely tied to the Federal Reserve's role in promoting financial stability. To do this, it needs deep and direct knowledge of the financial system through direct supervision of financial firms. Moreover, our proposals would also remove responsibility for consumer protection supervision and regulation from the Federal Reserve because we believe that this mission is better conducted by one agency with market wide coverage and a central mission of consumer protection. This mission is not closely related to the core responsibilities of the Nation's central bank. This step should make it easier for the Chairman and the Board to focus on core responsibilities.Q.2. Consumer Protection and Safety and Soundness--In making the case for a separate consumer protection agency the administration's white paper states ``banking regulators at the State and Federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission, but limited tools and jurisdiction.'' Secretary Geithner, please articulate the ``potentially conflicting mission'' between safety and soundness and consumer protection. It seems clear that a prudently underwritten loan will ensure that a consumer is protected, while also ensuring that a bank operates in a safe and sound manner.A.2. While in rare cases there may be conflicts between prudential regulation and consumer protection, we agree that strong consumer protection supports safety and soundness. We reject the notion that profits based on unfair and deceptive practices can ever be considered sound. Requiring all financial institutions to act fairly and transparently will improve the safety and soundness of banks while also providing consumers with the protection they need to make sound financial decisions. For the Consumer Financial Protection Agency (CFPA), protecting consumers will be its sole mission, whereas it is a secondary mission at the existing prudential regulators. Under the current system, consumer protection has always taken a back seat to safety and soundness concerns within the prudential regulators. In the lead-up to the current crisis, safety and soundness regulators failed to protect consumers from exploding subprime and exotic mortgages and unfair credit card features, and were far too slow in issuing rules to address these problems. The CFPA would have the responsibility and authority to act more quickly to protect consumers when they face undue risk of harm from changing products or practices. Our proposals are designed so that the CFPA prescribes regulations that are consistent with maintaining the safety and soundness of banks. The CFPA would be required by statute to consult with each of the prudential supervisors before issuing a new regulation. In addition, we propose that the National Bank Supervisor would be one of the five members of the CFPA board. These measures provide further assurance that the CFPA will consider safety and soundness interests when adopting regulations. Finally, in the very rare instance that conflicts do arise, we propose that the legislation incorporate reasonable dispute resolution mechanisms to force the CFPA and the prudential regulator to resolve any conflicts that they cannot work out on their own.Q.3. Role for Congress--Secretary Geithner, the Administration's Proposal grants the Fed and several other agencies vast new powers. It also gives the Treasury authority over the use of the Fed's 13(3) loan window. It also gives the Treasury, the FDIC, and the Fed authority to decide whether the Federal Government will bailout a troubled financial institution. Nowhere in the Proposal, however, does it consider granting Congress more authority over our regulatory system. There is not even a reporting requirement to Congress. Do you think that Congress should have a decision-making role in our financial regulatory system? Do you think that it is consistent with our republican form of government to concentrate so much power in independent agencies, such as the Fed? Would you support requiring Congressional approval before the Federal Government could bail out financial institutions?A.3. I believe that Congress has a strong role to play in reforming the financial regulatory system. Critically, it is Congress that will consider and enact the legislation that will form the framework for our new financial regulatory system. Of equal importance will be Congress' ongoing oversight role, which will be enhanced by many of our proposals. For example, the Financial Services Oversight Council will have the critical responsibility of identifying emerging threats and coordinating a response--because we know that threats to our economy can emerge from any corner of the financial system. The Council is required to report to Congress each year on these risks and threats and to coordinate action by individual regulators to address them. The Consumer Financial Protection Agency (CFPA) will have reporting requirements related to its rulemaking, supervisory and enforcement activity, and regarding consumer complaints. In addition, the Director of the Office of National Insurance will be required to submit an annual report to Congress on the insurance market. In formulating our proposals we were careful to include appropriate checks and balances to avoid concentrating authority in any single agency. For example, although our proposals provide for a modest enhancement of the Federal Reserve's powers, our proposals also move consumer protection authority from the Federal Reserve to a dedicated agency with a single mission and market-wide coverage. Moreover, our proposed resolution regime, which is modeled on the existing resolution regime for insured depository institutions, requires the consent of three separate agencies; Treasury must consult with the President, and it must receive the written recommendation of two-thirds of the members of the boards of both the Federal Reserve Board and the FDIC (or the SEC, if the SEC is the institution's primary supervisor). Moreover, even after the decision to use the resolution authority is made, the choice of the appropriate resolution method is not left to one agency. Under our proposals, the agency responsible for managing the resolution and Treasury must agree on the appropriate method. We expect this process will allow for timely decision making during a crisis while ensuring that there are appropriate perspectives included and that this new authority is exercised only under extraordinary circumstances. Anytime that this authority is exercised, the Treasury Secretary must submit a report to Congress regarding the determination, and each determination is also reviewed by the Government Accountability Office.Q.4. Hedge Funds--Secretary Geithner, you favor the mandatory registration of advisors to hedge funds, venture capital funds, and private equity funds with the SEC. As the Madoff and Stanford cases painfully illustrate, being registered with the SEC does not guarantee that a firm will be closely monitored. The administration white paper cites hedge fund de-leveraging as a contributor to the crisis. How will the registration of hedge fund advisors prevent them from de-leveraging in future crises?A.4. As noted in the Treasury's report to Congress, at various points in the financial crisis, de-leveraging by hedge funds contributed to the strain on financial markets. Because these funds were not required to register with regulators, the government lacked reliable, comprehensive data with which to assess this market activity and its potential systemic implications. Requiring registration of hedge fund advisors would allow data to be collected that would permit an informed assessment by the government of the market positions of such funds, how such funds are changing over time and whether any such funds or fund families have become so large, leveraged, or interconnected that they require additional oversight for financial stability purposes. Among other requirements, all registered hedge fund advisors would be subject to recordkeeping and reporting requirements, including the following information for each private fund advised by the adviser: amount of assets under management, borrowings, off-balance sheet exposures, trading and investment positions, and other information necessary or appropriate for the protection of investors or for the assessment of systemic risk. Information would be shared with the Federal Reserve, which would determine whether such a firm meets the Tier 1 Financial Holding Company (Tier 1 FHC) criteria. Designation as a Tier 1 FHC would subject the firm to robust and consolidated supervision and regulation as Tier 1 FHCs. The prudential standards for Tier 1 FHCs would include capital, liquidity, and risk management standards that are stricter and more conservative than those applicable to other firms to account for the risks that their potential failure would impose on the financial system.Q.5. What other problems did hedge funds, private equity funds, and venture capital funds cause and how will SEC registration of advisors to those funds address the problems caused by each of these types of funds?A.5. Although these funds do not appear to have been at the center of the current crisis, de-leveraging contributed to the strain on financial markets and the lack of transparency contributed to market uncertainty and instability. New advisor registration, recordkeeping, and disclosure requirements will give regulators access to important information concerning funds in order to address opacity concerns. Information about the characteristics of a hedge fund, including asset size, borrowings, off-balance sheet exposure, and other matters will help regulators to protect the financial system from systemic risk and help regulators to protect investors from fraud and abuse. In addition, this information will allow regulators to make an assessment of whether a firm is so large, leveraged, or interconnected that it poses a threat to financial stability, and thus require regulation as Tier 1 FHC.Q.6. How should the SEC allocate its examination resources between advisors to private pools of capital, on the one hand, and advisors to mutual funds and other advisors that serve the less affluent in our society, on the other?A.6. We defer to the SEC to address how resources should be allocated. In testimony on July 14, SEC Chairman Mary Schapiro addressed strengthening SEC examination and oversight and improving investor protection. The Chairman noted that the SEC is working towards improving its risk-based oversight, including extending that oversight to investment advisers. The SEC is recruiting additional professionals with specialized expertise, creating new positions in its examination program, and making use of automated systems to assist in determining which firms or practices raise red flags and require greater scrutiny.Q.7. Credit Rating Agencies--Secretary Geithner, the Administration's proposal calls for reduced regulatory reliance on credit ratings, but seems focused only on reducing reliance on ratings of structured products. Will you be recommending a legislative mandate to the SEC and other regulatory agencies to find ways to reduce their reliance on ratings of all types, not just ratings on structured products?A.7. It is clear that over-reliance on ratings from credit rating agencies contributed to the fragility of the system in the current crisis--especially as the systematic underestimation of risk in structured securities became clear. While the regulatory reliance on ratings covers both structured and unstructured products, we believe that the problems in the markets for structured products were particularly acute. Our legislative proposal includes a requirement that rating agencies distinguish the symbols used to rate structured products from those used for unstructured products. This will not directly reduce the use of ratings, but it will require that regulators and investors reassess their approaches to ratings--in regulations, contracts, and investment guidelines. In addition, we are working with the SEC and through the President's Working Group to identify other areas in Federal regulations where there is a need to reassess the use of ratings, with respect to both structured and unstructured products. For instance, as part of a comprehensive set of money market fund reform proposals, the SEC requested public comment on whether to eliminate references to ratings in the regulation governing money market mutual funds.Q.8. Fed Study of Itself--In the Administration's proposal, after giving the Fed extensive new regulatory power, you would ask the Fed to review ``ways in which the structure and governance of the Federal Reserve System affect its ability to accomplish its existing and proposed functions.'' Why should we give the Fed these additional responsibilities prior to knowing if they are able to administer them? Why do you have the Fed study itself'? Were other entities considered as alternatives for the purposes of conducting the study?A.8. As the supervisor of bank holding companies and financial holding companies, the Federal Reserve already supervises all large U.S. commercial and investment banking firms. As stated elsewhere in the responses to these questions for the record, we propose modestly expanding the Federal Reserve's regulatory authority over the largest and most interconnected financial institutions in large part because we believe that the Federal Reserve is the only agency with the depth of expertise in financial institutions and markets that such regulation would require. The role of banking supervision is closely tied to the Federal Reserve's role in promoting financial stability. To do this, it needs deep and direct knowledge of the financial system through direct supervision of financial firms. The proposed role for the Fed in supervising nondepository financial firms will require the Federal Reserve to acquire additional expertise in some areas of financial activity. But the potential extension of its consolidated supervision authority to some nonbanking financial institutions represents an evolution rather than a revolution in the Federal Reserve's role in the financial markets. At the same time, the structure and governance of the Federal Reserve System should be reviewed to determine whether and, if so, how it can be improved to facilitate accomplishment of the agency's current and proposed responsibilities. Every agency has the responsibility to review itself periodically to ensure that it is organized in a manner that best promotes its mission.Q.9. Congress Needs To Do Its Homework--Secretary Geithner, the Administration's Proposal defers making decisions on how to address the GSEs, improve banking supervision, modernize capital requirements, update insurance regulation, improve accounting standards, coordinate SEC and CFTC regulation, and even how to define systemic risk. The Administration has said that it will study these topics before proceeding. Should not Congress wait to pass reform legislation until after it has had the benefit of the Administration's studies on these topics? Would not that help ensure that Congress acts in an informed manner and that the final legislation is based on the best available information?A.9. The reform proposals for which we have submitted draft legislation in June and July do not depend on completion of the studies. It is important that Congress move forward to enact legislation to reform our financial regulatory system, while regulators, at the same time, move forward to find ways to improve the nuts and bolts of supervising U.S. financial firms.Q.10. Fed v. Systemic Risk Regulator--Secretary Geithner, despite strong opposition in Congress to expanding the powers of the Fed, the Administration has proposed doing just that. Do you recognize that this will create significant hurdles for passing regulatory reform? Is it more important to you that some entity be charged with regulating systemic risk, or must the Fed be the systemic risk regulator?A.10. We chose not to make one agency the ``systemic risk regulator'' or ``super regulator'' because our system should not depend on the foresight of a single institution or a single person to identify and mitigate systemic risks. This is why we have proposed that the critical role of monitoring for emerging risks and coordinating policy be vested in a Financial Services Oversight Council rather than the Federal Reserve or any other single agency. Each Federal supervisor will contribute to the systemic analysis of the Council through the institution-focused work of their examiners. We did propose an evolution in the Federal Reserve's authority to include the supervision and regulation of the largest and most interconnected financial firms. The Federal Reserve is the appropriate agency because of its depth of expertise, its existing mandate to promote financial stability, and its existing role as the supervisor for all large commercial and investment banking firms, including bank and financial holding companies.Q.11. Basel Capital Accords--Secretary Geithner, in the Obama Administration's white paper, you state that the administration will recommend various actions to the Basel Committee on Banking Supervision (BCBS). Previously, the BCBS has approved capital plans that were deemed inadequate by many in Congress, as well as the bank regulators. What will you do if the BCBS returns with measures and definitions that raise concerns along the same lines as Basel II? For the record, will you seek alterations to their standards as was done with Basel II, if the new standards are considered inadequate?A.11. The U.S. banking regulators have always played a significant role in the Basel Committee's policy development process and we strongly believe that they will be highly influential in the next phase of capital proposals in ways that will address flaws in the Basel II framework that have been made manifest by the current economic crisis. The U.S. regulatory community considers the Basel Committee to be a useful and receptive forum in which international supervisors can set consistent international supervisory standards. U.S. supervisors have and will continue to push for improvements to those standards. For example, the Basel Committee just released in mid-July significant enhancements to the Basel II framework that increase risk weights for the trading book, certain securitizations, and off-balance sheet activities, as supported by the President and myself at the G20 Leaders Summit in April.Q.12. Basel Leverage Measurement--Mr. Secretary, in the white paper, you clearly state that the Obama Administration will, ``urge the BCBS to develop a simple, transparent, nonmodel based measure of leverage, as recommended by the G20 leaders.'' Please expand on this statement and what manner of measuring leverage you envision, including what criteria will be used and how you arrived at these answers?A.12. As we explained in the Treasury Department's September 3, 2009, ``Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms,'' risk-based capital rules are a critical component of a regulatory capital regime; however, it is impossible to construct risk-based capital rules that perfectly capture all the risk exposures of banking firms. Inevitably, there will be gaps and weak spots in any risk-based capital framework and regulatory arbitrage activity by firms will tilt asset portfolios and risk taking toward those gaps and weak spots. A simple leverage constraint would make the regulatory system more robust by limiting the degree to which such gaps and weak spots in the risk-based capital framework can be exploited. A simple leverage constraint also can help reduce the threats to financial stability from categorical misjudgments about risk by market participants and the official sector. In addition, imposing a leverage constraint on banking firms would have macroprudential benefits. The balance sheets of financial firms and the intermediation chains between and among financial firms tend to grow fastest during good economic times but become subject to rapid reversal when economic conditions worsen. Supervisors generally have failed to exercise discretion to constrain leverage leading into a boom. A simple leverage ratio acts as a hard-wired dampener in the financial system that can be helpful to mitigate systemic risk. It is important to recognize that the leverage ratio is a blunt instrument that, viewed in isolation, can create its own set of regulatory arbitrage opportunities and perverse incentive structures for banking firms. The existing U.S. leverage ratio is calculated as the ratio of Tier 1 capital to total balance sheet assets. To mitigate potential adverse effects from an overly simplistic leverage constraint, the constraint going forward should at a minimum incorporate off-balance sheet items. It is also important to view the leverage constraint as a complement to a well designed risk-based capital requirement. Although it may be possible for banking firms to either arbitrage any free-standing risk-based capital requirement or any free-standing simple leverage constraint, it is much more difficult to arbitrage both frameworks at the same time.Q.13. Supervisory Colleges--Mr. Secretary, in the white paper, you state that, ``supervisors have established `supervisory colleges' for the 30 most significant global financial institutions. The supervisory colleges for all 30 firms have met at least once.'' Will information from these meetings be made public; will there be publication of any agendas, minutes, plans, membership, etc.? If this information will not be made public, will there be the opportunity for Congressional staff to receive reports and briefings of the conduct and actions of these colleges? Will the firms that are being examined have any opportunity to receive any information about these meetings?A.13. Supervisory colleges are confidential meetings, held by regulators from multiple countries, which function as an information-sharing mechanism with regards to large cross-border financial institutions. The information shared in these meetings is governed by information sharing agreements signed by the participating regulatory organizations. Supervisory colleges are not themselves decision-making regulatory bodies. The information shared within a supervised institution's college is used to assist regulators in conducting their supervisory responsibilities over that institution. A particular firm may be invited to brief regulators on specific topics. However, any resulting regulatory actions are conducted by the respective regulatory agencies. The Federal Reserve Board of Governors, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission participate in the supervisory colleges and can be contacted for further information.Q.14. Implications of Resolution Regime--Mr. Secretary, in the white paper, you state that the proposed resolution regime would provide authority to avoid disorderly resolution of any systemically critical firm. You also write that national authorities are inclined to protect assets with their own jurisdictions. I would hope that our regulators would continue to have this mind-set, to spare the U.S. taxpayer from additional costs. It seems that this paper takes a negative view of this mind-set. Can you explain your statement further? Also, please explain to the Committee why protecting assets, which protects the taxpayer, should not be the focus of our national regulators?A.14. Our proposal presents a new resolution regime, beyond what the U.S. already has, only where the failure of certain bank holding companies or nonbank financial firms threatens the stability of the entire financial system. The authority to invoke resolution procedures for these large entities would be used only for extraordinary circumstances and would be subject to strict governance and control procedures. Furthermore, the purpose of the expanded resolution regime would be to unwind, dismantle, restructure, or liquidate the firm in an orderly way to minimize costs to taxpayers and the financial system; all costs to exercise this authority would be recouped through assessments and liquidation of any acquired assets, therefore sparing the taxpayer. The global nature of the current crisis has also shown that in the failure of globally active financial firms, there needs to be improved coordination between national authorities representing jurisdictions that are affected. No common procedure exists among countries with respect to the failure of a large financial firm. The aim of this cross-border coordination should be to establish fair and orderly procedures to resolve a firm according to a system of laws and rules that investors can rely on as well as to protect the interests of U.S. taxpayers in globally active financial firms. The absence of predictability in cross-border procedures was a contributing factor to the contagion in our financial markets in the fall of 2008.Q.15. Federal Reserve Supervision of Foreign Tier 1 Financial Holding Companies--Secretary Geithner, you ``propose to change the Financial Holding Company eligibility requirements . . . but do not propose to dictate the manner in which those requirements are applied to foreign financial firms with U.S. operations.'' Please clarify this statement. Do you foresee the Federal Reserve getting information from other national supervisors or do you see the Federal Reserve conducting examinations of foreign Financial-Holding Companies overseas? What criteria would you recommend the Federal Reserve use when they evaluate foreign parent banks? Many financial products differ in other parts of the world, how should the Federal Reserve evaluate those products' safety and soundness for the parent company balance sheet?A.15. Treasury intends to work with the Financial Services Oversight Council and the Federal Reserve Board to create a regulatory framework for foreign companies operating in the United States that are deemed to be Tier 1 Financial Holding Companies (FHCs). That framework will be comparable to the standards applied to domestic Tier 1 FHCs, giving due regard to the principle of national treatment and equality of competitive opportunity. In determining today whether a foreign bank is well capitalized and well managed in accordance with FHC standards, the Board, relying on the existing Bank Holding Company Act, may take into account the foreign bank's risk-based capital ratios, composition of capital, leverage ratio, accounting standards, long-term debt ratings, reliance on government support to meet capital requirements, the anti-money laundering procedures, whether the foreign bank is subject to comprehensive supervision or regulation on a consolidated basis, and other factors that may affect analysis of capital and management. While not conducting examinations of foreign banks in a foreign country, the Federal Reserve Board consults with the home country supervisor for foreign banks as appropriate. Treasury intends to work with the Federal Reserve Board to determine what modifications to the existing FHC framework are needed for new foreign Tier 1 financial holding companies.Q.16. New Financial Stability Board (FSB)--Mr. Secretary, in the white paper, you ``recommend that the FSB complete its restructuring and institutionalize its new mandate to promote global financial stability by September 2009.'' To whom will the FSB be accountable and from where will it receive its funding? Will the FSB make their reports and conclusions public? Will the Congress be able to have access to FSB documents and decisions?A.16. The G20 Leaders in April 2009 agreed that the Financial Stability Forum should be reestablished as the Financial Stability Board (FSB) and be given a stronger mandate. Its membership was expanded to include all G20 member countries. The FSB is composed of finance ministries, central banks, regulatory authorities, international standard-setting bodies, and international institutions. It is supported by a small secretariat provided by the Bank for International Settlements. The FSB provides public statements following its meetings and may issue papers on important issues from time to time. It regularly posts information to its Web site (www.financialstabilityboard.org), which is available to Congress and the general public. The FSB can provide coordination and issue recommendations and principles (e.g., on crisis management; principles on compensation; protocols for supervisory colleges). The FSB operates as a consensus organization and it is up to each country whether and how to implement the recommendations of the FSB. The point of accountability for decisions and responses lies with each national regulator. The U.S. will work through the FSB as an effective body to coordinate and align international standards with those that we will set at home.Q.17. Adequacy of the Proposal--Secretary Geithner, the Administration's Proposal aims to address the causes of the financial crisis by closing regulatory gaps. I would like to know more about which gaps in our financial supervisory system the Administration believes contributed to the crisis. What are two cases where supervisory authority existed to address a problem but where regulators nevertheless failed act? What are two cases where supervisory authority did not exist to address a problem and regulators were unable to act? Does the Administration's Proposal address all of the cases you cited in your answers?A.17. There were a number of cases in which supervisory authority existed but supervisors did not act in a timely and forceful fashion. It was clear, at least by the early to mid-2000s, that banks and nonbanks were making subprime and nontraditional mortgage loans without properly assessing that the borrowers could afford the loans once scheduled payment increases occurred. Yet supervisors did not issue guidance requiring banks to qualify borrowers at the fully indexed interest rate and fully amortizing payment until 2006 and 2007. By consolidating consumer protection authority into a single agency with a focused mission, the CFPA will be able to recognize when borrowers are receiving loans provided in an unfair or deceptive manner earlier, and it will act more quickly and effectively through guidance or regulation to address such problems. In the securitization markets, regulatory authority existed to address the problems that emerged in the current crisis but the regulatory actions were not taken. For instance, regulators had the ability to address the treatment of off-balance sheet risks that many institutions retained when they originated new financial products such as structured investment vehicles and collateralized debt obligations, but supervisors did not fully grasp these risks and did not require sufficient capital to be held. Our proposals would increase capital charges for off-balance sheet risks to account more fully for those risks. In addition, in many instances, regulators simply lacked the authority to take the actions necessary to address problems that existed. For example, independent mortgage companies and brokers were major players in the market for nontraditional and sub-prime mortgages at the heart of the foreclosure crisis and operated without Federal supervision. Under our proposals, they would have been subject to supervision and regulation by the proposed CFPA. Similarly, AIG took advantage of loopholes in the SHC act and was not adequately supervised on a consolidated basis. Under our proposals, AIG would have been subject to supervision and regulation by the Federal Reserve for safety and soundness, with an explicit mandate to look across the risks to the enterprise as a whole, not simply to protect the depository institution subsidiary. As discussed above, the Administration's proposals create a comprehensive framework that would have addressed each of these failures.Q.18. Fed as Consolidated Supervisor--Secretary Geithner, I find it interesting that, under your proposal, the entire financial industry would be within the Federal Reserve's regulatory reach. While you have created a shadow consolidated regulator, you have not bothered to get rid of the other regulators. If you are intent on creating a single financial regulator, why not move everything into an agency with political accountability and eliminate the other regulatory agencies?A.18. The entire financial industry would not be within the Federal Reserve's regulatory reach and we are not intending to create a single financial regulator. The Financial Services Oversight Council will have the authority and responsibility to identify emerging risks to the financial system and will help facilitate a coordinated response. In critical markets, like those for securities and derivatives, the SEC and CFTC will play leading roles. We are also proposing to retain and enhance crucial roles for the National Bank Supervisor and the FDIC on prudential regulation, and resolution of banks. The Federal Reserve would be the consolidated regulator of Tier 1 FHCs and would be responsible, as it is today, for prudential matters in the basic plumbing of the system--payment, settlement, and clearance systems. In formulating our proposals we were careful to include appropriate checks and balances to avoid concentrating authority in any single agency. For example, although our proposals provide for a modest enhancement of the Federal Reserve's powers, our proposals also strip power from the Federal Reserve in the consumer protection area.Q.19. Regulatory Overlap--Secretary Geithner, the Administration's proposal states that jurisdictional boundaries among agencies should be drawn clearly to avoid mission overlap and afford agencies exclusive regulatory authority. How do you reconcile that principle with the proposal to expand the Fed's regulatory authority into so many different areas, many of which already have primary regulators?A.19. In Treasury's report to Congress, we articulate a principle that agencies should be held accountable for critical missions such as promoting financial stability and protecting consumers of financial products. The consolidated supervisor of the holding company and the functional supervisor of the subsidiary each have critical roles to play.Q.20. Over-the-Counter Derivatives--Secretary Geithner, the Administration does not appear to have made much headway in fleshing out the details of last month's outline for regulating over-the-counter derivatives. How will you encourage standardization of derivatives without preventing companies from being able to buy derivatives to meet their unique hedging needs?A.20. As you know, we have now sent up detailed legislative language to implement our proposal. Any regulatory reform of magnitude requires deciding how to strike the right balance between financial innovation and efficiency on the one hand, and stability and protection on the other. We failed to get this balance right in the past. If we do not achieve sufficient reform, we will leave ourselves weaker as a Nation and more vulnerable to future crises. Our proposals have been carefully designed to provide a comprehensive approach. That means strong regulation and transparency for all OTC derivatives, regardless of the reference asset, and regardless of whether the derivative is customized or standardized. In addition, our plan will provide for strong supervision and regulation of all OTC derivative dealers and all other major participants in the OTC derivative markets. We recognize, however, that standardized products will not meet all of the legitimate business needs of all companies. That is why our proposals do not--as some have suggested--ban customized OTC derivatives. Instead, we propose to encourage substantially greater use of standardized OTC derivatives primarily through higher capital charges and margin requirements on customized derivatives, and thereby facilitate a more substantial migration of these OTC derivatives on to central clearinghouses and exchanges.Q.21. Systemically Significant Firms--Secretary Geithner, systemically significant firms, or Tier 1 Financial Holding Companies, will be required to make enhanced public disclosures ``to support market evaluation.'' Don't you believe that giving these firms a special label, a special oversight regime, and special disclosure will simply send a signal to the market that these firms are too big to fail and therefore do not need to be monitored?A.21. Identification as a Tier 1 Financial Holding Company (Tier 1 FHC) does not come with any commitment of government support nor does it provide certain protection against failure. Instead our proposals would apply stricter prudential standards and more stringent supervision. For example, higher capital charges for Tier 1 FHCs would be used to account for the greater risk to financial stability that these firms could pose if they failed. It is designed to internalize the externalities that their failure might pose, to reduce incentives to excessive risk-taking at the taxpayer's expense, and to create a large buffer in the event of failure. In addition, in the event of failure, our proposals provide for a special resolution regime that would avoid the disruption that disorderly failure can cause to the financial system and the economy. That regime, however, would be triggered only in extraordinary circumstances when financial stability is at risk, and bankruptcy would remain the dominant tool for handling the failure of a financial company. Moreover, the purpose of the special resolution regime is to provide the government with the option of an orderly resolution, in which creditors and counterparties may share in the losses, without threatening the stability of the financial system.Q.22. Federal Reserve and Systemically Important Firms--Secretary Geithner, under your proposal, the Federal Reserve would identify and regulate firms the failure of which, could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness. It is unclear just what types of companies might fall into this new category of so-called Tier 1 Financial Holding Companies, because it will be up to the Fed to identify them. Could Starbucks--which offers a credit card and would certainly affect numerous sectors of the economy if it failed--be classified as a Tier 1 Financial Holding Company and be subjected to Fed oversight?A.22. Starbucks is not a financial firm and therefore would not qualify as a Tier 1 FHC. Starbucks currently offers a credit card through an independent financial institution.Q.23. Financial Services Oversight Council--Secretary Geithner, the Administration recommends replacing the President's Working Group on financial Markets with a Financial Services Oversight Council. Aside from having slightly enlarged membership and a dedicated staff, how will this Council differ from the PWG? Is this anything more than a cosmetic change?A.23. There are important differences between the President's Working Group (PWG) and the Financial Services Oversight Council (FSOC or Council). As an initial matter, the PWG was created by executive order and the Council would have permanent statutory status. In addition, the Council would have a substantially expanded mandate to facilitate information sharing and coordination, identify emerging risks, advise the Federal Reserve on the identification of Tier 1 FHCs and systemically important payment, clearing, and settlement activities, and provide a forum in which supervisors can discuss issues of mutual interest and settle jurisdictional disputes. It would also enjoy the benefit of a dedicated staff that will enable it to undertake its missions in a unified way and to effectively conduct analysis on emerging risks. In addition, unlike the PWG, the Council will have authority to gather information from market participants and will report to Congress annually on financial market developments and emerging systemic risks.Q.24. Identifying Systemic Risk--Secretary Geithner, your proposal gives the Federal Reserve the authority to identify and regulate financial firms that pose a systemic risk due to their combination of size, leverage, and interconnectedness. Because neither ``systemic risk'' nor ``financial firm'' is defined, it is unclear what types of firms will fall within the Tier 1 Financial Holding Company designation. Theoretically, the term could include large investment advisers, mutual funds, broker-dealers, insurance companies, private equity funds, pension funds, and sovereign wealth funds, to name a few possibilities. What further specificity will you be providing about your intentions with respect to the reach of the Fed's new powers?A.24. In the draft legislation sent to Congress in July, we proposed the specific factors that the Federal Reserve must consider when determining whether an individual financial firm is a Tier 1 FHC. Our proposed legislation defines a Tier 1 FHC as a financial firm whose material financial distress could pose a threat to financial stability or the economy during times of economic stress. Our proposed legislation requires the Fed to designate U.S. financial firms as Tier 1 FHCs based on an analysis of the following factors: the amount and nature of the company's financial assets; the amount and types of the company's liabilities, including the degree of reliance on short-term funding; the extent of the company's off-balance sheet exposures; the extent of the company's transactions and relationships with other major financial companies; 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; the recommendation, if any, of the Financial Services Oversight Council.Q.25. Expertise of the Fed--Secretary Geithner, the Administration's Proposal chooses to grant the Fed authority to regulate systemic risk because it ``has the most experience'' to regulate systemically significant institutions. I believe this represents a grossly inflated view of the Fed's expertise. Presently, the Fed regulates primarily bank holding companies and State banks. As a systemic risk regulator, the Fed would likely have to regulate insurance companies, hedge funds, asset managers, mutual funds and a variety of other financial institutions that it has never supervised before. Since the Fed lacks much of the expertise it needs to be an effective systemic regulator, why could not the responsibility for regulating systemic risk just as easily be given to another or a newly created entity?A.25. We are not proposing that the Federal Reserve act as a systemic risk regulator. In critical markets, like those for securities and derivatives, the SEC and CFTC will play lead roles. The bank regulators all play crucial roles as prudential supervisors of banks. The Financial Services Oversight Council will have the authority and responsibility to identify emerging risks to the financial system and will help facilitate a coordinated response. We have proposed that the Federal Reserve act as the consolidated supervisor of the largest and most interconnected financial firms. The Federal Reserve has broad expertise in supervising financial institutions involved in diverse financial markets through the exercise of its current responsibilities as the supervisor of bank and financial holding companies. We are confident that it can acquire expertise where needed to oversee the supervision of Tier 1 Financial Holding Companies that do not own a depository institution. As noted above, the potential extension of its consolidated supervision authority to some nonbanking financial institutions represents an evolution in the Federal Reserve's responsibilities.Q.26. Skin-in-the-Game--Secretary Geithner, your proposal would require that mortgage originators maintain an unhedged 5 percent stake in securitized loans. Will the administration adopt the same position with respect to government programs that assist borrowers in obtaining mortgages and require increased down payment requirements and other such measures to increase ``skin-in-the-game?''A.26. One of the key problems that the financial system experienced in the buildup to the current crisis, was a breakdown in loan underwriting standards--especially in cases where the ability to sell loans in a secondary market allowed originators and securitizers to avoid any long-term economic interest in the credit risk of the original loans. We are proposing that securitizers or originators retain up to a 10 percent stake in securitized loans to align their interests with those of the ultimate investor in those loans. This directly addresses the incentives of originators and securitizers to consider the performance of the underlying loans after asset-backed securities were issued. A family buying a home is in a different position from a loan originator or securitizer. The household faces substantial tangible and intangible costs if it is forced to move. Our proposal would not require home owners to increase their down payment. Also our proposal specifically gives regulators authority to exempt government-guaranteed loans from the skin-in-the-game requirement.Q.27. Insurance Regulation--Secretary Geithner, the Proposal states that the Administration will support measures to modernize insurance regulation, but fails to offer a specific plan. While we all recognize the difficulties involved in modernizing insurance regulation, the problems with AIG's insurance subsidiaries and the fact that several insurers needed TARP money demonstrates that we need to reconsider how we regulate insurance companies. Will systemically significant insurance companies be regulated by the Fed? If so, will this effectively require the Fed to act as a Federal insurance regulator so that it can properly supervise the company? Does the Fed have the necessary expertise in insurance to regulate an insurance company? Would it be more efficient to establish a Federal insurance regulator that can specialize in regulating large insurance companies?A.27. Under the Administration's proposals, all firms designated as Tier 1 Financial Holding Companies (Tier 1 FHCs) will be subject to robust, consolidated supervision and regulation. Tier 1 FHCs will be regulated and supervised by the Board of Governors of the Federal Reserve System (Board). Consolidated supervision of a Tier 1 FHC will extend to the parent company and to all of its subsidiaries--regulated and unregulated, U.S. and foreign. This could include an insurance company, if it or its parent were designated as a Tier 1 FHC. For all Tier 1 FHCs, functionally regulated subsidiaries like insurance companies will continue to be supervised and regulated by their current regulator. However, the Federal Reserve will have a strong oversight role, including authority to require reports from and conduct examinations of a Tier 1 FHC and all its subsidiaries, including insurance companies. We believe that the current insurance regulatory system is inefficient and that there is a need for a Federal center for expertise and information on the insurance industry. The Administration has proposed creating an Office on National Insurance (ONI) to develop expertise, coordinate policy on prudential aspects of international insurance matters, and consult with the States regarding insurance matters of national and international importance, among other duties. The ONI will receive and collect data and information on and from the insurance industry and insurers, enter into information-sharing agreements, and analyze and disseminate data and information, and issue reports for all lines of insurance except health insurance. This will allow the ONI to identify the emergence of problems within the insurance industry that could affect the economy as a whole. In addition, our proposal lays out core principles to consider proposals for additional reforms to insurance regulation: Increased consistency in the regulatory treatment of insurance, including strong capital standards and consumer protections, would enhance financial stability, result in real improvements for consumers and also increase economic efficiency in the insurance industry. One of our core principles for insurance regulation is to increase national uniformity of insurance regulation through either a Federal charter or effective action by the States. We look forward to working with you and others in the Congress on this important issue.Q.28. Resolution Plans--Secretary Geithner, under your proposal, systemically significant firms would be required to devise their own plans for rapidly resolving themselves in times of financial distress. Will firms be able to incorporate into their death plans the expectation of taxpayer money to cover wind-down expenses?A.28. No. That is the opposite of what we have in mind. We propose that the Federal Reserve should require each Tier 1 FHC to prepare and periodically update a credible plan for the rapid resolution of the firm in the event of severe financial distress. Such a requirement would create incentives for the firm to better monitor and simplify its organizational structure and would better prepare the government, as well as the firm's investors, creditors, and counterparties, in the event that the firm collapsed. The Federal Reserve should review the adequacy of each firm's plan on a regular basis. It would not be appropriate for firms to incorporate in such a plan the expectation of taxpayer money to cover wind-down expenses. As I have stated elsewhere in my responses to these questions for the record, identification as a Tier 1 FHC does not come with any commitment of government support. Moreover, any government support through our proposed special resolution regime would be available only in extraordinary circumstances when financial stability is at risk and only upon the agreement of three different government agencies. In most circumstances, bankruptcy would remain the dominant tool for handling the failure of a financial company.Q.29. Citigroup--Secretary Geithner, you mentioned AIG and Lehman as being examples of untenable options for firms nearing failure during a financial crisis. I would add Citigroup to that list of untenable options. As you surveyed the landscape to understand the types of scenarios that might have to be handled by the new resolution authority that you propose, are there any entities that would still require ad hoc solutions as Lehman, AIG, and Citigroup did?A.29. Our proposals are designed to provide a comprehensive set of tools to address the potential disorderly failure of any bank holding company, including Tier 1 FHCs, when the stability of the financial system is at risk. It is important to note that after the TARP purchase authority expires this year, the government will lack the effective legal tools that it would need to adequately address a similar situation to that which we have seen in the past 2 years. We believe that our comprehensive regulatory reform proposals would provide the government with the tools necessary to wind down any large, interconnected highly leveraged financial firm if such a failure would threaten financial stability.Q.30. Accounting Standards--Secretary Geithner, among the changes recommended by your proposal are changes in accounting standards. What is the appropriate role of the administration in directing the substantive determinations of an independent accounting standard setter?A.30. It is critical that the FASB be fully independent in carrying out its mission to establish accounting and financial reporting standards for public and private companies. The health and soundness of capital markets depend critically on the provision of honest and neutral accounting and financial reporting, not skewed to favor any particular company, industry, or type of transaction or purposefully biased in favor of regulatory, social, or economic objectives other than sound reporting to investors and the capital markets. Governmental entities with knowledge and responsibility for the health of capital markets have an interest and expertise in maintaining the health of America's capital markets. These entities include the SEC, which has specific oversight of disclosure for publicly held firms, the Public Company Accounting Oversight Board, which is tasked with overseeing the auditors of public companies, and other financial regulators, which have oversight over the soundness of the entities they regulate.Q.31. SEC-CFTC Merger--Secretary Geithner, the proposal acknowledges the need for harmonization between the SEC and CFTC, but stops short of merging the two agencies. Instead, you direct the agencies to work their differences out among themselves and report back in September. Given the tortured history of compromise between the SEC and CFTC, why do you anticipate that the two agencies can come to agreement in a matter of months? Wouldn't a merger of the agencies be a better way to force them to work out their differences?A.31. In the last few months, the SEC and the CFTC have made great progress towards eliminating their differences. Treasury worked closely with the SEC and CFTC to propose a comprehensive framework for regulation of derivatives that is consistent across both SEC and CFTC jurisdiction. In addition, the SEC and CFTC held joint public hearings in early September to identify issues in the process of harmonization and to collect public comment on the process. The SEC and CFTC have produced a joint report on reducing differences in their two frameworks for regulation. We considered whether to merge the SEC and CFTC. At bottom, however, we are focused on the substance of regulation, not the boxes and the lines. In terms of substance, the most necessary reform is to harmonize futures and securities regulation between these entities, and the SEC and CFTC have begun a process to accomplish that.Q.32. Broker-Dealers and Investment Advisors--Secretary Geithner, the Administration's proposal recommends applying a fiduciary standard to broker-dealers that offer investment advice. How will this change affect the way FINRA regulates broker-dealer activities? Do you anticipate recommending a self-regulatory organization for investment advisors or eliminating FINRA as an SRO for broker-dealers?A.32. Treasury's report to Congress advocates a fiduciary standard for investment advisers and broker-dealers offering investment advice. We have not taken a position with respect to the role of SROs.Q.33. Barriers to Entry--Secretary Geithner, in many ways the Administration's proposal rewards failure. The Fed, which fumbled the responsibilities it had, will get more responsibility. The SEC, which failed to properly oversee the advisors registered with it, will have more registered advisors. And some of the biggest financial firms, the ones that made so many miscalculations with respect to risk management, stand to benefit from the additional layers of regulatory red-tape that your system creates. Yet in your statement, you state that the changes you are proposing reward innovation, often the product of smaller firms. What specific changes in your proposal make the environment more conducive to small, innovative firms?A.33. Under existing law, financial instruments with similar characteristics may be designed or forced to trade on different exchanges that are subject to different regulatory regimes. Harmonizing the regulatory regimes would remove such distinctions and permit a broader range of instruments to trade on any regulated exchange. For example, we propose the harmonization of futures and securities regulation. By eliminating jurisdictional uncertainties and ensuring that economically equivalent instruments are regulated in the same manner, regardless of which agency has jurisdiction, our proposals will foster innovation resulting from competition rather than the ability to evade regulation. Permitting direct competition between exchanges also would help ensure that plans to bring OTC derivatives trading onto regulated exchanges or regulated transparent electronic trading systems would promote rather than hinder competition. Greater competition would make these markets more efficient and create an environment more conducive to the most innovative participants. Innovation is advanced by promoting competition among firms and between financial products. By eliminating arbitrary jurisdictional differences and creating a regulatory regime that is stable and promotes transparency, fairness, accountability, and access, our proposals will increase competition and reward innovation.Q.34. Bank of America-Merrill--Secretary Geithner, last year, Bank of America contemplated not going forward with a merger with Merrill Lynch, but was strongly exhorted by the Fed and Treasury to proceed with the merger. Did you play a role in deliberations about how to handle the Bank of America-Merrill merger? If the Administration's proposed changes were in place, would the Fed and Treasury have had any additional tools in their arsenal to deal with the potential fallout of the failed merger that would have made it unnecessary to exercise a heavy hand behind the scenes to force the merger to close?A.34. After President Obama advised me that I would be his nominee for Treasury Secretary, I no longer participated in policy decisions regarding the Merrill-Lynch situation, including a possible merger with Bank of America. I was, however, kept apprised of developments involving the merger in my role as President of the NYFED. Consequently, I was not involved in policy decisions regarding Bank of America potentially exercising the materially adverse change clause and not going forward with the merger. While I will not comment on the specifics of the Bank of America-Merrill Lynch merger, it is clear that the government lacked the tools it needed during this crisis to provide for an orderly resolution of a large, nonbank financial firm whose failure could threaten financial stability. That is why we have proposed a special resolution regime for extraordinary circumstances and subject to high procedural and substantive hurdles to fill this gap. Under our proposal, the government would have the ability to establish a receivership for a failing firm. The regime also would provide for the ability to stabilize the financial system as a result of a failing institution going into receivership. In addition, the receiver of the firm would have broad powers to take action with respect to the financial firm. For example, it would have the authority to take control of the operations of the firm or to sell or transfer all or any part of the assets of the firm in receivership to a bridge institution or other entity. That would include the authority to transfer the firm's derivatives contracts to a bridge institution and thereby avoid termination of the contracts by the firm's counterparties (notwithstanding any contractual rights of counterparties to terminate the contracts if a receiver is appointed).Q.35. Multiple Banking Regulators--The administration outline states ``similar financial institutions should face the same supervisory and regulatory standards, with no gaps, loopholes, or opportunities for arbitrage.'' Your plan envisions a national banking regulator that combines or eliminates many of the various types of banking charters such as thrifts, ILCs, and credit card banks. Your plan, however, seeks to eliminate only one regulator, the Office of Thrift Supervision, while adding one more Federal regulator solely for consumer protection. Thus the total number of bank regulators remains the same. Why did you decide to leave the Federal Reserve and the FDIC as the primary supervisor of some commercial banks? If the desire is to achieve more accountability from our regulatory system why not consolidate the commercial banking regulatory structure into one Federal and one State Charter?A.35. Our proposals for structural reform of our regulatory system are focused on eliminating opportunities for regulatory arbitrage. Most importantly, we address the central source of arbitrage in the bank regulatory environment by proposing the creation of a new National Bank Supervisor through the merger of the Office of Thrift Supervision and the Office of the Comptroller of the Currency. These agencies granted Federal banking charters whereas the FDIC and Federal Reserve have oversight regarding charters granted by the States. As such, we are reducing the potential for arbitrage regarding Federal charters. In addition, by recommending closing the loopholes in the legal definition of a ``bank,'' we also make sure that no company that owns a depository institution escapes firm-wide supervision. Moreover, our proposals on preemption and examination fee equalization would substantially reduce arbitrage opportunities between national and State charters.Q.36. Resolution Regime--Secretary Geithner, if Lehman had been resolved under your proposed resolution regime, how would Lehman's foreign broker-dealer have been handled?A.36. The financial regulatory reform initiative that we are proposing is comprehensive. Under the plan, all subsidiaries of Tier 1 FHCs, including foreign entities, will be subject to consolidated supervision. The focus of this supervision is on activities of the firm as a whole and the risks the firm might pose to the financial system. First, United States Tier 1 FHCs will be required to maintain and update a credible rapid resolution plan, to be used to facilitate the resolution of an institution and all of its subsidiaries (U.S. and foreign) in the event of severe financial distress. This requirement will provide incentives for better monitoring and simplification of organizational structures, including foreign subsidiaries, so that the government and the entity's customers, investors, and counterparties may be better prepared in the event of firm collapse. Second, in the event that the Tier 1 FHC is resolved through the proposed special resolution regime, the appointed receiver would coordinate with foreign authorities involved in the resolution of subsidiaries of the firm established in a foreign jurisdiction. This is the same process the FDIC would use for failing banks with foreign subsidiaries.Q.37. Would U.S. taxpayer funds have been used to satisfy foreign customer liabilities?A.37. The resolution regime that we are proposing is not designed to replace or augment existing customer protections, either domestically or internationally. We would expect existing programs to protect insured depositors, customers of broker-dealers, and insurance policyholders to continue. The resolution regime would allow the receiver to create a bridge institution in order to more effectively unwind the firm while protecting financial stability and it is possible that liabilities held by foreign counterparties could be put into the bridge institution. However, the purpose of the special resolution regime would be to unwind, dismantle, restructure, or liquidate the firm in an orderly way to minimize costs to taxpayers and the financial system. All holders of Tier 1 and Tier 2 regulatory capital would be forced to absorb losses, and management responsible for the failure would be fired. If there are any losses to the government in connection with the resolution regime, these will be recouped from large financial institutions in proportion to their size.Q.38. Over-the-Counter Derivatives--Secretary Geithner, the Administration's plan does not provide much detail about the Administration's views as to the proper allocation of responsibility with respect to over-the-counter derivatives between the Securities and Exchange Commission and the Commodity Futures Trading Commission. As you devise your recommendations for allocating regulatory responsibility over derivatives, how are you taking into account the importance of interest rate swaps and currency swaps to the debt securities markets.A.38. As a general matter, our plan allocates responsibility for over-the-counter derivatives (swaps) between the SEC and CFTC consistent with how existing law allocates responsibility over futures. More specifically, we provide the SEC with authority to regulate swaps based on a single security or a narrow-based securities index; we provide the CFTC with authority to regulate swaps based on broad-based securities indices and other commodities (including interest rates, currencies, and nonfinancial commodities). Given the functional similarities between swaps and futures, we believed that it was important to have the swaps regulatory jurisdictions parallel those of the futures markets. In addition, to ensure that all classes of swaps face similar constraints, we have required the SEC and CFTC to issue joint rules on the regulation of swaps, swap dealers, and major swap participants. In designing our swaps framework, we took into account the importance of interest rate swaps and currency swaps to the debt markets. We believe that our proposals will enhance the transparency and stability of those markets. Although our proposals require central clearing of standardized derivatives, we have preserved the ability of businesses to hedge their interest rate and currency risks through customized derivatives in appropriate cases. ------ CHRG-111shrg56376--151 Chairman Dodd," I should have asked this of Gene as well. In your examination of global examples, you mentioned Australia and Canada, and I do not know this, so I apologize for my ignorance on this. I do not know what the Australian banking system looks like. Is there duality there at all? Or is this all one system? Is there any place you looked at that has a comparable duality of systems that would---- " CHRG-111hhrg52400--155 Mrs. Biggert," Okay. Well, it appears that the insurance sector has fared better than the banking and the securities counterparts in the current economic crisis. What are the reasons for that, and what are some of the elements of the State insurance regulatory system that could be instructive to Federal policymakers in setting up a systemic risk regulatory system? " CHRG-110hhrg46596--255 Mr. Barrett," Well, that is an answer. I know it is tough. There seems to be a lot of fundamental inconsistencies between the claim the financial system was at risk because of toxic assets and the claims that the TARP go to healthy banks. I heard your answer, and I understand that. But looking in my district, and looking across America, it seems like the smaller banks are the healthier banks. They are the ones that are actually doing well right now. Is bigger better? Is giving TARP funds to these healthy banks that are in turn buying other banks and becoming mega banks, and it seems to me that that was part of the problem that some of these institutions were too big and didn't know what was going on, that seems a little counterproductive. Walk me through that. " FinancialCrisisReport--243 CASE STUDY OF MOODY’S AND STANDARD & POOR’S Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA ratings that made residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status. 953 The July mass downgrades sent the value of mortgage related securities plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the financial crisis. In the months and years of buildup to the financial crisis, warnings about the massive problems in the mortgage industry were not adequately addressed within the ratings industry. By the time the rating agencies admitted their AAA ratings were inaccurate, it took the form of a massive ratings correction that was unprecedented in U.S. financial markets. The result was an economic earthquake from which the aftershocks continue today. Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody’s and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO securities issued in the United States, deeming them safe investments even though many relied on subprime and other high risk home loans. In late 2006, high risk mortgages began to go delinquent at an alarming rate. Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to issue investment grade ratings for numerous subprime RMBS and CDO securities. In July 2007, as mortgage defaults intensified and subprime RMBS and CDO securities began incurring losses, both companies abruptly reversed course and began downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a year old. Investors like banks, pension funds, and insurance companies were suddenly forced to sell off their RMBS and CDO holdings, because they had lost their investment grade status. RMBS and CDO securities held by financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS market initially froze and then collapsed, leaving investors and financial firms around the world holding unmarketable subprime RMBS securities plummeting in value. A few months later, the CDO market collapsed as well. Traditionally, investments holding AAA ratings have had a less than 1% probability of incurring defaults. But in the financial crisis, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Investors and financial institutions holding those AAA securities lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets. Inaccurate AAA 953 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this Report will refer to both ratings as “AAA.” credit ratings introduced systemic risk into the U.S. financial system and constituted a key cause of the financial crisis. CHRG-111shrg49488--37 Mr. Green," The other example I think relates to the U.S. investment banks, which almost uniquely at the global level were not regulated along with the rest of the banking system. And that led to gaps or inconsistencies. They were not--although they did business that was very similar---- " CHRG-111hhrg63105--56 Mr. Chilton," Congressman, by and large they are a factor of the fundamentals, but I couldn't--and I am not an economist. Neil Cavuto tried to get me to say, well, how much is speculators and how much is price demand, and I wasn't going there. I am not an economist and it would be irresponsible. But to go to this thing about we need to document, we need to do this before we impose. The purpose of the Commodity Exchange Act says that we are to prevent and deter fraud, abuse, and manipulation. So all of a sudden we have been given, for people who don't want the regulation, this new hurdle to say, well, you have to prove beyond a shadow of a doubt that this equals that. These are very complicated markets, and it is not always easy to put things together like that. So to protect consumers, to ensure the folks in your districts are using these vehicles, like they want to, for adequate risk mitigation, that is why these limits are important to put in place thoughtfully. I get letters every day, Congressman. I have one right here from Dunkin' Donuts we received last night. They are concerned about speculation. Swift says they are thinking about getting out of the market in part because of speculation. Delta Airlines wrote the other day. These are real concerns about people, the hedgers who are in these markets that are concerned they can't use them. Look, nobody is talking about going crazy on this. We just want to--I just want to do what Congress intended and try to do it in a reasonable fashion; doesn't make anything crazy, just do what we are told. " CHRG-111shrg53085--169 Mr. Patterson," I think we need to be very cautious about considering the role of the FDIC as an intermediary in that process. The Deposit Insurance Fund is funded by the commercial banks. We need to maintain the integrity of that system. The FDIC, obviously in collaboration with the leadership in Congress, is looking at ways to work with their working capital, but whether it has to do with the resolution of a nonbank major systemically important institution and the cost of that resolution or whether it has to do with such an intermediary role, the Deposit Insurance Fund does not need to be a part of that process. " FinancialCrisisInquiry--243 Chairman Greenspan said—encouraged people to take these loans. Remember one of those statements he made, and I couldn’t believe he said that. And he did. He apologized after the fact for it. But he did say it. BORN: Ms. Gordon, do you have any input on this? GORDON: My only input is to agree that the regulators—all of them, not just the Fed—had ample information to know that there was a problem. When we did our report on subprime mortgages in 2006 and looked back at the longitudinal performance of loans by origination year, I mean, we could see that the subprime loans had very high failure rates from very early on—from 1998 through 2001. And the regulators, presumably, would have had the same ability to find this information as we did. You know, by 2005, quite a number of the subprime originators had already collapsed or been the targets of major law enforcement actions. There was, you know, Household and an associates and Ameriquest—there was a ton of stuff out there. You know, the OTS had examiners on site at WaMu. I don’t know what they were doing, but they weren’t noticing the risky loans that were going on. BORN: Well, and all the federal banking supervisors should have had examiners in the national banks, the bank-holding companies, the thrifts. And they should have been examining for prudential—for prudential standards, shouldn’t they? ZANDI: Can I give my $0.03 on the topic? BORN: CHRG-110hhrg45625--78 Mr. Bernanke," I would just make the point, as the Secretary did, that historically these situations have dealt with institutions that have already failed or primarily close to failing. In that case you take the assets off the balance sheet, or you just put capital in them, and then you take all the ownership and restore them to functioning. In this case, we have two differences. One is that the banking system for the most part is still an ongoing concern. It is not extending credit to the extent we would like, but it is not failing. If there are failing institutions, we can address those individually. But more broadly, the problem is that with the complexity of these securities and the difficulty of valuation, nobody knows what the banks are worth and therefore, it is very difficult for private capital to come in to create more balance sheet capacity so banks can make loans. So it is a rather different situation from past episodes. That being said there is flexibility in this, and I think it is the intention of the Secretary, and certainly I would advise him--under the oversight of the oversight committee or whatever is set up to watch over this process--to be flexible and respond to conditions as they change. If this process is not working effectively, there are other ways to use this money that will again purchase assets or purchase capital and support the banking system. " CHRG-111hhrg55809--131 Mr. Bernanke," I am willing to say ``no,'' except I have one concern, which is that outside of bank holding companies, if there are firms which are systemically critical and they are not designated as systemically critical, how do we know that they received special attention, that is my question. " CHRG-111shrg54589--85 Mr. Pickel," Yes, I think what I would focus on in terms of the priority is systemic risk issues, and specifically how do we prevent another AIG type situation? And while regulation of dealers could be helpful in that, I think most importantly is having some window for regulators into risk, and that will be achieved partly by these trade information warehouses that have been talked about, getting the information there where, frankly, all regulators could have access to that, not just a systemic risk regulator but all regulators. And, second, what happened with AIG is many of the counterparties were dealers, and many of them were banks and overseen by banking regulators. They were each building up risk, but nobody was there to connect all the different dots, like a systemic risk regulator could, if established by the Congress, to give that window into risk and to put on the brakes or make changes when they see that risk building up in the system. " CHRG-111shrg49488--3 OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you, Mr. Chairman. Mr. Chairman, as you mentioned, this is the third in a series of hearings held by our Committee to examine America's financial crisis, and I commend you for your leadership in convening this series of hearings because I believe that until we reform our financial regulatory system, we are not going to address some of the root causes of the current financial crisis. Our prior hearings have reviewed the causes of the crisis and whether a systemic risk regulator and other reforms might have helped prevent it. Testimony at these hearings has demonstrated that, for the most part, financial regulators in our country failed to foresee the coming financial meltdown. No one regulator was responsible for the oversight of all the sectors of our financial market, and none of our regulators alone could have taken comprehensive, decisive action to prevent or mitigate the impact of the collapse. These oversight gaps and the lack of attention to systemic risk undermined our financial markets. Congress, working with the Administration, must act to help put in place regulatory reforms to help prevent future meltdowns like this one. Based on our prior hearings and after consulting with a wide range of financial experts, in March, I introduced the Financial System Stabilization and Reform Act. This bill would establish a Financial Stability Council that would be charged with identifying and taking action to prevent or mitigate systemic threats to our financial markets. The council would help to ensure that high-risk financial products and practices could be detected in time to prevent their contagion from spreading to otherwise healthy financial institutions and markets. This legislation would fundamentally restructure our financial regulatory system, help restore stability to our markets, and begin to rebuild the public confidence in our economy. The concept of a council to assess overall systemic risk has garnered support from within the financial regulatory community. The National Association of Insurance Commissioners, the Securities and Exchange Commission (SEC) Chair Mary Schapiro, and the Federal Deposit Insurance Corporation (FDIC) Chair Sheila Bair are among those who support creating some form of a systemic risk council in order to avoid an excessive concentration of power in any one financial regulator, yet take advantage of the expertise of all the financial regulators. As we continue to search for solutions to this economic crisis, it is instructive for us to look outside our borders at the financial systems of other nations. The distinguished panel of witnesses that we will hear from today will testify about the financial regulatory systems of the United Kingdom, Canada, and Australia. They will also provide a broader view of global financial structures. We can learn some valuable lessons from studying their best practices. Canada's banking system, for example, has been ranked as the strongest in the world, while ours is ranked only as number 40. I am very pleased that Edmund Clark has joined the other experts at the panel. It was through a meeting in my office when he started describing the differences between the Canadian system of regulation, financial practices, and mortgage practices versus our system that I became very interested in having him share his expertise officially, and I am grateful that he was able to change his schedule to be here on relatively short notice. I am also looking forward to hearing from the other experts that we have convened here today. America's Main Street small businesses, homeowners, employees, savers, and investors deserve the protection of an effective regulatory system that modernizes regulatory agencies, sets safety and soundness requirements for financial institutions to prevent excessive risk taking, and improves oversight, accountability, and transparency. This Committee's ongoing investigation will continue to shed light on how the current crisis evolved and focus attention on the reforms that are needed in the structure and regulatory apparatus to restore the confidence of the American people in our financial system. Thank you, Mr. Chairman. " CHRG-111hhrg55814--75 Secretary Geithner," Okay. This is a very important key thing. The system Congress designed for small banks and thrifts today works in a similar way. It's different because it's part of an explicit insurance regime. But in that case, if the government has to step in--and the FDIC does this every week, step in and manage the failure of a bank--if in that case, the government assumes any risk of loss, it has to put a fee on institutions to recoup that loss over time, so the taxpayer is protected. What we are doing is a very simple thing. We're taking that basic framework, and we're adapting it to the system we have today. We should have done that 10 years ago, but we didn't do it. But it's a very simple thing. If the government is exposed to loss when it acts to protect the system--any risk of loss--it should assess a fee on banks over time to recoup that loss. That's to make sure the taxpayer is not in the position of absorbing those losses. That's the basic premise. " CHRG-111shrg51303--129 Mr. Kohn," I think we need to do our best to realize the best returns, minimize any losses to the taxpayer, through any avenue we can do. I do think another issue that is highlighted by this whole situation is the lack of a resolution regime for anything but banks. So we have, for systemically important banks, through the FDIC, we have a way of resolving banks. We have an exception to the least-cost resolution for systemically important banks. Another thing on the to-do list for the administration, the Federal Reserve, and the Congress is a regime where whoever is designated--it doesn't matter who--could come in and figure out how to stabilize the system, impose some losses on some of the creditors. That regime, those authorities don't exist right now without---- Senator Warner. And my last--my time is up, but if in just maybe a straight yes or no on whether I am hearing you correctly. What we must do prospectively in terms of fixing that, I fully understand. But until that time, and with the case of AIG, we have no option other than what appears to be a bottomless pit with no knowledge of who we are helping out and that we are going to continue to pay off 100 cents on the dollar. " CHRG-111shrg52619--175 PREPARED STATEMENT OF JOSEPH A. SMITH, JR. North Carolina Commissioner of Banks, and Chair-Elect of the Conference of State Bank Supervisors March 19, 2009Introduction Good morning Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My name is Joe Smith, and I am the North Carolina Commissioner of Banks. I also serve as incoming Chairman of the Conference of State Bank Supervisors (CSBS) and a member of the CSBS Task Force on Regulatory Restructuring. I am pleased to be here today to offer a state perspective on our nation's financial regulatory structure--its strengths and its deficiencies, and suggestions for reform. As we work through a federal response to this financial crisis, we need to carry forward a renewed understanding that the concentration of financial power and a lack of transparency are not in the long-term interests of our financial system, our economic system or our democracy. This lesson is one our country has had to learn in almost every generation, and I hope that the current lesson will benefit future generations. While our largest and most complex institutions are no doubt central to a resolution of the current crisis, my colleagues and I urge you to remember that the health and effectiveness of our nation's financial system also depends on a diverse and competitive marketplace that includes community and regional institutions. While changing our regulatory system will be far from simple, some fairly simple concepts should guide these reforms. In evaluating any governmental reform, we must ask if our financial regulatory system: Ushers in a new era of cooperative federalism, recognizing the rights of states to protect consumers and reaffirming the state role in chartering and supervising financial institutions; Fosters supervision tailored to the size, scope and complexity of an institution and the risk it poses to the financial system; Assures the promulgation and enforcement of consumer protection standards that are applicable to both state and federally chartered institutions and are enforceable by state officials; Encourages a diverse universe of financial institutions as a method of reducing risk to the system, encouraging competition, furthering innovation, insuring access to financial markets, and promoting efficient allocation of credit; Supports community and regional banks, which provide relationship lending and fuel local economic development; and Requires financial institutions that are recipients of governmental assistance or pose systemic risk to be subject to safety and soundness and consumer protection oversight. We have often heard the consolidation of financial regulation at the federal level is the ``modern'' answer to the challenges our financial system. We need to challenge this assumption. For reasons more fully discussed below, my colleagues and I would suggest to you that an appropriately coordinated system of state and federal supervision and regulation will promote a more effective system of financial regulation and a more diverse, stable and responsive financial system.The Role of the States in Financial Services Supervision and Regulation The states charter and supervise more than 70 percent of all U.S. banks (Exhibit A), in coordination with the FDIC and Federal Reserve. The rapid consolidation of the industry over the past decade, however, has created a system in which a handful of large national banks control the vast majority of assets in the system. The more than 6,000 banks supervised and regulated by the states now represent less than 30 percent of the assets of the banking system (Exhibit B). While these banks are smaller than the global institutions now making headlines, they are important to all of the markets they serve and are critical in the nonmetropolitan markets where they are often the major sources of credit for local households, small businesses and farms. Since the enactment of nationwide banking in 1994, the states, working through CSBS, have developed a highly coordinated system of state-to-state and state-to-federal bank supervision. This is a model that has served this nation well, embodying our uniquely American dynamic of checks and balances--a dynamic that has been missing from certain areas of federal financial regulation, with devastating consequences. The dynamic of state and federal coordinated supervision for state-chartered banks allows for new businesses to enter the market and grow to meet the needs of the markets they serve, while maintaining consistent nationwide standards. Community and regional banks are a vital part of America's economic fabric because of the state system. As we continue to work through the current crisis, we need to do more to support community and regional banks. The severe economic recession and market distortions caused by bailing out the largest institutions have caused significant stress on these institutions. While some community and regional banks have had access to the TARP's capital purchase program, the processing and funding has grown cumbersome and slow. We need a more nimble and effective program for these institutions. This program must be administered by an entity with an understanding of community and regional banking. This capital will enhance stability and provide support for consumer and small business lending. In addition to supervising banks, I and many of my colleagues regulate the residential mortgage industry. All 50 states and the District of Columbia now provide some regulatory oversight of the residential mortgage industry. The states currently manage over 88,000 mortgage company licenses, over 68,000 branch licenses, and approximately 357,000 loan officer licenses. In 2003, the states, acting through the CSBS and the American Association of Residential Mortgage Regulators, first proposed a nationwide mortgage licensing system and database to coordinate our efforts in regulating the residential mortgage market. The system launched on January 2, 2008, on time and on budget. The Nationwide Mortgage Licensing System (NMLS) was incorporated in the federal S.A.F.E. Act and, as a result, has established a new and important partnership with the United States Department of Housing and Urban Development, the federal banking agencies and the Farm Credit Administration. We are confident that this partnership will result in an efficient and effective combination of state and federal resources and a nimble, responsive and comprehensive system of regulation. This is an example of what we mean by ``a new era of cooperative federalism.''Where Federalism Has Fallen Short For the past decade it has been clear to the states that our system of mortgage finance and mortgage regulation was flawed and that a destructive and widening chasm had formed between the interests of borrowers and of lenders. Over that decade, through participation in GAO reports and through congressional testimony, one can observe an ever-increasing level of state concern over this growing chasm and its reflection in the state and federal regulatory relationship. Currently, 35 states plus the District of Columbia have enacted predatory lending laws. \1\ First adopted by North Carolina in 1999, these state laws supplement the federal protections of the Home Ownership and Equity Protection Act of 1994 (HOEPA). The innovative actions taken by state legislatures have prompted significant changes in industry practices, as the largest multi-state lenders have adjusted their practices to comply with the strongest state laws. All too often, however, we are frustrated in our efforts to protect consumers by the preemption of state consumer protection laws by federal regulations. Preemption must be narrowly targeted and balance the interest of commerce and consumers.--------------------------------------------------------------------------- \1\ Source: National Conference of State Legislatures.--------------------------------------------------------------------------- In addition to the extensive regulatory and legislative efforts, state attorneys general and state regulators have cooperatively pursued unfair and deceptive practices in the mortgage market. Through several settlements, state regulators have returned nearly one billion dollars to consumers. A settlement with Household resulted in $484 million paid in restitution, a settlement with Ameriquest resulted in $295 million paid in restitution, and a settlement with First Alliance Mortgage resulted in $60 million paid in restitution. These landmark settlements further contributed to changes in industry lending practices. But successes are sometimes better measured by actions that never receive media attention. States regularly exercise their authority to investigate or examine mortgage companies for compliance not only with state law, but with federal law as well. These examinations are an integral part of a balanced regulatory system. Unheralded in their everyday routine, enforcement efforts and examinations identify weaknesses that, if undetected, might be devastating to the company and its customers. State examinations act as a check on financial problems, evasion of consumer protections and sales practices gone astray. Examinations can also serve as an early warning system of a financial institution conducting misleading, predatory or fraudulent practices. Attached as Exhibit C is a chart of enforcement actions taken by state regulatory agencies against mortgage providers. In 2007, states took nearly 6,000 enforcement actions against mortgage lenders and brokers. These actions could have resulted in a dialog between state and federal authorities about the extent of the problems in the mortgage market and the best way to address the problem. That did not happen. The committee should consider how the world would look today if the ratings agencies and the OCC had not intervened and the assignee liability and predatory lending provisions of the Georgia Fair Lending Act had been applicable to all financial institutions. I would suggest we would have far fewer foreclosures and may have avoided the need to bailout our largest financial institutions. It is worth noting that the institutions whose names were attached to the OCC's mortgage preemption initiative--National City, First Franklin, and Wachovia--were all brought down by the mortgage crisis. That fact alone should indicate how out of balance the system has become. From the state perspective, it has not been clear for many years exactly who was setting the risk boundaries for the market. What is clear is that the nation's largest and most influential financial institutions have been major contributing factors in our regulatory system's failure to respond to this crisis. At the state level, we sometimes perceived an environment at the federal level that is skewed toward facilitating the business models and viability of our largest financial institutions rather than promoting the strength of the consumer or our diverse economy. It was the states that attempted to check the unhealthy evolution of the mortgage market and apply needed consumer protections to subprime lending. Regulatory reform must foster a system that incorporates the early warning signs that state laws and regulations provide, rather than thwarting or banning them. Certainly, significant weaknesses exist in our current regulatory structure. As GAO has noted, incentives need to be better aligned to promote accountability, a fair and competitive market, and consumer protection.Needed Regulatory Reforms: Mortgage Origination I would like to thank this committee for including the Secure and Fair Enforcement for Mortgage Licensing Act (S.A.F.E.) in the Housing and Economic Recovery Act of 2008 (HERA). It has given us important tools that continue our efforts to reform mortgage regulation. CSBS and the states are working to enhance the regulatory regime for the residential mortgage industry to ensure legitimate lending practices, provide adequate consumer protection, and to once again instill both consumer and investor confidence in the housing market and the economy as a whole. The various state initiatives are detailed in Exhibit D.Needed Regulatory Reforms: Financial Services Industry Many of the problems we are experiencing are both the result of ``bad actors'' and bad assumptions by the architects of our modern mortgage finance system. Enhanced supervision and improved industry practices can successfully weed out the bad actors and address the bad assumptions. If regulators and the industry do not address both causes of our current crisis, we will have only the veneer of reform and will eventually repeat our mistakes. Some lessons learned from this crisis must be to prevent the following: the over-leveraging that was allowed to occur in the nation's largest institutions; outsourcing of loan origination with no controls in place; and industry consolidation to allow institutions to become so large and complex that they become systemically vital and too big to effectively supervise or fail. While much is being done to enhance supervision of the mortgage market, more progress must be made towards the development of a coordinated and cooperative system of state-federal supervision.Preserve and Enhance Checks and Balances/Forge a New Era of Federalism The state system of chartering and regulating has always been a key check on the concentration of financial power, as well as a mechanism to ensure that our banking system remains responsive to local economies' needs and accountable to the public. The state system has fostered a diversity of institutions that has been a source of stability and strength for our country, particularly locally owned and controlled community banks. To promote a strong and diverse system of banking-one that can survive the inevitable economic cycles and absorb failures-preservation of state-chartered banking should be a high priority for Congress. The United States boasts one of the most powerful and dynamic economies in the world because of those checks and balances, not despite them. Consolidation of the industry and supervision and preemption of applicable state law does not address the cause of this crisis, and has in fact exacerbated the problem. The flurry of state predatory lending laws and new state regulatory structures for lenders and mortgage brokers were indicators that conditions and practices were deteriorating in our mortgage lending industry. It would be incongruous to eliminate the early warning signs that the states provide. Just as checks and balances are a vital part of our democratic government, they serve an equally important role in our financial regulatory structure. Put simply, states have a lower threshold for crisis and will most likely act sooner. This is an essential systemic protection. Most importantly, it serves the consumer interest that the states continue to have a role in financial regulation. While CSBS recognizes the financial services market is a nationwide industry that has international implications, local economies and individual consumers are most drastically affected by mortgage market fluctuations. State regulators must remain active participants in mortgage supervision because of our knowledge of local economies and our ability to react quickly and decisively to protect consumers. 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 national banks. In its report, the Panel recommends Congress ``amend the National Banking Act to provide clearly that state consumer protection laws can apply to national banks and to reverse the holding that the usury laws of a national bank's state of incorporation govern that bank's operation through the nation.'' \2\ We believe the same policy should apply to the Office of Thrift Supervision. To preserve a responsive system, states must be able to continue to produce innovative solutions and regulations to provide consumer protection.--------------------------------------------------------------------------- \2\ The Congressional Oversight Panel's ``Special Report on Regulatory Reform'' can be viewed at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- The federal government would better serve our economy and our consumers by advancing a new era of cooperative federalism. The S.A.F.E. Act enacted by Congress requiring licensure and registration of mortgage loan originators through the Nationwide Mortgage Licensing System provides a model for achieving systemic goals of high regulatory standards and a nationwide regulatory roadmap and network, while preserving state authority for innovation and enforcement. The 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. A federal standard should allow for further state refinements in lending standards and be enforceable by state and federal regulators. Additionally, a federal lending standard should clarify expectations of the obligations of securitizers.Consumer Protection/Enforcement Consolidated regulation minimizes resources dedicated to supervision and enforcement. As FDIC Chairman Sheila Bair recently told the states' Attorneys General, ``if ever there were a time for the states and the feds to work together, that time is right here, right now. The last thing we need is to preempt each other.'' Congress should establish a mechanism among the financial regulators for identifying and responding to emerging consumer issues. This mechanism, perhaps through the Federal Financial Institutions Examination Council (FFIEC), should include active state regulator and law enforcement participation and develop coordinated responses. The coordinating federal entity should report to Congress regularly. The states must retain the right to pursue independent enforcement actions against all financial institutions as an appropriate check on the system.Systemic Supervision/Capital Requirements As Congress evaluates our regulatory structure, I urge you to examine the linkages between the capital markets, the traditional banking sector, and other financial services providers. Our top priority for reform must be a better understanding of systemic risks. The federal government must facilitate the transparency of financial markets to create a financial system in which stakeholders can understand and manage their risks. Congress should establish clear expectations about which regulatory authority or authorities are responsible for assessing risk. The regulator must have the necessary tools to identify and mitigate risk, and resolve failures. Congress, the administration, and federal regulators must also consider how the federal government itself may inadvertently contribute to systemic risk--either by promoting greater industry consolidation or through policies that increase risk to the system. Perhaps we should contemplate that there are some institutions whose size and complexity make their risks too large to effectively manage or regulate. Congress should aggressively address the sources of systemic risk to our financial system. While this crisis has demanded a dramatic response from the federal government, the short-term result of many of these programs, including the Troubled Asset Relief Program (TARP), has been to create even larger and more complex institutions and greater systemic risk. These responses have created extreme disparity in the treatment of financial institutions, with the government protecting those deemed to be too big or too complex to fail, perhaps at the expense of smaller institutions and the diversity of our financial system. At the federal level, our state-chartered banks may be too-small-to-care but in our cities and communities, they are too important to ignore. It is exactly the same dynamic that told us that the plight of the individual homeowner trapped in a predatory loan was less important than the needs of an equity market hungry for new mortgage-backed securities. There is an unchallenged assumption that federal regulatory reforms can address the systemic risk posed by our largest and most complex institutions. If these institutions are too large or complex to fail, the government must give preferential treatment to prevent these failures, and that preferential treatment distorts and harms the marketplace, with potentially disastrous consequences. Our experience with Fannie Mae and Freddie Mac exemplifies this problem. Large systemic institutions such as Fannie and Freddie inevitably garner advantages and political favor, and the lines between government and industry blur in ways that do not reflect American values of fair competition and merit-based success. My fellow state supervisors and I have long believed capital and leverage ratios are essential tools for managing risk. For example, during the debate surrounding the advanced approach under Basel II, CSBS supported FDIC Chairman Sheila Bair in her call to institute a leverage ratio for participating institutions. Federal regulation needs to prevent capital arbitrage among institutions that pose systemic risks, and should require systemic risk institutions to hold more capital to offset the grave risks their collapse would pose to our financial system. Perhaps most importantly, Congress must strive to prevent unintended consequences from doing irreparable harm to the community and regional banking system in the United States. Federal policy to prevent the collapse of those institutions considered too big to fail should ultimately strengthen our system, not exacerbate the weaknesses of the system. Throughout the current recession, community and regional banks have largely remained healthy and continued to provide much needed credit in the communities where they operate. The largest banks have received amazing sums of capital to remain solvent, while the community and regional banks have continued to lend in this difficult environment with the added challenge of having to compete with federally subsidized entities. Congress should consider creating a bifurcated system of supervision that is tailored to the size, scope, and complexity of financial institutions. The largest, most systemically significant institutions should be subject to much more stringent oversight that is comprehensive enough to account for the complexity of the institution. Community and regional banks should be subject to regulations that are tailored to the size and sophistication of the institutions. In financial supervision, one size should no longer fit all.Roadmap for Unwinding Federal Liquidity Assistance and Systemic Responses The Treasury Department and the Federal Reserve should be required to provide a plan for how to unwind the various programs established to provide liquidity and prevent systemic failure. Unfortunately, the attempts to avert crisis through liquidity programs have focused predominantly upon the needs of the nation's largest institutions, without consideration for the unintended consequences for our diverse financial industry as a whole, particularly community and regional banks. Put simply, the government is now in the business of picking winners and losers. In the extreme, these decisions determine survival, but they also affect the overall competitive landscape and relative health and profitability of institutions. The federal government should develop a plan that promotes fair and equal competition, rather than sacrificing the diversity of our financial industry to save those deemed too big to fail.Conclusion Chairman Dodd, Ranking Member Shelby, and Members of the Committee, the task before us is a daunting one. The current crisis is the result of well over a decade's worth of policies that promoted consolidation, uniformity, preemption and the needs of the global marketplace over those of the individual consumer. If we have learned nothing else from this experience, we have learned that big organizations have big problems. As you consider your responses to this crisis, I ask that you consider reforms that promote diversity and create new incentives for the smaller, less troubled elements of our financial system, rather than rewarding the largest and most reckless. At the state level, we are constantly pursuing methods of supervision and regulation that promote safety and soundness while making the broadest possible range of financial services available to all members of our communities. We appreciate your work toward this common goal, and thank you for inviting us to share our views today. APPENDIX ITEMSExhibit D: State Initiatives To Enhance Supervision of the Mortgage IndustryCSBS-AARMR Nationwide Mortgage Licensing System The states first recognized the need for a tool to license mortgage originators several years ago. Since then, states have dedicated tremendous monetary and staff resources to develop and enact the Nationwide Mortgage Licensing System (NMLS). First proposed among state regulators in late 2003, NMLS launched on time and on budget on January 2, 2008. The Nationwide Mortgage Licensing System is more than a database. It serves as the foundation of modern mortgage supervision by providing dramatically improved transparency for regulators, the industry, investors, and consumers. Seven inaugural participating states began using the system on January 2, 2008. Only 15 months later, 23 states are using NMLS and by January 2010--just 2 years after its launch--CSBS expects 40 states to be using NMLS. NMLS currently maintains a single record for every state-licensed mortgage company, branch, and individual that is shared by all participating states. This single record allows companies and individuals to be definitively tracked across state lines and over time as entities migrate among companies, industries, and federal and state jurisdictions. Additionally, this year consumers and industry will be able to check on the license status and history of the companies and individuals with which they wish to do business. NMLS provides profound benefits to consumers, state supervisory agencies, and the mortgage industry. Each state regulatory agency retains its authority to license and supervise, but NMLS shares information across state lines in real-time, eliminates any duplication and inconsistencies, and provides more robust information to state regulatory agencies. Consumers will have access to a central repository of licensing and publicly adjudicated enforcement actions. Honest mortgage lenders and brokers will benefit from the removal of fraudulent and incompetent operators, and from having one central point of contact for submitting and updating license applications. The hard work and dedication of the states was ultimately recognized by Congress as they enacted the Housing and Economic Recovery Act of 2008 (HERA). The bill acknowledged and built upon the work that had been done in the states to protect consumers and restore the public trust in our mortgage finance and lending industries. Title V of HERA, titled the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (S.A.F.E. Act), is designed to increase uniformity, reduce regulatory burden, enhance consumer protection, and reduce fraud by requiring all mortgage loan originators to be licensed or registered through NMLS. In addition to loan originator licensing and mandatory use of NMLS, the S.A.F.E. Act requires the states to do the following: 1. Eliminate exemptions from mortgage loan originator licensing that currently exist in state law; 2. Screen and deny mortgage loan originator licenses for felonies of any kind within 7 years and certain financially related felonies permanently; 3. Screen and deny licenses to individuals who have ever had a loan originator license revoked; 4. Require loan originators to submit personal history information and authorize background checks to determine the applicant's financial responsibility, character, and general fitness; 5. Require mortgage loan originators to take 20 hours of pre- licensure education in order to enter the state system of licensure; 6. Require mortgage loan originators to pass a national mortgage loan originator test developed by NMLS; 7. Establish either a bonding or net worth requirement for companies employing mortgage loan originators or a recovery fund paid into by mortgage loan originators or their employing company in order to protect consumers; 8. Require companies licensed or registered through NMLS to submit a Mortgage Call Report on at least an annual basis; 9. Adopt specific confidentiality and information sharing provisions; and 10. Establish effective authority to investigate, examine, and conduct enforcement of licensees. Taken together, these background checks, testing, and education requirements will promote a higher level of professionalism and encourage best practices and responsible behavior among all mortgage loan originators. Under the legislative guidance provided by Congress, the states drafted the Model State Law for uniform implementation of the S.A.F.E. Act. The Model State Law not only achieves the minimum licensing requirements under the federal law, but also accomplishes Congress' ten objectives addressing uniformity and consumer protection. The Model State Law, as implementing legislation at the state level, assures Congress that a framework of localized regulatory controls are in place at least as stringent as those pre-dating the S.A.F.E. Act, while setting new uniform standards aimed at responsible behavior, compliance verification and protecting consumers. The Model State Law enhances the S.A.F.E. Act by providing significant examination and enforcement authorities and establishing prohibitions on specific types of harmful behavior and practices. The Model State Law has been formally approved by the Secretary of the U.S. Department of Housing and Urban Development and endorsed by the National Conference of State Legislatures and the National Conference of Insurance Legislators. The Model State Law is well on its way to approval in almost all state legislatures, despite some unfortunate efforts by industry associations to frustrate, weaken or delay the passage of this important Congressional mandate.Nationwide Cooperative Protocol and Agreement for Mortgage Supervision In December 2007, CSBS and AARMR launched the Nationwide Cooperative Protocol and Agreement for Mortgage Supervision to assist state mortgage regulators by outlining a basic framework for the coordination and supervision of Multi-State Mortgage Entities (those institutions conducing business in two or more states). The goals of this initiative are to protect consumers; ensure the safety and soundness of institutions; identify and prevent mortgage fraud; supervise in a seamless, flexible, and risk-focused manner; minimize regulatory burden and expense; and foster consistency, coordination, and communication among state regulators. Currently, 48 states plus the District of Columbia and Puerto Rico have signed the Protocol and Agreement. The states have established risk profiling procedures to determine which institutions are in the greatest need of a multi-state presence and we are scheduled to begin the first multi-state examinations next month. Perhaps the most exciting feature of this initiative is the planned use of robust software programs to screen the institutions portfolios for risk, compliance, and consumer protection issues. With this software, the examination team will be able to review 100 percent of the institution's loan portfolio, thereby replacing the ``random sample'' approach that left questions about just what may have been missed during traditional examinations.CSBS-AARMR Reverse Mortgage Initiatives In early 2007, the states identified reverse mortgage lending as one of the emerging threats facing consumers, financial institutions, and supervisory oversight. In response, the states, through CSBS and AARMR, formed the Reverse Mortgage Regulatory Council and began work on several initiatives: Reverse Mortgage Examination Guidelines (RMEGs). In December 2008, CSBS and AARMR released the RMEGs to establish uniform standards for regulators in the examination of institutions originating and funding reverse mortgage loans. The states also encourage industry participants to adopt these standards as part of an institution's ongoing internal review process. Education materials. The Reverse Mortgage Regulatory Council is also developing outreach and education materials to assist consumers in understanding these complex products before the loan is made.CSBS-AARMR Guidance on Nontraditional Mortgage Product Risks In October 2006, the federal financial agencies issued the Interagency Guidance on Nontraditional Mortgage Product Risks which applies to insured depository institutions. Recognizing that the interagency guidance does not apply to those mortgage providers not affiliated with a bank holding company or an insured financial institution, CSBS and AARMR developed parallel guidance in November 2006 to apply to state-supervised residential mortgage brokers and lenders, thereby ensuring all residential mortgage originators were subject to the guidance.CSBS-AARMR-NACCA Statement on Subprime Mortgage Lending The federal financial agencies also issued the Interagency Statement on Subprime Mortgage Lending. Like the Interagency Guidance on Nontraditional Mortgage Product Risks, the Subprime Statement applies only to mortgage providers associated with an insured depository institution. Therefore, CSBS, AARMR, and the National Association of Consumer Credit Administrators (NACCA) again developed a parallel statement that is applicable to all mortgage providers. The Nontraditional Mortgage Guidance and the Subprime Statement strike a fair balance between encouraging growth and free market innovation and draconian restrictions that will protect consumers and foster fair transactions.AARMR-CSBS Model Examination Guidelines Further, to promote consistency, CSBS and AARMR developed state Model Examination Guidelines (MEGs) for field implementation of the Guidance on Nontraditional Mortgage Product Risks and the Statement on Subprime Mortgage Lending. Released on July 31, 2007, the MEGs enhance consumer protection by providing state regulators with a uniform set of examination tools for conducting examinations of subprime lenders and mortgage brokers. Also, the MEGs were designed to provide consistent and uniform guidelines for use by lender and broker compliance and audit departments to enable market participants to conduct their own review of their subprime lending practices. These enhanced regulatory guidelines represent a new and evolving approach to mortgage supervision.Mortgage Examinations With Federal Regulatory Agencies Late in 2007, CSBS, the Federal Reserve System (Fed), the Federal Trade Commission (FTC), and the Office of Thrift Supervision (OTS) engaged in a pilot program to examine the mortgage industry. Under this program, state examiners worked with examiners from the Fed and OTS to examine mortgage businesses over which both state and federal agencies had regulatory jurisdiction. The FTC also participated in its capacity as a law enforcement agency. In addition, the states separately examined a mortgage business over which only the states had jurisdiction. This pilot is truly the model for coordinated state-federal supervision. ______ CHRG-111hhrg53234--17 Mr. Kohn," Recalling that in our view, the systemic risk regulatory function that the Treasury has suggested for us is an incremental change to what we are doing now, it is not a big change, because we already have the systemically important institutions under our authority. I think it would require some more staffing, both on the side of the economists and the side of the supervisors, to evaluate systemic risk in a more systematic way, but I don't think this is a major change in our responsibilities that would require a substantial increase in what we are doing. Now, we have had to staff-up over the last year because we have several large investment banks, for example, that are now bank holding companies, and we have had to change and adapt to our new responsibilities. And we are doing that. " CHRG-111shrg52966--17 Mr. Long," Yes, I do think we began to communicate pretty well in the 2006 range, as my colleague says, but let me back up to answer you. I want to make sure I answer your question. As I stated in my written testimony--it is difficult at times to strike that balance of letting a bank keep competitive and innovative at the same time and order a bank to constrain a certain business activity because we believe they are taking on too much risk. It is always a delicate balance and it is something we work hard to do. But I think we did, going back to 2004. I know at the OCC and amongst other regulators, we did begin to see this buildup of risk and this buildup of excessive aggregation of risk. We issued guidance going back to 2004. We had the interagency credit card guidance. We issued guidance on home equity lending, on non-traditional mortgage products, on commercial real estate lending, and then most recently some interagency guidance on complex structured products. As we issued guidance to the industry, our examiners were in the banks and they were examining for this. We frequently cited matters requiring attention and began taking actions, various types of actions, surrounding these guidance. So from 2004 up to 2007, I think we all saw the accumulation of risk. At the OCC, we looked vertically very well into those companies. If there were lessons learned by us, it was probably in two things. Number one, we underestimated the magnitude of the effects of the global shut-down beginning in August of 2007, and we did not rein in the excesses driven by the market. So a real lesson learned, and I think you have heard it in some of the statements and in the GAO report, the ability to look vertically into these companies is good. The ability to look across the companies in terms of the firms we supervise, we need to get better at that, and looking horizontally across the system is something I think we all need to do. A good example of that is in the firms that we supervise, we underestimated the amount of subprime exposure they had. We basically kicked the subprime lenders out of the national banking system. Our banks were underwriting very little of the subprime loans. What we didn't realize is that affiliates and subsidiaries of the banks that we supervised were turning around, buying those loans, structuring them, and bringing that risk back in in another division in the bank, and that is a good example of being able to look horizontally across a company and see that coming. Senator Reed. What inhibited you from looking across these other subsidiaries? " CHRG-111hhrg48674--66 Mrs. Maloney," What gets me is we keep trying so many things, and what I am hearing from the public and what I hear from my colleagues in Congress is that the loans are not getting out to the public. Now, banks say that they are increasing their loans, but there is some type of disconnect. Maybe they are long-term loans that were made a long time ago. New credit is not getting out into the markets. We just came back from a retreat of the Democrats, and my colleagues were telling me across the country, in every State, they feel that their constituents are telling them they can't get access to credit. Very reasonable, respected businesses are having their long-term credit cut, and there is no credit for commercial loans. There seems to be a huge problem there, and I would like to hear your ideas. Obviously, the bank system is the wheel that has to get our economy going, yet we hear that part of the new program is there is going to be a business and consumer loan program coming from the Federal Reserve. Why is that coming from the Federal Reserve? Shouldn't that be coming from our financial institutions? Why can't we get them working properly? Is the problem the toxic assets? Do we need to get them off the books? I don't think we should have to create a new lending system. Why can't we get the lending system that has served this country for decades working? Why is credit not getting out there to the public, and what can we do about it? " CHRG-111hhrg48868--712 Mrs. Maloney," Yes. AIG prepared a document that I would like to put in the record that said if AIG failed, it would be a tremendous shock to our American economy. I would venture to say that if every company said and prepared a document like that, our Treasury would be bankrupt. So I looked at the counterparties. We were told that this was systemic risk. Now, some of the counterparties were municipalities. I'm a former city council member. I love cities, but if we bailed out every municipality that made a bad decision, we would be bankrupt in this country. So I would venture to say that that was not a systemic risk. Also in the document that I haven't thoroughly studied, because we just got it, there were two foreign banks. Certainly, bailing out foreign banks is not a systemic risk to the American economy. I would say we were basically bailing out the governments of Germany and France. If the bank was so important to their economy, they would have bailed it out. So, indirectly, we bailed out two different countries, and, I would venture to say that it was not a systemic risk to our own economy. So I would venture, were there any guidelines that said what would be systemic risk? Anyway, I just find that very, very disturbing. But, the main point is we could have saved the insurance arm, but let the derivatives business go, and possibly be in better economic condition. In the prior hearing, I questioned the insurance regulator, one of them, of AIG. He said the insurance arm was very healthy. Would you agree with that? " CHRG-110hhrg46593--170 Secretary Paulson," The mission of the program is focused on banks and bank holding companies and getting capital into the system. We don't have capability at the Federal level looking at insurance. So what we are going to do is applications. If applications-- " CHRG-110shrg50409--39 Mr. Bernanke," We have begun to work with, as you know, the Securities and Exchange Commission, who are the primary regulator. We have been working with them to help evaluate and oversee the four large investment banks and the other primary dealers. That is because of the lending facility that we opened up after Bear Stearns. We have a responsibility to protect our loans, and I believe that the SEC views our participation as helpful in trying to make sure that these firms are sufficiently strong. It remains to be seen how the Congress would like to think through regulation going forward. I do think that the investment banks need a consolidated supervisor, but have not proposed a particular agency to do that. The key issue is that they have strong consolidated supervision. The only area in which I have raised the possibility of additional powers for the Federal Reserve--in my testimony and in speeches--is in payment systems, which are systemically important and where in most countries central banks have considerable oversight responsibility. I think it would be useful for the Congress to review how payment and settlement systems are overseen and to ask whether, from a systemic point of view, they are adequately regulated and whether the Fed should have some additional role in that area. Otherwise, we are going to have to do a lot of thinking, all of us, and certainly the Congress, about how, if at all, the regulatory structure should change based on what we have learned in the last year. Senator Allard. Some of the discussions I have been involved in have said that if the Fed assumes a greater regulatory role, it could affect your independence. And I would like to hear you comment on that as acting in your current role. " CHRG-111hhrg53248--99 Secretary Geithner," I think you are absolutely right. And let me just say for the record we have a system which has 8,000 small community banks as a core part of our system. It is a great strength of our system. Many of those institutions were dramatically more prudent than their larger competitors, and that is a good thing about our system. And you are also right to point out that one of the challenges they faced was we had a system that allowed nonbanks to compete with them without the same basic standards, regulatory framework. That was not so good for them. It required many of them, if they wanted to compete, to lower their standards. That is something we have to prevent. That is why we need a level playing field. That is why we need a single point of accountability around these basic standards, more evenly enforced. I think the thrust of this will be very helpful for banks, reducing the risk in the future. They are going to be faced with that kind of competitive pressure solely produced by the ability to evade the kind of protections Congress legislates. " CHRG-111shrg54533--87 PREPARED STATEMENT OF SENATOR SHERROD BROWN Thank you, Mr. Chairman, for convening this hearing on the President's plan to improve the regulatory structure of the Nation's financial services system. Thank you, Secretary Geithner, for appearing before us today and for your hard work on this plan. Let me say at the outset that I agree with the President that we must reform our Nation's financial regulatory system. Why? All you have to do is pick up a paper or turn on the television to learn about homes being lost, Americans losing their jobs because businesses can't get access to credit, and banks being shuttered. I believe that one of our Nation's forefathers, James Madison, said it best when he wrote that ``If men were angels, no government would be necessary.'' Much has been said and written about how we got here, how we arrived at the point of needing a comprehensive overhaul of the financial system. One way we got here is through the free-wheeling creation and sale of complex financial instruments that only a small percentage of the world understands. These instruments were largely based on bets that the mortgage market would reap huge gains indefinitely and funded by loans to homeowners and investors, who often did not fully understand their loan terms and in many cases could not afford them. The other route we took involved the failure of those charged with ensuring the health of our banking and financial services sector. I am referring to the patchwork quilt of regulators on whom we have relied to ensure that our bank accounts are safe and that we can invest with the confidence that all risks have been fully disclosed. My priorities for reform are the protection of consumers, investors, and jobs and ensuring the stability of the Nation's financial infrastructure. We must put in place a regulatory structure that will not only protect consumers and investors but protect valuable financial sector jobs. In the news we heard about the collapse of AIG, Lehman, Fannie, Freddie, and Bear Stearns and the numerous banks that have either closed down or been purchased by other banks. This really hits home in Ohio. National City, an institution that has been a pillar of the community for more than a century and a half, vanished over the course of a few months. We cannot forget about those Americans as we work to put a plan in place. It boils down to this: People in my State want their hard-earned savings protected. They want to be able to get an affordable loan to purchase a home--on terms that they can understand. They want to know that when they invest, the institutions handling their investments aren't so over-extended that a light breeze causes their house of cards to tumble. And small businesses want access to credit without impossible-to-meet requirements. The Administration plan seeks to: promote strong supervision and regulation of financial firms; establish comprehensive supervision and regulation of financial markets; protect consumers and investors from financial abuse; provide the government with tools it needs to manage financial crises; and raise international regulatory standards and improve international cooperation among financial institutions and markets. As we consider the Administration's plan and what I am sure will be numerous competing proposals for regulatory reform, I have several questions: How will the Administration's plan actually protect the average consumer of credit products and the average investor? How can we have confidence that the Fed will be able to effectively execute its new responsibilities? How will the components of the new scheme be integrated? How will this plan prevent us from coming back to this same spot years from now? We need vision and courage going forward. We also need to do more than pay lip service to the American consumer that we are ``getting tough'' on the institutions that caused this mess. We need to ensure that any new powers we give to existing institutions and any new agencies we create are designed to produce real results and not more of the same. We need regulatory reform because, left to their own devices, too many financial institutions will act to preserve themselves at the risk of the system as a whole. Sensible bankers and insurers will have to pay the price for their selfish colleagues who think only in the short term. And so will the rest of us. We cannot afford the status quo. We must act now to put a plan in place that protects consumers and investors, saves jobs, and ensures the integrity of our financial system. ______ CHRG-111shrg53822--80 Mr. Wallison," I think what Raghu has said is a very interesting proposal. I have this concern, however. And if we keep our eye on the ball, we are talking about systemic risk. And what is systemic risk? Systemic risk is the risk that when a large financial institution fails, a large bank fails, it has effects on all others throughout the economy, or many others, a contagion, if you will, a cascading of losses. The idea that we would convert debt into equity is good for the bank, but you have to consider what it does to the holders who previously had debt and now have equity; what it does to their balance sheets and what it does to their risk profiles. And what it does, of course, it make them much more risky. So in other words, in a time when we are talking about trying to prevent systemic risk, we are also thinking favorably about an idea that, actually, encourages, increases the possibility of contagion from a failed institution or a failing institution, to institutions that might otherwise be healthy. " CHRG-111shrg55278--114 RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM SHEILA C. BAIRQ.1. Too-Big-To-Fail--Chairman Bair, the Obama administration's proposal would have regulators designate certain firms as systemically important. These firms would be classified as Tier 1 Financial Holding Companies and would be subject to a separate regulatory regime. If some firms are designated as systemically important, would this signal to market participants that the Government will not allow these firms to fail? If so, how would this worsen our ``too-big-to-fail'' problem?A.1. We have concerns about formally designating certain institutions as a special class. Any recognition of an institution as systemically important risks invoking the moral hazard that accompanies institutions that are considered too-big-to-fail. That is why, most importantly, a robust resolution mechanism, in addition to enhanced supervision, is important for very large financial organizations. A vigorous systemic risk regulatory regime, along with resolution authority for bank holding companies and systemically risky financial firms would go far toward eliminating ``too-big-to-fail.''Q.2. Government Replacing Management?--In your testimony, while discussing the need for a systemic risk regulator to provide a resolution regime, you state that ``losses would be borne by the stockholders and bondholders of the holding company, and senior management would be replaced.'' Could you expand upon how the senior management would be replaced? Would the systemic risk regulator decide who needed to be replaced and who would replace them?A.2. When the FDIC takes over a large insured bank and establishes a bridge bank, the normal business practice is to replace certain top officials in the bank, usually the CEO, plus any other senior officials whose activities were tied to the cause of the bank failure. The resolution authority would decide who to replace based on why the firm failed.Q.3. ``Highly Credible Mechanism'' for Orderly Resolution--Chairman Bair, in your testimony you suggest that we must redesign our system to allow the market to determine winners and losers, ``and when firms--through their own mismanagement and excessive risk taking--are no longer viable, they should fail.'' You also suggest that the solution must involve a ``highly credible mechanism'' for orderly resolution of failed institutions similar to that which exists for FDIC-insured banks. Do you believe that our current bankruptcy system is inadequate, or do you believe that we must create a new resolution regime simply to fight the perception that we will not allow a systemically important institution to fail?A.3. In the United States, liquidation and rehabilitation of most failing corporations are governed by the Federal bankruptcy code and administered primarily in the Federal bankruptcy courts. Separate treatment, however, is afforded to banks, which are resolved under the Federal Deposit Insurance Act and administered by the FDIC. \1\ The justifications for this separate treatment are banks' importance to the aggregate economy, and the serious adverse effect of their insolvency on others.--------------------------------------------------------------------------- \1\ Another exception would be the liquidation or rehabilitation of insurance companies, which are handled under State law.--------------------------------------------------------------------------- Bankruptcy focuses on returning value to creditors and is not geared to protecting the stability of the financial system. When a firm is placed into bankruptcy, an automatic stay is placed on most creditor claims to allow management time to develop a reorganization plan. This can create liquidity problems for creditors--especially when a financial institution is involved--who must wait to receive their funds. Bankruptcy cannot prevent a meltdown of the financial system when a systemically important financial firm is troubled or failing. Financial firms--especially large and complex financial firms--are highly interconnected and operate through financial commitments. Most obtain a significant share of their funding from wholesale markets using short-term instruments. They provide key credit and liquidity intermediation functions. Like banks, financial firms (holding companies and their affiliates) can be vulnerable to ``runs'' if their short-term liabilities come due and cannot be rolled over. For these firms, bankruptcy can trigger a rush to the door, since counterparties to derivatives contracts--which are exempt from the automatic stay placed on other contracts--will exercise their rights to immediately terminate contracts, net out their exposures, and sell any supporting collateral. The statutory right to invoke close-out netting and settlement was intended to reduce the risks of market disruption. Because financial firms play a central role in the intermediation of credit and liquidity, tying up these functions in the bankruptcy process would be particularly destabilizing. However, during periods of economic instability this rush-to-the-door can overwhelm the market and even depress market prices for the underlying assets. This can further destabilize the markets and affect other financial firms as they are forced to adjust their balance sheets. By contrast, the powers that are available to the FDIC under its special resolution authority prevent the immediate close-out netting and settlement of financial contracts of an insured depository institution if the FDIC, within 24 hours after its appointment as receiver, decides to transfer the contracts to another bank or to an FDIC-operated bridge bank. As a result, the potential for instability or contagion caused by the immediate close-out netting and settlement of qualified financial contracts can be tempered by transferring them to a more stable counterparty or by having the bridge bank guarantee to continue to perform on the contracts. The FDIC's resolution powers clearly add stability in contrast to a bankruptcy proceeding. For any new resolution regime to be truly ``credible,'' it must provide for the orderly wind-down of large, systemically important financial firms in a manner that is clear, comprehensive, and capable of conclusion. Thus, it is not simply a matter of ``perception,'' although the new resolution regime must be recognized by firms, investors, creditors, and the public as a mechanism in which systemically important institutions will in fact fail.Q.4. Firms Subject to New Resolution Regime--Chairman Bair, in your testimony, you continuously refer to ``systemically significant entities,'' and you also advocate for much broader resolution authority. Could you indicate how a ``systemically significant entity'' would be defined? Will the list of systemically significant institutions change year-to-year? Do you envision it including nonfinancial companies such as GM? Would all financial and ``systemically significant entities'' be subject to this new resolution regime? If not, how would the market determine whether the company would be subject to a traditional bankruptcy or the new resolution regime? Why do we need a systemic risk regulator if we are going to allow institutions to become ``systemically important''?A.4. 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. While not commenting on any specific company, nonfinancial firms that become major financial system participants should have their financial activities come under the same regulatory scrutiny as any other major financial system participant.Q.5. Better Deal for the Taxpayer--Chairman Bair, you advocate in your testimony for a new resolution mechanism designed to handle systemically significant institutions. Could you please cite specific examples of how this new resolution regime would have worked to achieve a better outcome for the taxpayer during this past crisis?A.5. A proposed new resolution regime modeled after the FDIC's existing authorities has a number of characteristics that would reduce the costs associated with the failure of a systemically significant institution. First and foremost, the existence of a transparent resolution scheme and processes will make clear to market participants that there will be an imposition of losses according to an established claims priority where stockholders and creditors, not the Government, are in the first loss position. This will provide a significant measure of cost savings by imposing market discipline on institutions so that they are less likely to get to the point where they would have otherwise been considered too-big-to-fail. Also, the proposed resolution regime would allow the continuation of any systemically significant operations, but only as a means to achieve a final resolution of the entity. A bridge mechanism, applicable to the parent company and all affiliated entities, would allow the Government to preserve systemically significant functions. Also, for institutions involved in derivatives contracts, the new resolution regime would provide an orderly unwinding of counterparty positions as compared to the rush to the door that can occur during a bankruptcy. In contrast, since counterparties to derivatives contracts are exempt from the automatic stay placed on other contracts under the Bankruptcy Code, they will exercise their rights to immediately terminate contracts, net out their exposures, and sell any supporting collateral, which serves to increase the loss to the failed institution. In addition, the proposed resolution regime enables losses to be imposed on market players who should appropriately bear the risk, including shareholders and unsecured debt investors. This creates a buffer that can reduce potential losses that could be borne by taxpayers. Further, when the institution and its assets are sold, this approach creates the possibility of multiple bidders for the financial organization and its assets, which can improve pricing and reduce losses to the receivership. The current financial crisis led to illiquidity and the potential insolvency of a number of systemically significant financial institutions during 2008. Where Government assistance was provided on an open-institution basis, the Government exposed itself to significant loss that would otherwise have been mitigated by these authorities proposed for the resolution of systemically significant institutions. A new resolution regime for firms such as Lehman or AIG would ensure that shareholders, management, and creditors take losses and would bar an open institution bail-out, as with AIG. The powers of a receiver for a financial firm would include the ability to require counterparties to perform under their contracts and the ability to repudiate or terminate contracts that impose continuing losses. It also would have the power to terminate employment contracts and eliminate many bonuses. ------ CHRG-111shrg57709--245 PREPARED STATEMENT OF NEAL S. WOLIN Deputy Secretary, Department of the Treasury February 2, 2010 Chairman Dodd, Ranking Member Shelby, thank you for the opportunity to testify before your Committee today about financial reform--and in particular about the Administration's recent proposals to prohibit certain risky financial activities at banks and bank holding companies and to prevent excessive concentration in the financial sector. The recent proposals complement the much broader set of reforms proposed by the Administration in June, passed by the House in December, and currently under consideration by this Committee. We have worked closely with you and with your staffs over the past year, and we look forward to working with you to incorporate these additional proposals into comprehensive legislation. Sixteen months from the height of the worst financial crisis in generations, no one should doubt the urgent need for financial reform. Our regulatory system is outdated and ineffective, and the weaknesses that contributed to the crisis still persist. Through a series of extraordinary actions over the last year and a half, we have made significant progress in stabilizing the financial system and putting our economy back on the path to growth. But the progress of recovery does not diminish the urgency of the task at hand. Indeed, our financial system will not be truly stable, and our recovery will not be complete, until we establish clear new rules of the road for the financial sector. The goals of financial reform are simple: to make the markets for consumers and investors fair and efficient; to lay the foundation for a safer, more stable financial system, less prone to panic and crisis; to safeguard American taxpayers from bearing risks that ought to be borne by shareholders and creditors; and to end, once and for all, the dangerous perception any financial institution is ``Too Big to Fail.'' The ingredients of financial reform are clear: All large and interconnected financial firms, regardless of their legal form, must be subject to strong, consolidated supervision at the Federal level. The idea that investment banks like Bear Stearns or Lehman Brothers or other major financial firms could escape consolidated Federal supervision should be considered unthinkable from now on. The days when being large and substantially interconnected could be cost-free--let alone carry implicit subsidies--should be over. The largest, most interconnected firms should face significantly higher capital and liquidity requirements. Those requirements should be set at levels that compel the major financial firms to pay for the additional costs that they impose on the financial system, and give such firms positive incentives to reduce their size, risk profile, and interconnectedness. The core infrastructure of the financial markets must be strengthened. Critical payment, clearing, and settlement systems, as well as the derivatives and securitization markets, must be subject to thorough, consistent regulation to improve transparency, and to reduce bilateral counterparty credit risk among our major financial firms. We should never again face a situation--so devastating in the case of AIG--where a virtually unregulated major player can impose risks on the entire system. The government must have robust authority to unwind a failing major financial firm in an orderly manner--imposing losses on shareholders, managers, and creditors, but protecting the broader system and ensuring that taxpayers are not forced to pay the bill. The government must have appropriately constrained tools to provide liquidity to healthy parts of the financial sector in a crisis, in order to make the system safe for failure. And we must have a strong, accountable consumer financial protection agency to set and enforce clear rules of the road for providers of financial services--to ensure that customers have the information they need to make fully informed financial decisions. Throughout the financial reform process, the Administration has worked with Congress on reforms that will provide positive incentives for firms to shrink and to reduce their risk and to give regulators greater authorities to force such outcomes. The Administration's White Paper, released last June, emphasized the need to give regulators extensive authority to limit risky, destabilizing activities by financial firms. We worked closely with Chairman Frank and subcommittee Chairman Kanjorski in the House Financial Services Committee to give regulators explicit authority to require a firm to cease activities or divest businesses that could threaten the safety of the firm or the stability of the financial system. In addition, through tougher supervision, higher capital and liquidity requirements, the requirement that large firms develop and maintain rapid resolution plans--also known as ``living wills''--and the financial recovery fee which the President proposed at the beginning of January, we have sought indirectly to constrain the growth of large, complex financial firms. As we have continued our ongoing dialog, within the Administration and with outside advisors such as the Chairman of the President's Economic Recovery Advisory Board, former Federal Reserve Chairman Paul Volcker, whose counsel has been of tremendous value, we have come to the conclusion that further steps are needed: that rather than merely authorize regulators to take action, we should impose mandatory limits on proprietary trading by banks and bank holding companies, and related restrictions on owning or sponsoring hedge funds or private equity funds, as well as on the concentration of liabilities in the financial system. These two additional reforms represent a natural--and important--extension of the reforms already proposed. Commercial banks enjoy a Federal Government safety net in the form of access to Federal deposit insurance, the Federal Reserve discount window, and Federal Reserve payment systems. These protections, in place for generations, are justified by the critical role the banking system plays in serving the credit, payment and investment needs of consumers and businesses. To prevent the expansion of that safety net and to protect taxpayers from risk of loss, commercial banking firms have long been subject to statutory activity restrictions, and they remain subject to a comprehensive set of activity restrictions today. Activity restrictions are a hallowed part of this country's bank regulatory tradition, and our new scope proposals represent a natural evolution in this framework. The activities targeted by our proposal tend to be volatile and high risk. Major firms saw their hedge funds and proprietary trading operations suffer large losses in the financial crisis. Some of these firms ``bailed out'' their troubled hedge funds, depleting the firm's capital at precisely the moment it was needed most. The complexity of owning such entities has also made it more difficult for the market, investors, and regulators to understand risks in major financial firms, and for their managers to mitigate such risks. Exposing the taxpayer to potential risks from these activities is ill-advised. Moreover, proprietary trading, by definition, is not done for the benefit of customers or clients. Rather, it is conducted solely for the benefit of the bank itself. It is therefore difficult to justify an arrangement in which the Federal safety net redounds to the benefit of such activities. For all these reasons, we have concluded that proprietary trading, and the ownership or sponsorship or hedge funds and private equity funds, should be separated, to the fullest extent practicable, from the business of banking--and from the safety net that benefits the business of banking. While some details concerning the implementation of these proposals will appropriately be worked out through the regulatory process following enactment, it may be helpful if I take a moment to clarify the Administration's intentions on a few particularly salient issues. First, with respect to the application of the proposed scope limits: all banking firms would be covered. This means any FDIC-insured depository institution, as well as any firm that controls an FDIC-insured depository institution. In addition, the proposal would apply to the U.S. operations of foreign banking organizations that have a U.S. branch or agency and are therefore treated under current U.S. law as bank holding companies. The prohibition also would generally apply to the foreign operations of U.S.-based banking firms. This proposal forces firms to choose between owning an insured depository institution and engaging in proprietary trading, hedge fund, or private equity activities. But--and this is very important to emphasize--it does not allow any major firm to escape strict government oversight. Under our regulatory reform proposals, all major financial firms, whether or not they own a depository institution, must be subject to robust consolidated supervision and regulation--including strong capital and liquidity requirements--by a fully accountable and fully empowered Federal regulator. Second, with respect to the types of activity that will be prohibited: this proposal will prohibit investments of a banking firm's capital in trading operations that are unrelated to client business. For instance, a firm will not be allowed to establish or maintain a separate trading desk, capitalized with the firm's own resources, and organized to speculate on the price of oil and gas or equity securities. Nor will a firm be allowed to evade this restriction by simply rolling such a separate proprietary trading desk into the firm's general market making operations. The proposal would not disrupt the core functions and activities of a banking firm: banking firms will be allowed to lend, to make markets for customers in financial assets, to provide financial advice to clients, and to conduct traditional asset management businesses, other than ownership or sponsorship of hedge funds and private equity funds. They will be allowed to hedge risks in connection with client-driven transactions. They will be allowed to establish and manage portfolios of short-term, high-quality assets to meet their liquidity risk management needs. Traditional merger and acquisition advisory, strategic advisory, and securities underwriting, and brokerage businesses will not be affected. In sum, the proposed limitations are not meant to disrupt a banking firm's ability to serve its clients and customers effectively. They are meant, instead, to prevent a banking firm from putting its clients, customers and the taxpayers at risk by conducting risky activities solely for its own enrichment. Let me now turn to the second of the President's recent proposals: the limit on the relative size of the largest financial firms. Since 1994, the United States has had a 10 percent concentration limit on bank deposits. The cap was designed to constrain future concentration in banking. Under this concentration limit, firms generally cannot engage in certain inter-state banking acquisitions if the acquisition would put them over the deposit cap. This deposit cap has helped constrain the growth in concentration among U.S. banking firms over the intervening years, and it has served the country well. But its narrow focus on deposit liabilities has limited its usefulness. Today, the largest U.S. financial firms generally fund themselves at significant scale with non-deposit liabilities. Moreover, the constraint on deposits has provided the largest U.S. financial firms with a perverse incentive to fund themselves through more volatile forms of wholesale funding. Given the increasing reliance on non-bank financial intermediaries and non-deposit funding sources in the U.S. financial system, it is important to supplement the deposit cap with a broader restriction on the size of the largest firms in the financial sector. This new financial sector size limit should not require existing firms to divest operations. But it should serve as a constraint on future excessive consolidation among our major financial firms. The size limit should not impede the organic growth of financial firms--after all, we do not want to limit the growth of successful businesses. But it should constrain the capacity of our very largest financial firms to grow by acquisition. The new limit should supplement, not replace, the existing deposit cap. And it should at a minimum cover all firms that control one or more insured depository institutions, as well as all other major financial firms that are so large and interconnected that they will be brought into the system of consolidated, comprehensive supervision contemplated by our reforms. An updated size limit for financial firms will have a beneficial effect on the overall health of the financial system. Limiting the relative size of any single financial firm will reduce the adverse effects from the failure of any single firm. These proposals should strengthen our financial system's resiliency. It is true today that the financial systems of most other G7 countries are far more concentrated than ours. It is also true today that major financial firms in many other economies generally operate with fewer restrictions on their activities than do U.S. banking firms. These are strengths of our economy--strengths that we intend to preserve. Limits on the scale and scope of U.S. banking firms have not materially impaired the capacity of U.S. firms to compete in global financial markets against larger, foreign universal banks, nor have these variations stopped the United States from being the leading financial market in the world. The proposals I have discussed today preserve the core business of banking and serving clients, and preserve the ability of even our largest firms to grow organically. Therefore we are confident that we should not impact the competitiveness of our financial firms and our financial system. Before closing, I would like to again emphasize the importance of putting these new proposals in the broader context of financial reform. The proposals outlined above do not represent an ``alternative'' approach to reform. Rather, they are meant to supplement and complement the set of comprehensive reforms put forward by the Administration last summer and passed by the House of Representatives before the holidays. Added to the core elements of effective financial reform previously proposed, the activity restrictions and concentration cap that are the focus of today's hearing will play an important role in making the system safer and more stable. But like each of the other core elements of financial reform, the scale and scope proposals are not designed to stand alone. Members of this Committee have the opportunity--by passing a comprehensive financial reform bill--to help build a safer, more stable financial system. It is an opportunity that may not come again. We look forward to working with you to bring financial reform across the finish line--and to do all that we can to ensure that the American people are never again forced to suffer the consequences of a preventable financial catastrophe. Thank you. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM PAUL A. VOLCKERQ.1. The government safety net for financial firms is larger than just deposit insurance. In particular, the Fed has made its lending available to all kinds of firms, including those that are not banks. Should firms that have access to any forms of Fed money be subject to these same limits on risk taking?A.1. Yes.Q.2. Under this proposal, would banks be allowed to continue their derivatives dealer business?A.2. Yes, as long as they are originating these products on behalf of their customers, and are not trading them for their own account.Q.3. Chairman Volker, in your New York Times piece you state that there are some investment banks and insurance companies that are too big to fail. What do you propose we do about them?A.3. To be clear, I think I said that some of those firms present systemic risk, but in my view no firm is too big to fail. Their financial statements, business practices, and interconnectedness would be continuously reviewed by a ``Systemic Overseer'', as well they would be subject to reasonable capital, leverage and liquidity requirements. These firms would also be operating under the auspices of a new resolution authority for non-banks.Q.4.a. Chairman Volker, would you allow Goldman Sachs and Morgan Stanley, which became bank holding companies in order to get greater access to Fed money, to drop their bank charters so they could keep trading on their own account?A.4.a. Yes, and then they would be operating outside the Federal safety net.Q.4.b. If yes, how would that resolve any of the systemic risks posed by those firms?A.4.b. They would be subject to the supervision outlined in my answer to Question 3. In the event of their failure, they would be liquidated or merged under a new resolution authority for nonbanks.Q.5. Under this proposal, would banks be allowed to lend to hedge funds or private equity firms?A.5. Yes, as these funds would be considered customers of the banks.Q.6. What measurement do you propose we use to limit the size of financial institutions in the future?A.6. I think the deposit and liability cap being contemplated by the Treasury is a reasonable means of limiting the size of financial institutions. I have not yet seen the percentage limit being proposed by Treasury, however I understand a new cap will be high enough so as not to require any existing firm to shrink. Size, though, is not the sole criteria for measuring the systemic risk of an institution. It is important to have an Overseer that is looking at the complexity and diversification of the institution's holdings, its interconnectedness with other institutions and markets, and other risk measures.Q.7. If we put in place size limitations or trading limitations, who is going to be able to step in and buy other large firms that are in danger of failing? For example, what would happen to a transaction like the Bank of America-Merrill Lynch merger?A.7. Again, I defer to Treasury with respect to the size criteria to be proposed. In the future, I hope that we will have a stable of strong financial institutions capable of executing such a transaction should a large bank or non-bank fail. If we do not have institutions that are capable and willing to acquire or merge with a competitor in trouble, then the failing firm will be liquidated under the auspices of the new resolution authority for non-banks. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT FROM NEAL S. WOLINQ.1. As you know, many major banks and bank-holding companies in the United States offer prime brokerage services to their large institutional clients. In fact, prime brokerage is significant source of revenue for some of these banking entities. SEC Regulation SHO requires that, prior to executing a short sale, a prime broker need only ``locate'' shares on behalf of a client. It is possible to ``over-lend'' shares without ever firmly locating the shares. Under existing regulations prime brokers are compensated for lending the customers' shares for uses that are often contrary to their customers' investment strategies. What is the Administration doing to bring full disclosure and accountability to this process and do you think that the government should at least require the major banks and bank-holding companies that offer prime brokerage services to obtain affirmative, knowing consent of the customer for the lending of their shares at the time the consumer signs the brokerage agreement?A.1. Did not respond by publication deadline. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM NEAL S. WOLINQ.1. In his testimony, Chairman Volker makes it clear that banks would continue to be allowed to package mortgages or other assets into securities and sell them off. That was an activity that was at the center of the credit bubble and the current crisis. Why should banks be allowed to continue that behavior?A.1. Did not respond by publication deadline.Q.2. The government safety net for financial firms is larger than just deposit insurance. In particular, the Fed has made its lending available to all kinds of firms, including those that are not banks. Should firms that have access to any forms of Fed money be subject to these same limits on risk taking?A.2. Did not respond by publication deadline.Q.3. Under this proposal, would banks be allowed to continue their derivatives dealer business?A.3. Did not respond by publication deadline.Q.4.a. Would you allow Goldman Sachs and Morgan Stanley, which became bank holding companies in order to get greater access to Fed money, to drop their bank charters so they could keep trading on their own account?A.4.a. Did not respond by publication deadline.Q.4.b. If yes, how would that resolve any of the systemic risks posed by those firms?A.4.b. Did not respond by publication deadline.Q.5. Under this proposal, would banks be allowed to lend to hedge funds or private equity firms?A.5. Did not respond by publication deadline.Q.6. Secretary Wolin, what measurement do you propose we use to limit the size of financial institutions in the future?A.6. Did not respond by publication deadline.Q.7. If we put in place size limitations or trading limitations, who is going to be able to step in and buy other large firms that are in danger of failing? For example, what would happen to a transaction like the Bank of America-Merrill Lynch merger?A.7. Did not respond by publication deadline. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER FROM NEAL S. WOLINQ.1. How would you define proprietary trading?A.1. Did not respond by publication deadline.Q.2. Will the restrictions on proprietary trading and hedge fund ownership apply to all bank holding companies--including Goldman Sachs and Morgan Stanley--or only to deposit taking institutions?A.2. Did not respond by publication deadline.Q.3. Do you think the failure of Lehman Brothers would have been less painful if these rules had been in place? If you do, please explain how.A.3. Did not respond by publication deadline.Q.4. Do you think it would have been easier to allow AIG or Bear Stearns to fail if these rules had been in place? If you do, please explain why.A.4. Did not respond by publication deadline.Q.5. It would also be instructive to hear from you how the largest bank failures in U.S. history. How would the Volker rule have impacted Washington Mutual and IndyMac? Please be specific to each institution and each aspect of the proposed limit in size and scope.A.5. Did not respond by publication deadline.Q.6. Do you think that it would be easier in the future to allow any large, interconnected non-bank financial institution to fail if these rules are in place? If so, why?A.6. Did not respond by publication deadline.Q.7. How does limiting the size and scope of an institution prevent banks from making too many risky home loans?A.7. Did not respond by publication deadline.Q.8. In your testimony you correctly say, ``Since 1994, the United States has had a 10 percent concentration limit on bank deposits. The cap was designed to constrain future concentration in banking. Under this concentration limit, firms generally cannot engage in certain inter-state banking acquisitions if the acquisition would put them over the deposit cap. This deposit cap has helped constrain the growth in concentration among U.S. banking firms over the intervening years, and it has served the country well.'' Yet, you also say that the new size limit ``should not require existing firms to divest operations.'' Why should we not consider this newly proposed rule as protecting the chosen few enormous institutions that are currently too big to fail?A.8. Did not respond by publication deadline.Q.9. Banking regulators have waived long standing rules in order to allow certain companies to hold more than 10 percent of the nation's deposits despite a rule barring such a practice. Do you support a continued waiver, or should the regulators enforce the statutory depository caps?A.9. Did not respond by publication deadline.Q.10. A sad truth of the sweeping government interventions and bailouts last year is that it has made the problem of ``too big to fail'' worse because it has increased the spread between the average cost of funds for smaller banks and the cost of funds for larger ``too big to fail'' institutions. A study done by the FDIC shows that it has become even more profitable. Do you believe that there are currently any financial companies that are too big and should be broken up?A.10. Did not respond by publication deadline. Additional Material Supplied for the Record GONE FISHING: E. GERALD CORRIGAN AND THE ERA OF CHRG-111hhrg56766--70 Mr. Bernanke," As I said, I think around the end of the year we will have some formal standards, but we have been very much involved in pushing banks to raise more capital. That was one of the outcomes of the stress test we did last spring, that U.S. banks raised a very substantial amount of capital, and that has been very helpful in restoring confidence for the banking system. " CHRG-111hhrg48674--362 Mr. Bernanke," Well, by strengthening supervisory oversight over the risk management, making banks responsible for strengthening those controls. I think the system just got carried away by the credit bubble, and the risk management systems didn't succeed in protecting the system from that. There are also a lot of gaps in the regulatory system, places where there is duplicate oversight, places where there is not enough oversight. So we have a lot of work to do. " CHRG-111shrg57709--129 Mr. Volcker," Well, if the rule was adopted, they would not have been engaging, obviously, in some of these activities. But they could still get in trouble. Banks have had a history of centuries of getting in trouble. So that is one of the reasons we have a Federal Reserve. If they get in trouble and it seems to be a viable institution, a solvent institution, you have recourse to the Federal Reserve to handle even rather extreme liquidity needs, and I think that is totally appropriate. That is one form of Government support given to the banking system, and I do not see that changing. I think it is important to provide that backstop, and almost every country in the world provides that kind of backstop to its banking system. So that does not change. Senator Johnson. Secretary Wolin, if the proposal includes a provision that gives banks the explicit choice to exit the bank holding company regime, do you have any concerns that this would create new regulatory gaps? Are there concerns that American companies would go abroad where there are not proprietary trading restrictions? " CHRG-111shrg56415--31 Mr. Tarullo," Senator, I think it depends, as it often does, on how one conceives of what a systemic risk regulator is doing. I think there have been discrete functions which sometimes get lumped under that umbrella. What we have thought of in terms of the Federal Reserve's role is consolidated supervision of systemically important institutions, and so it is very much a supervisory function, making sure that you are covering everybody who could pose a risk to the system. And in that context, of course, if there is a State bank, the State banking supervisor absolutely should be participating. A second context is thinking in terms of collective efforts to identify emerging risks and figure out what can be done, and there I think it is profitable to have people who see things from different parts of the financial system participating. Senator Tester. OK. If there is a council of regulators, should the State regulators be represented? " FinancialCrisisInquiry--118 To solve this OTC derivatives problem—I heard a few of the—of the potential solutions this morning. But I’ll go over the three that I think are absolutely mandatory to fix this problem. One is—is the key issue—is homogeneous minimum collateral requirements. All participants in the derivatives marketplace—do not bar the dealers from this— should be required to post initial capital based upon some formulaic determination of the risk by the appropriate regulatory body. Two, centralized clearing and mandatory price reporting of all standardized CDS, FX and interest rate derivatives—we believe close to 90 percent of these derivatives are standardized. Centralized data repository for all cleared and non-cleared derivatives trades—essentially there must be some place where every single transaction is recorded and monitored. As of today, that still doesn’t exist. It’s hard for me to believe that where we are today that that doesn’t exist. The second thing I’d like to talk about is bank leverage. And this is just the fundamental tenants of the U.S. banking system. Under current regulatory guidelines, banks are deemed to be well- capitalized with 6 percent tier one capital and adequately capitalized with 4 percent tier one capital based upon risk weighted assets. As an aside, the concept of risk weighting in assets should also be reviewed. This in turn means that a well-capitalized bank is leveraged 16 times to its capital, much more to its tangible common equity. And an adequately capitalized bank is—or a minimum capitalized bank—sorry—is 25 times levered to its tier one capital. I don’t know how many prudent individuals or institutions can possibly manage a portfolio of assets that is 25 times levered when we hit a crisis. But—but I surely can’t. Unfortunately, the answer so far has been not many of the other banks have been able to manage these risks either. Of the 170 banks that have failed during the crisis to date, the average loss to the FDIC and the taxpayer is well over 25 percent of their assets. When you think about that, that means they’ve lost more than six times their equity, of the banks that have gone down so far. CHRG-111shrg57320--79 Mr. Rymer," Well, let me explain. I mean, the bank was the initial victim, but certainly as those mortgages passed through the system, there were lots more people harmed from that fraud than just the bank. Senator Kaufman. Correct. " FOMC20060131meeting--20 18,CHAIRMAN GREENSPAN.," Without exception. Our next item is the selection of a Federal Reserve Bank to execute transactions for the System Open Market Account. My notes say that New York is again the odds-on favorite. [Laughter] I’m always going with the odds-on favorite. I would suggest that, unless somebody moves, I will do so and assume it’s effectively implemented. Without objection, so ordered. Next, selection of a Manager of the System Open Market Account. Dino Kos is the incumbent. And on the presumption that he is acceptable to the New York Bank, he then becomes the candidate for Manager of the System Open Market Account. Would somebody like to move the nomination?" CHRG-111shrg56376--57 Mr. Dugan," Senator, I believe you could do more streamlining. You could move more in the direction you are talking about. We do not have an ideal system. But as my testimony suggests, there are some issues you are going to have to confront if you want to have an effective Federal Deposit Insurance Corporation. If you go for long periods without having any bank failures, they are not going to have a lot to do and will not know the system very well if they do not supervise banks. Likewise, the Federal Reserve has some things to offer to supervision, particularly of the very largest institutions at the holding company level that are engaged in a lot of nonbanking activities. And to think that a banking supervisor would do all of that as well without having the benefit of direct supervision raises some questions. Senator Tester. OK. " CHRG-111shrg62643--86 Mr. Bernanke," Well, the excess reserves, which is about $1 trillion held by the Federal Reserve, does not count--it is an asset. It does not count as capital. It is really a form of liquidity, and it helps to ensure that banks have all the access to liquid funds that they might need, and that it is another belt-and-suspender protection for the banking system. They have so far been reluctant to make use of those reserves, probably because they view the demand for credit as being weak or the quality of borrowers as being weak, or in some cases because they are uncertain about how much capital they will need in the longer term and are, therefore, being cautious about putting their capital to work. But capital reserves are different quantities. Senator Gregg. But they all reflect the strength of the system? " CHRG-111shrg54789--27 Mr. Barr," We would be happy to work with the Committee to provide whatever information would be available and useful to you. Senator Shelby. You state, Mr. Secretary, repeatedly that the status quo is not acceptable because things are changing every day in the marketplace, as we know, and the need for a new independent consumer protection regime could not be clearer. In addition, you state that, ``Banks can choose the least restrictive supervisor among several banking supervisors.'' Yet the Administration leaves in place in their overall proposal exactly that fragmented system for prudential supervision, four or five regulators. Why is it that we must and why would you propose only one agency responsible for consumer protection, but four Federal banking agencies is entirely appropriate for safety and soundness regulation of our system? Why would you do that if you are going to have the other? If we had one prudential banking regulator, you could draw the analogy, but I don't know how you do it here. " CHRG-111shrg50564--193 PREPARED STATEMENT OF PAUL A. VOLCKER Chairman, Steering Committee of the Group of 30 February 4, 2009 Mr. Chairman and Members of the Senate Banking Committee: I appreciate your invitation to discuss the recent Report on Financial Reform issued by the ``Group of 30''. I remind you that the Group is international, bringing together members with broad financial experience from both the private and public sectors and drawn from both highly developed and emerging economies. While certainly relevant to the United States, most of the recommendations are generally applicable among globally active financial markets. I understand that the text of the Report has been distributed to you and your staff and will be included in the Committee record. Accordingly, my statement will be short. What is evident is that we meet at a time of acute distress in financial markets with strongly adverse effects on the economy more broadly. There is a clear need for early and effective governmental programs both to support economic activity and to ease the flow of credit. It is also evident that fundamental changes and reform of the financial system will be required to assure that strong, competitive and innovative private financial markets can in the future again support economic growth without risk of a systemic financial breakdown. It is that latter challenge to which the G-30 Report is addressed. I understand that President Obama and his administration will soon place before you a specific program for dealing with the banking crisis. Such emergency measures are not the subject of our Report. However, I do believe that the implementation of the more immediate measures will be facilitated by an agreed sense of the essential elements of a reformed financial system. In that respect, the basic thrust of the G-30 Report is to distinguish among the basic functions of any financial system. First, there is a need for strong and stable institutions serving the needs of individuals, businesses, governments, and others for a safe and sound repository of funds, as a reliable source of credit, and for a robust financial infrastructure able to withstand and diffuse shocks and volatility. I think of this as the service-oriented part of the financial system dealing with customer relationships. It is characterized mainly by commercial banks that have long been supported and protected by deposit insurance, access to Federal Reserve credit, and other elements of the Federal safety net. What has become apparent during this period of crisis is increasing concentration in banking and the importance of official support for systemically important institutions at risk of failure. What is apparent is that a sudden breakdown or discontinuity in the functioning of such institutions risks widespread repercussions on markets, on closely interconnected financial institutions, and on the broader economy. The design of any financial system raises large questions about the appropriate criteria for, and the ways and means of, providing official support for these systemically important institutions. In common ground with virtually all official and private analysts, the Report calls for ``particularly close regulation and supervision, meeting high and common international standards'' for institutions deemed systemically critical. It also explicitly calls for restrictions on ``proprietary activities that present particularly high risks and serious conflicts of interest'' deemed inconsistent with the primary responsibilities of those institutions. Of relevance in the light of recent efforts of some commercial enterprises to recast financial affiliates as bank holding companies, the Report strongly urges continuing past U.S. practice of prohibiting ownership or control of Government-insured, deposit-taking institutions by non-financial firms. Secondly, the Report implicitly assumes that, while regulated banking institutions will be dominant providers of financial services, a variety of capital market institutions will remain active. Organized markets and private pools of capital will be engaging in trading, transformation of credit instruments, and developing derivatives and hedging strategies, and other innovative activities, potentially adding to market efficiency and flexibility. These institutions do not directly serve the general public and individually are less likely to be of systemic significance. Nonetheless, experience strongly points to the need for greater transparency. Specifically beyond some minimum size, registration of hedge and equity funds, should be required, and if substantial use of borrowed funds takes place, an appropriate regulator should be able to require periodic reporting and appropriate disclosure. Furthermore, in those exceptional cases when size, leverage, or other characteristics pose potential systemic concerns, the regulator should be able to establish appropriate standards for capital, liquidity and risk management. The Report does not deal with important and sensitive questions of the appropriate administrative arrangements for the regulatory and supervisory functions. These are in any case likely to be influenced by particular national traditions and concerns. What is emphasized is that the quality and effectiveness of prudential regulation and supervision must be improved. Insulation from political and private special interests is a key, along with adequate and highly competent staffing. That implies adequate funding. The precise role and extent of the central bank with respect to regulation and supervision is not defined, and is likely to vary country by country. There is, however, a strong consensus that central banks should accept a continuing role in promoting and maintaining financial stability, not just in times of crisis, but in anticipating and dealing with points of vulnerability and risk. The Report deals with many more specific issues cutting across all institutions and financial markets. These include institutional and regulatory standards for governance and risk management, an appropriate accounting framework (including common international standards), reform of credit rating agencies, and appropriate disclosure and transparency standards for derivatives and securitized credits. Specifically, the Report calls for ending the hybrid private/public nature of the two very large Government-sponsored mortgage enterprises in the United States. Under the pressure of financial crisis, they have not been able to serve either their public purposes or private stockholders successfully. To the extent the Government wishes to provide support for the residential mortgage market, it should do so by means of clearly designated Government agencies. Finally, I want to emphasize that success in the reform effort, in the context of global markets and global institutions, will require consistency in approach among countries participating significantly in international markets. There are established fora for working toward such coordination. I trust the forthcoming G-20 meeting, bringing together leaders of so many relevant nations, can provide impetus for thoughtful and lasting reform. ______ CHRG-111hhrg54868--199 Mr. Bachus," And then there are other arguments that you made that I am not sure that most Members, including me, have considered, and that is many of the members were concentrating not only in real estate, which obviously was a major problem, but were also concentrating in California, those institutions that failed. And that was just as Atlanta--the other earlier conversations--Atlanta was a boom area, and your institutions happened to be in those areas that went up very fast and came down very fast. Ms. Waters. Thank you very much, Mr. Bachus. I will recognize myself for 5 minutes. Let me thank our panelists for being here today. Thank you for your patience. I would like very much to talk about the Consumer Finance Protection Agency, and I would also like to talk about the plight of small banks and regional banks, but I don't have enough time to do so. So I have decided that I am going to spend some time talking about the plight of minority banks, and before I do that, let the record show that my husband is an investor in a minority institution, and also let me disclose for the record that our broker, Merrill Lynch, has been taken over by a systemically important bank, the Bank of America. So I guess I better disclose that also. Now, having said that, the OTS and the FDIC are required to provide assistance to minority-owned banks under section 308 of FIRREA. The law requires banking regulators to preserve the present number of minority banks; preserve the minority character--or preserve the minority character of these banks in cases involving mergers or acquisitions of minority banks; provide technical assistance to prevent the insolvency of institutions that are not currently insolvent; promote and encourage the creation of new minority banks; and provide the training, technical assistance and education programs. The Federal Reserve and the OCC are not statutorily required to assist minority-owned banks, but you do have policies and programs to assist minority-owned banks. This appears to me to be opportunities that may be missed. Given what I have just read, what I have just indicated, I don't understand what you do to assist minority-owned banks in the ways that are described by law. And I would like to ask each of you if you could tell me if this is an area that perhaps you would just like to improve, if you haven't done a lot, or that you have done a lot, and I just don't know about it. I will start with Ms. Sheila Bair. Ms. Bair. We have an annual conference for minority depository institutions. We bring together technical experts and sources of capital investment, regulators speak, and we provide technical assistance. We have a program at Historically Black Colleges to help train bank management and to support careers with minority depository institutions. In terms of a resolution function, again, the resolution process is governed by Prompt Corrective Action, which is triggered by capital levels at banks, and is a very strict process. There is not a lot of flexibility there. Ms. Waters. What do you do to promote and encourage the creation of new minority banks? Ms. Bair. We don't charter banks, but as part of the deposit insurance application process, we would weigh heavily in the balance of serving unmet needs in particular communities. We have had a few minority depository institution (MDI) failures and have actively recruited other MDIs to bid. We let them know about these situations. Acting Director Bowman and I personally intervened with Dwelling House in Pittsburgh to try to stabilize the situation and made some calls, and unfortunately we couldn't find an MDI acquirer. But it is something I have a personal interest in and a commitment to. And certainly if there are other ways we should be addressing this, I would be open to suggestions. Ms. Waters. I would like to know--while I am talking with you, let me talk a little bit about the opportunities that are being created as you dissolve and take over banks. You have some way by which you are selling off or asking the management of assets of those banks. You have other things that you are doing. Is there anything included in your efforts to include minority-owned banks in any way? Ms. Bair. Well, if there is a minority depository institution that will be closed, our resolution staff will get on the phone and actively recruit other minority depository institutions and ask them to review the institution to bid. I think there were two situations where we had an MDI failure and were able to sell it to another MDI. Ms. Waters. What about nonminority-owned banks that are being taken over? How do you outreach to banks or organizations that would like to take over failed banks? Ms. Bair. Well, I personally have had several meetings with those who have a particular interest in investing in MDIs. As part of our preresolution marketing process, we actively reach out to other MDIs to bid on MDIs that are going to fail. Somewhat related, we also have a good contractor outreach program. We have a very good record on minority contractors. Through a variety of outreach tools, we do have a strong commitment in this area. And again, if there are other things we can do, I would be open to suggestions. Ms. Waters. I think I have heard you talk about this before. This week we have the annual legislative conference of the Black Caucus in town, and we have money managers and minorities and financial services, various financial service organizations, and this is the number one topic because of the bailout, because of the $700-and-what billion that the citizens have made available to save the financially--the systemically important institutions. Minorities are complaining about a lack of involvement and opportunities across-the-board, from the Treasury to the FDIC to--you name it, and I just wish we had something to tell them this weekend. Ms. Bair. Congresswoman, we do have a good record. I have gotten a lot of positive feedback on our programs. If there are individuals who are complaining that they don't think there is appropriate access or education, I would like to know that, because I have gotten a lot of good feedback about our programs, and I think we have a very good story to tell on our minority contracts. We are happy to give those numbers to you. Again, if there are other things we can be doing, we are open to suggestions, but I have gotten a lot of positive feedback on our outreach efforts. " CHRG-111hhrg56766--10 The Chairman," I thank the gentleman from North Carolina. The gentleman from North Carolina will have 2 minutes and 10 seconds. The gentleman from Texas is now recognized, the ranking member of the Subcommittee on Domestic and International Monetary Policy, for 3 minutes. Dr. Paul. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am interested in the suggestion that Mr. Volcker has made recently about curtailing some of the investment banking risk they are taking. In many ways, I think he brings up a very important subject and touches on it, but I think it is much bigger than what he has addressed. Back when we repealed Glass-Steagall, I voted against this, even though as a free market person, I endorse the concept that banks ought to be allowed to do commercial and investment banking. The real culprit, of course, is the insurance, the guarantee behind this, and the system of money that we have. In a free market, of course, the insurance would not be guaranteed by the taxpayers or by the Federal Reserve creating more money. The FDIC is an encouragement of moral hazard as well. I think the Congress contributes to this by pushing loans on individuals who do not qualify, and I think the Congress has some responsibility there, too. I also think there has been a moral hazard caused by the tradition of a line of credit to Fannie Mae and Freddie Mac and this expectation of artificially low interest rates helped form the housing bubble, but also the concept still persists, even though it has been talked about, that it is too-big-to-fail. It exists and nobody is going to walk away. There is always this guarantee that the government will be there along with the Federal Reserve, the Treasury, and the taxpayers to bail out anybody that looks like it is going to shake it up. It does not matter that the bad debt and the burden is dumped on the American taxpayer and on the value of the dollar, but it is still there. ``Too-big-to-fail'' creates a tremendous moral hazard. Of course, the real moral hazard over the many decades has been the deception put into the markets by the Federal Reserve creating artificially low interest rates, pretending there has been savings, pretending there is actually capital out there, and this is what causes the financial bubbles, and this is the moral hazard because people believe something that is not true, and it leads to the problems we have today because it is unsustainable. It works for a while, but eventually, we have to pay the price. The moral hazard catches up with us and then we see the disintegration of the system that we have artificially created. We are in a situation coming up soon, even though we have been already in a financial crisis, we are going to see this get much worse and we are going to have to address this subject of the monetary system and whether we want to have a system that does not guarantee that we will always bail out all the banks and dump these bad debts on the people, and that it is filled with moral hazard, the whole system is. When that time comes, I hope we come to our senses and decide that the free market works pretty well. It gets rid of these problems much sooner and much smoother than when it becomes politicized that some firms get bailed out and others get punished. It is an endless battle. Hopefully, we will see the light and do a better job in the future. " CHRG-110hhrg46591--283 Mr. Yingling," I would agree with that. In the dual banking system, the diversity of charters has been critical. It is one area where we differ from some other countries. One of the advantages of it is that there is much more lending and capital available to small businesses and to entrepreneurs in this country because we have such a diverse system. I think another thing--and this committee has worked hard on it--is to recognize that when you pass rules designed to solve a problem, that they quite often apply most heavily to your analogy that did not cause the problem. One of the really big problems for community banks, and it may be the biggest problem in competing today, is just the huge regulatory burden. There are great economies of scale in dealing with these regulations, and the small banks just cannot deal with that. " CHRG-111hhrg48867--210 Mr. Plunkett," I would say empower prudential regulators to stop these problems before they start through better product-level regulation to prevent risk from being created, first and foremost. Ms. Jorde. And I would add to expand regulation to cover non-bank financial firms, which really have been largely outside the banking regulatory system, even those subsidiaries of banks that were regulated from the banking side but not the non-bank side. " CHRG-111shrg53085--213 PREPARED STATEMENT OF GAIL HILLEBRAND Financial Services Campaign Manager, Consumers Union of United States, Inc., March 24, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate the opportunity to testify on behalf of Consumers Union, the nonprofit publisher of Consumer Reports, \1\ on the important topic of reforming and modernizing the regulation and oversight of financial institutions and financial markets in the United States.--------------------------------------------------------------------------- \1\ Consumers Union of United States, Inc., publisher of Consumer Reports and Consumer Reports Online, is a nonprofit membership organization chartered in 1936 to provide consumers with information, education, and counsel about goods, services, health and personal finance. Consumers Union's print and online publications have a combined paid circulation of approximately 8.5 million. These publications regularly carry articles on Consumers Union's own product testing; on health, product safety, financial products and services, and marketplace economics; and on legislative, judicial, and regulatory actions that affect consumer welfare. Consumers Union's income is solely derived from the sale of Consumer Reports, its other publications and services, and noncommercial contributions, grants, and fees. Consumers Union's publications and services carry no outside advertising and receive no commercial support. Consumers Union's mission is ``to work for a fair, just, and safe marketplace for all consumers and to empower consumers to protect themselves.'' Our Financial Services Campaign engages with consumers and policymakers to seek strong consumer protection, vigorous law enforcement, and an end to practices that impede capital formation for low and moderate income households.---------------------------------------------------------------------------Introduction and Summary The job of modernizing the U.S. system of financial markets oversight and financial products regulation will involve much more than the addition of a layer of systemic risk oversight. The regulatory system must provide for effective household risk regulation as well as systemic risk regulation. Regulators must exercise their existing and any new powers more vigorously, so that routine, day to day supervision becomes much more effective. Gaps that allow unregulated financial products and sectors must be closed. This includes an end to unregulated status for the ``shadow'' financial sector. Regulators must place a much higher value on the prevention of harm to consumers. This new infrastructure, and the public servants who staff it, must protect individuals as consumers, workers, small business owners, investors, and taxpayers. A reformed financial regulatory structure must include: Strong consumer protections to reduce household risk; A changed regulatory culture; A federal agency independent of the banking industry that focuses on the safety of consumer financial products; An active role for state consumer protection; Credit reform leading to suitable and sustainable credit; An approach to systemic risk that includes systemic oversight addressing more than large financial institutions, stronger prudential regulation for risk, and closing regulatory gaps; and Increased accountability by all who offer financial products.1. Strong, effective, preventative consumer protection can reduce systemic risk Proactive, affirmative consumer protection is essential to modernizing financial system oversight and to reducing risk. The current crisis illustrates the high costs of a failure to provide effective consumer protection. The complex financial instruments that sparked the financial crisis were based on home loans that were poorly underwritten; unsuitable to the borrower; arranged by persons not bound to act in the best interest of the borrower; or contained terms so complex that many individual homeowners had little opportunity to fully understand the nature or magnitude of the risks of these loans. The crisis was magnified by highly leveraged, largely unregulated financial instruments and inadequate risk management. The resulting crisis of confidence led to reduced credibility for the U.S. financial system, gridlocked credit markets, loss of equity for homeowners who accepted nonprime mortgages and for their neighbors who did not, empty houses, declining neighborhoods and reduced property tax revenue. All of this started with a failure to protect consumers. Effective consumer protection is a key part of a safe and sound financial system. As FDIC Chairman Bair testified before this Committee, ``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.'' \2\--------------------------------------------------------------------------- \2\ Bair, Sheila C., Chairman, Federal Deposit Insurance Corporation, Testimony before the Senate Committee on Banking, Housing and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009, http://www.fdic.gov/news/news/speeches/chairman/spmar0319.html.--------------------------------------------------------------------------- Effective consumer protection will require: Changing the regulatory culture so that every existing federal financial regulatory agency places a high priority on consumer protection and the prevention of consumer harm; Creating an agency charged with requiring safety in financial products across all types of financial services providers (holding concurrent jurisdiction with the existing banking agencies); and Restoring to the states the full ability to develop and enforce consumer protection standards in financial services.2. A change in federal regulatory culture is essential Consumer advocates have long noted that federal banking agencies give insufficient attention to achieving effective consumer protection. \3\ Perhaps this stems partly from undue confidence in the regulated industry or an assumption that problems for consumers are created by just a few ``bad apples.'' One federal bank regulator has even attempted to weaken efforts by another federal agency to protect consumers from increases in credit card interest rates on funds already borrowed. \4\ Consumers Union believes that federal banking regulators have placed too much confidence in the private choices of bank management and too much unquestioning faith in the benefits of financial innovation. Too often, the perceived value of financial innovation has not been weighed against the value of preventing harm to individuals. The Option ARM, as sold to a broad swath of ordinary homeowners, has shown that the harm from some types and uses of financial services innovation can far outweigh the benefits.--------------------------------------------------------------------------- \3\ Improving Federal Consumer Protections in Financial Services, Testimony of Travis Plunkett, before the Committee on Financial Services of the U.S. House of Representatives, July 25, 2007, available at http://www.consumerfed.org/pdfs/Financial_Services_Regulation_House_Testimony_072507.pdf. \4\ The OCC unsuccessfully asked the Federal Reserve Board to add significant exemptions to the Fed's proposed rule to limit the raising of interest rates on existing credit card balances. See the OCC's comment letter: http://www.occ.treas.gov/foia/OCC%20Reg%20AA%20Comment%20Letter%20to%20FRB_8%2018%2008.pdf.--------------------------------------------------------------------------- We need a fundamental change in regulatory culture at most of the federal banking regulatory agencies. Financial regulators must place a much higher value on preventing harm to individuals and to the public. Comptroller Dugan's testimony to this Committee on March 19, 2009, may have unintentionally illustrated the regulatory culture problem when he described the ``sole mission'' of the OCC as ``bank supervision.'' \5\--------------------------------------------------------------------------- \5\ The Comptroller stated: ``Most important, moving all supervision to the Board would lose the very real benefit of having an agency whose sole mission is bank supervision. That is, of course, the sole mission of the OCC . . . '' Dugan, John C., Comptroller of the Currency, Testimony before the Senate Committee on Banking, Housing and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009, p.11, available at: http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=494666d8-9660-439f82fa-b4e012fe9c0f&Witness_D=845ef046-9190-4996-8214-949f47a096bd. Other parts of the testimony indicate that the Comptroller was including compliance with existing consumer laws within ``supervision.''--------------------------------------------------------------------------- The purpose of this hearing is to build for a better future, not to assign blame for the current crisis. However, the missed opportunities to slow or stop the products and practices that led to the current crisis should inform the decisions about the types of changes needed in future regulatory oversight. Consumer groups warned federal banking agencies about the harms of predatory practices in subprime lending long before it exploded in volume. For example, Consumers Union asked the Federal Reserve Board in 2000 to reinterpret the triggers for the application of the Home Ownership and Equity Protection Act (HOEPA) in a variety of ways that would have expanded its coverage. \6\ Other consumer groups, such as the National Consumer Law Center, had been seeking similar reforms for some time. In the year 2000, the New York Times reported on how securitization was fueling the growth in subprime loans with abusive features. \7\ While the current mortgage meltdown involves practices in loan types beyond subprime and high cost mortgages, we will never know if stamping out some of the abusive practices that consumer advocates sought to end in 2000 would have prevented more of those practices from spreading.--------------------------------------------------------------------------- \6\ Garcia, Norma Paz, Senior Attorney, Consumers Union, Testimony before the Federal Reserve Board of Governors regarding Predatory Lending Practices, Docket No. R-1075, San Francisco, CA, September 7, 2000, available at: www.defendyourdollars.org/2000/09/cus_history_of_against_predato.html. In that testimony, Consumers Union asked the Federal Reserve Board to adjust the HOEPA triggers to include additional costs within the points and fees calculation, which would have brought more loans under the basic HOEPA prohibition on a pattern or practice of extending credit based on the collateral--that is, that the consumer is not expected to be able to repay from income. We also asked the Board to issue a maximum debt to income guideline to further shape industry practice in complying with the affordability standard. \7\ Henriques, D., and Bergman, L., Mortgaged Lives: A Special Report.; Profiting from Fine Print with Wall Street's Help, New York Times, March 20, 2000, available at: http://www.nytimes.com/2000/03/15/business/mortgagedlives-special-report-profiting-fine-print-with-wall-street-s-help.html.--------------------------------------------------------------------------- Some have claimed that poor quality loans and abusive lender practices were primarily an issue only for state-chartered, solely state-overseen lenders, but the GAO found that a significant volume of nonprime loans were originated by banks and by subsidiaries of nationally chartered banks, thrifts or holding companies. The GAO analyzed nonprime originations for 2006. That report covers the top 25 originators of nonprime loans, who had 90 percent of the volume. The GAO report shows that the combined nonprime home mortgage volume of all banks and of subsidiaries of federally chartered banks, thrifts, and bank holding companies actually exceeded the nonprime origination volume of independent lenders subject only to state oversight. The GAO reported these volumes for nonprime originations: $102 billion for all banks, $203 billion for subsidiaries of nationally chartered entities, and $239 billion for independent lenders. Banks had a significant presence, and subsidiaries of federally chartered entities had a volume of nonprime originations nearly as high as the volume for state-only-supervised lenders. \8\--------------------------------------------------------------------------- \8\ Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO 09-216, January 2009, at 24, available at: http://www.gao.gov/new.items/d09216.pdf.--------------------------------------------------------------------------- It is too easy for a bank regulator to see its job as complete if the bank is solvent and no laws are being violated. The current crisis doesn't seem to have brought about a fundamental change in this regulatory perspective. Comptroller Dugan told this Committee just last week: ``Finally, I do not agree that the banking agencies have failed to give adequate attention to the consumer protection laws that they have been charged with implementing.'' \9\ Clearly, the public thinks that bank regulation has failed. Homeowners in distress, as well as their neighbors who are suffering a loss in home values, think that bank regulation has failed. Taxpayers who are footing the bill for the purchase of bank capital think that bank regulation has failed.--------------------------------------------------------------------------- \9\ Dugan, John C., Comptroller of the Currency, Testimony before the Senate Committee on Banking, Housing, and Urban Affairs. U.S. Senate, March 19, 2009. p 11, available at: http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=494666d8-9660-439f82fa-b4e012fe9c0f&Witness_ID=845ef046-9190-4996-8214-949f47a096bd.---------------------------------------------------------------------------3. Consumers need a Financial Product Safety Commission (FPSC) The bank supervision model lends itself to the view that the regulator's job is finished if existing laws are followed. Unfortunately, a compliance-focused mentality leaves no one with the primary job of thinking about how evolving, perhaps currently legal, business practices and product features may pose undue harm to consumers. A strong Financial Product Safety Commission can fill the gap left by compliance-focused bank regulators. The Financial Product Safety Commission would set a federal floor for consumer protection without displacing stronger state laws. It would essentially be an ``unfair practices regulator'' for consumer credit, deposit and payment products. \10\ Investor protection would remain elsewhere. \11\--------------------------------------------------------------------------- \10\ Payment products include prepaid cards, which increasingly are marketed as account substitutes, including to the unbanked. For a discussion of the holes in current consumer law with respect to these cards, see: G. Hillebrand, Before the Grand Rethinking, 83 Chicago-Kent L. Rev. No. 2, 769 (2008), available at: http://www.consumersunion.org/pdf/WhereisMyMoney08.pdf. Consumers Union and other consumer and community groups asked the Federal Reserve Board to expand Regulation E to more clearly cover these cards, including cards on which unemployment benefits are delivered, in 2004. Consumer Comment letter to Federal Reserve Board in Docket R-1210, October 24, 2004, available at: http://www.consumersunion.org/pdf/payroll1004.pdf. That protection is still lacking. In February 2009, the Associated Press reported on consumer difficulties with the use of prepaid cards to deliver unemployment benefits. Leonard, C., Jobless Hit with Bank Fees on Benefits, Associated Press, Feb. 19, 2009. \11\ Investor protection has long been important to Consumers Union. In May 1939, Consumer Reports said: ``I know it is quite impossible for the average investor to examine and judge the real security that stands behind mere promises of security, and that unless one has expert knowledge and disinterested judgment available, he must shun all such plans, no matter how attractive they seem. We cannot wait for the next depression to tell us that these financial plans--appealing and reasonable in print--failed and created such widespread havoc, not because of the depression, but because they were not safeguarded to weather a depression.''--------------------------------------------------------------------------- The Financial Product Safety Commission would not remove the obligation on existing regulators to ensure compliance with current laws and regulations. Instead, the Commission would promulgate rules that would apply regardless of the chartering status of the product provider. This would insulate consumers from some of the harmful effects of ``charter choice,'' because chartering would be irrelevant to the application of rules designed to minimize unreasonable risks to consumers. Only across the board standards can eliminate a ``race to the bottom'' in consumer protection. Without endorsing the FPSC, FDIC Chairman Bair has emphasized the need for standards that apply across types of providers of financial products, stating: 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. \12\--------------------------------------------------------------------------- \12\ Bair, Sheila C., Chairman, Federal Deposit Insurance Corporation, Testimony before the Committee on Banking, Housing, and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009. The Financial Product Safety Commission is part of a larger shift we must make in consumer protection to move away from failed ``disclosure-only'' approaches. Financial products which are too complex for the intended consumer carry special risks that no amount of additional disclosure or information will fix. Many of the homeowners who accepted predatory mortgages did not understand the nature of their loan terms. The over 60,000 individuals who filed comments in the Federal Reserve Board's Regulation AA docket on unfair or deceptive credit card practices described many instances in which they experienced unfair surprise because the fine print details of the credit arrangement did not match their understanding of the product that they were currently using. The Financial Product Safety Commission can pay special attention to practices that make financial products difficult for consumers to use safely.4. State power to protect financial services consumers, regardless of the chartering of the financial services provider, must be fully restored The Financial Product Safety Commission would set a federal floor, not a federal cap, on consumer protection in financial services products. No agency can foresee all of the potentially harmful consequences of new practices and products. A strong concurrent role for state law and state agencies is essential to provide more and earlier enforcement of existing standards and to provide places to develop new standards for addressing emerging practices. Harmful financial practices often start in one region or are first targeted to one subgroup of consumers. When those practices go unchallenged, others feel a competitive pressure to adopt similar practices. State legislatures should be in a unique position to spot and stop bad practices before they spread. However, federal preemption has seriously compromised the ability of states to play this role. Some might ask why states can't just regulate state-chartered entities, while federal regulators address the conduct of federally chartered entities. There are several reasons. First, federal bank regulators aren't well-suited to address conduct issues of operating subsidiaries of national banks in local and state markets. Second, assertions of federal preemption for nationally chartered entities and their subsidiaries interfere with the ability of states to restrict the conduct of state-chartered entities. The reason for this is simple: if national financial institutions or their operating subsidiaries have a sizable percentage of any market, this creates a barrier to state reforms applicable only to state-only entities. The state-chartered entities argue strongly against the reforms on the grounds that their direct competitors would be exempt. As FDIC Chairman Bair told the Committee on March 19, 2009: Finally, in the ongoing 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. \13\--------------------------------------------------------------------------- \13\ Bair, Sheila C., Chairman, Federal Deposit Insurance Corporation. Testimony before the Senate Committee on Banking, Housing, and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009. The Home Owners' Loan Act stymies application of state consumer protection laws to federally chartered thrifts due to its field preemption, which should be changed by statute. State standards for lender conduct and state enforcement against national banks and their operating subsidiaries have been severely compromised by the OCC's preemption rules and operating subsidiary rule. \14\ The OCC has even taken the position that state law enforcement cannot investigate violations of non-preempted state laws against a national bank or its operating subsidiaries. \15\ That latter issue is now pending in the U.S. Supreme Court.--------------------------------------------------------------------------- \14\ In 2004, the Office of the Comptroller of the Currency promulgated regulations to preempt state laws, state oversight, and consumer enforcement in the broad areas of deposits, real-estate loans, non-real estate loans, and the oversight of operating subsidiaries of national banks. 12 CFR 7.4000, 7.4007, 7.4008, 7.4009, and 34.4. These regulations interpret portions of the National Bank Act that consumer advocates believe were designed to prevent states from imposing harsher conditions on national banks than on state banks, not to give national banks an exemption from state laws governing financial products and services. The OCC has repeatedly sided in court with banks seeking to invalidate state consumer protection laws. One example is the case of Linda A. Watters, Commissioner, Michigan Office of Insurance and Financial Services v. Wachovia Bank, N.A., 550 U.S. 1 (2007). The OCC filed an amicus brief in support of Wachovia in the United States Supreme Court to prevent Michigan from regulating the practices of a Wachovia mortgage subsidiary. The OCC argued that its regulations and the National Bank Act preempt state oversight and enforcement and prevented state mortgage lending protections from applying to a national bank's operating subsidiary. The Supreme Court then held that Michigan's licensing, reporting, and investigative powers were preempted. Wachovia is no longer in business, and many observers attribute that to its mortgage business. \15\ In Office of the Comptroller of the Currency v. Spitzer, 396 F. Supp. 2d 383 (S.D.N.Y., 2005), aff'd in part, vacated in part on other grounds and remanded in part on other grounds sub nom. The Clearing House Ass'n v. Cuomo, 510 F.3d 105 (2d Cir., 2007), cert. granted, Case No. 08-453, New York's Attorney General sought to investigate whether the residential mortgage lending practices of several national banks doing business in New York were racially discriminatory because the banks were issuing high-interest home mortgage loans in significantly higher percentages to African-American and Latino borrowers than to White borrowers. The OCC and a consortium of national banks sued to prevent the Attorney General from investigating and enforcing the anti-discrimination and fair lending laws against national banks. The OCC claimed that only it could enforce these state laws against a national bank. The district court granted declaratory and injunctive relief, and the Second Circuit affirmed. (See http://www.ca2.uscourts.gov:8080/isysnative/RDpcT3BpbnNcT1BOXDA1LTU5OTYtY3Zfb3BuLnBkZg==/055996-cv_opn.pdf.) The case is now being briefed in the U.S. Supreme Court.--------------------------------------------------------------------------- The OCC is an agency under the U.S. Treasury Department. The Administration should take immediate steps to repeal the OCC's package of preemption and visitorial powers rules. \16\ This would remove the agency's thumb from the scale as courts determine the meaning of the National Bank Act. Further, because the OCC's broad view of preemption has influenced the Courts' views on the scope of preemption under the National Bank Act, Congress should amend the National Bank Act to make it crystal clear that state laws requiring stronger consumer protections for financial services consumers are not preempted; state law enforcement is not ``visitation'' of a national bank; and any visitorial limitation has no application to operating subsidiaries of national banks.--------------------------------------------------------------------------- \16\ Those rules are 12 CFR 7.4000, 7.4007, 7.4008, 7.4009, and 34.4.--------------------------------------------------------------------------- Once the preemption barrier is removed, state legislation can provide an early remedy for problems that are serious for one subgroup of consumers or region of the country. State legislation can also develop solutions that may later be adopted at the federal level. Prior to the overbroad preemption rules, as well as in the regulation of credit reporting agencies which falls outside of OCC preemption, states have pioneered such consumer protections as mandatory limits on check hold times, the free credit report, the right to see the credit score, and the security freeze for use by consumers to stop the opening of new accounts by identity thieves. \17\ Congress later adopted three of these four developments into statute for the benefit of consumers nationwide.--------------------------------------------------------------------------- \17\ The first two of these developments were described by Consumers Union in its comment letter to the OCC opposing its broad preemption rule before adoption. Consumers Union letter of Oct. 1, 2003, in OCC Docket 03-16, available at: http://www.consumersunion.org/pub/core_financial_services/000770.html. The free credit report and the right to a free credit score if the score is used in a home-secured loan application process were both made part of the FACT Act. For information on the security freeze, which is available in 46 states by statute and the remaining states through an industry program, see: http://www.consumersunion.org/campaigns//learn_more/003484indiv.html.---------------------------------------------------------------------------5. Credit reform can provide access to suitable and sustainable credit Attempts to protect consumers in financial services are often met with assertions that protections will cause a reduction in access to credit. Consumers Union disputes the accuracy of those assertions in many contexts. However, we also note that not every type of credit is of net positive value to consumers. For example, the homeowner with a zero interest Habitat for Humanity loan who was refinanced into a high cost subprime mortgage would have been much better off without that subprime loan. \18\ The same is true for countless other homeowners with fixed rate, fully amortizing home loans who were persuaded to refinance into loans that contained rate resets, balloon payments, Option ARMs, and other adverse features of variable rate subprime loans.--------------------------------------------------------------------------- \18\ Center for Responsible Lending founder Martin Eakes described this homeowner as the reason he become involved in anti-predatory lending work in a speech to the CFA Consumer Assembly.--------------------------------------------------------------------------- Creating access to sustainable credit will require substantial credit reform. This will have to include steps such as: outlawing pricing structures that mislead; requiring underwriting to the highest rate the loan payment may reach; requiring that the ``shelter rule'' which ends purchaser responsibility for problems with the loan be waived by the purchaser of any federally related mortgage loan; requiring borrower income to be verified; ending complex pricing structures that obscure the true cost of the loan; requiring suitability and fiduciary duties; and ending steering payments and negative amortization abuses.6. Systemic risk regulation, prudential risk regulation, and closing regulatory gapsA. Scope of systemic risk regulation There has been discussion about whether the systemic risk regulator should focus on institutions which are ``too big to fail.'' Federal Reserve Board Chairman Bernanke has noted that the incentives, capital requirements, and other risk management requirements must be tight for any institution so large that its failure would pose a systemic risk. \19\--------------------------------------------------------------------------- \19\ Bernanke, Ben S., Chairman, Federal Reserve Board. Speech to the Council on Foreign Relations. Washington, DC, March 10, 2009, available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm#f4.--------------------------------------------------------------------------- FDIC Chairman Bair's recent testimony posed the larger question about whether any value to the economy of extremely large and complex financial institutions outweighs the risk to the system should such institutions fail, or the cost to the taxpayer if policymakers decide that these institutions cannot be permitted to fail. Consumers Union suggests that one goal of systemic risk regulation should be to internalize to large and complex financial market participants the costs to the system that the risks created by their size and complexity impose on the financial system. ``Too big to fail'' institutions either have to become ``smaller and less complex'' or they have to become ``too strong to fail'' despite their size and complexity--without future expectations of public assistance. There are many ideas in development with respect to what a systemic risk oversight function would entail, who should perform it, and what powers it should have. Systemic risk oversight should focus on protecting the markets, not specific financial institutions. Systemic risk oversight probably cannot be limited to the largest firms. It will have to also focus on practices used by bank and nonbank entities that create or magnify risk through interdependencies with both insured depository institutions and with other entities which hold important funds such as retirement savings and the money to fund future pensions. The mortgage crisis has shown that a nonfinancial institution, such as a rating agency or a bond insurer, can adopt a practice that has consequences throughout the entire financial system. Toxic mortgage securitizations which initially received solid gold ratings are an example of the widespread consequences of practices of nonfinancial institutions.B. Who should undertake the job of systemic risk regulation? There are many technical questions about the exact structure for a systemic risk regulator and its powers. Like other groups, Consumers Union looks forward to learning from the debate. Accordingly we do not offer a recommendation as between giving the job to the Federal Reserve Board, the Treasury, the FDIC, the new agency, or to a panel, committee, or college of regulators. However, we offer the following comments on some of the proposal. We agree with the proposition put forth by the AFL-CIO that the systemic risk regulator should not be governed by, or do its work through, any body that is industry-dominated or uses a self-regulatory model. We question whether the same agency should be responsible for both ongoing prudential oversight of bank holding companies and systemic risk oversight involving those same companies. If part of the idea of the systemic risk regulator is a second pair of eyes, that can't be accomplished if one regulator has both duties for a key segment of the risk-producers. The panel or committee approach has other problems. A panel made up of multiple regulators would be composed of persons who have a shared allegiance to the systemic risk regulator and to another agency. It could become a forum for time-wasting turf battles. In addition, systemic risk oversight should not be a part-time job. We also are concerned with the proposal made by some industry groups that the systemic risk regulator be limited in most cases to acting through or with the primary regulator. This could recreate the type of cumbersome and slow interagency process that the GAO discussed in the context of mortgage regulation. \20\--------------------------------------------------------------------------- \20\ Government Accountability Office. Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, January 2009, GAO 09-216, p. 43, available at: http://www.gao.gov/new.items/d09314t.pdf.--------------------------------------------------------------------------- Consumers Union supports a clear, predictable, rules-based process for overseeing the orderly resolution of nondepository institutions. However, it is not clear that the systemic risk regulator should oversee the unwinding. That job could be given to the FDIC, which has deep experience in resolving banks. Assigning the resolution job to the FDIC might leave the systemic risk regulator more energy to focus on risk, rather than the many important details in a well-run resolution.C. Relationship of systemic risk regulation to stronger across the board prudential regulation and to closing regulatory gaps Federal financial regulators must have new powers and new obligations. How much of the job is assigned to the systemic risk regulator may depend in part on how effectively Congress and the regulators close existing loopholes and by how much the regulators improve the quality and sophistication of day to day prudential regulation. For example, if the primary regulator sees and considers all liabilities, including those now treated as off-balance sheet, that will change what remains to the done by the systemic oversight body. Thus, each of the powers described in the next subsection for a systemic risk regulator should also be held, and used, by primary prudential regulators. The more effectively they do so, the more the systemic risk regulator will be able to focus on new and emerging practices and risks. Closing the gaps that have allowed some entities to offer financial products, impose counterparty risk on insured institutions, engage in bank-like activities, or otherwise impinge on the health of the financial system without regulation is at least as important, if not more important, than the creation and powers of a systemic risk regulator. Gaps in regulation must be closed and kept closed. Gaps can permit small corners of the law to become safe harbors from the types of oversight applicable to similar practices and products. The theory that some investors don't require protection, due to their level of sophistication, has been proved tragically wrong for those investors, with adverse consequences for millions of ordinary people. The conduct of sophisticated investors and the shadow market sector contributed to the crisis of confidence and thus to the credit crunch. The costs of that crunch are being paid, in part, by individuals facing tighter credit limits and loss of jobs as their employers are unable to get needed business credit.D. Powers of a systemic risk regulator Consumers Union suggests these powers for a systemic risk regulator. Other powers may also be needed. As already discussed, we also believe that the primary regulator should be exercising all or most of these powers in its routine prudential supervision. Power to set capital, liquidity, and other regulatory requirements directly related to risk and risk management: It is essential to ensuring that all the players whose interconnections create risk for others in the financial system are well capitalized and well-managed for risk. Power to act by rule, corrective action, information, examination, and enforcement: The systemic risk regulator must have the power to act with respect to entities or practices that pose systemic risk, including emerging practices that could fall in this category if they remain unchecked. This should include the power to require information, take corrective action, examine, order a halt to specific practices by a single entity, define specific practices as inappropriate using a generally applicable rule, and engage in enforcement. Power to publicize: The recent bailout will be paid for by U.S. taxpayers. Even if some types of risks might have to be handled quietly at some stages of the process, the systemic risk regulator must have the power and the obligation to make public the nature of too-risky practices, and the identities of those who use those practices. Power and obligation to evaluate emerging practices, predict risks, and recommend changes in law: Even the best-designed set of regulations can develop unintended loopholes as financial products, practices and industry structure change. Part of the failure of the existing regulatory structure has been that financial products and practices regularly outpace existing legal requirements, so that new products fit into regulatory gaps. For this reason, every financial services regulator, including the systemic risk regulator, should be required to make an annual, public evaluation of emerging practices, the risks that those emerging practices may pose, and any recommendations for legislation or regulation to address those practices and risks. Power to impose receivership, conservatorship, or liquidation on an entity which is systemically important, for orderly resolution: Consumers Union agrees with many others who have endorsed developing a method for predictable, orderly resolution of certain types of nonbank entities. There will have to be a required insurance premium, paid in advance, for the costs of resolution. Such an insurance program is unlikely to work if it is voluntary, since those engaged in the riskiest practices might also be those least likely to choose to opt in to a voluntary insurance system. Undermining of confidence from a power to modify or suspend accounting requirements: Some have recommended that the systemic risk regulator be given the power to suspend, or modify the implementation of, accounting standards. Consumers Union believes that this could lead to a serious undermining of confidence. As the past year has shown, confidence is an essential element in sustaining financial markets.7. Promoting increased accountability Consumers Union strongly agrees with President Obama's statement that market players must be held accountable for their actions, starting at the top. \21\ There are many elements to accountability. Here is a nonexclusive list.--------------------------------------------------------------------------- \21\ Overhaul, post to the White House blog on Feb. 25, 2009, available at http://www.whitehouse.gov/blog/09/02/25/Overhaul/.--------------------------------------------------------------------------- Consumers Union believes that accountability must include making every entity receiving a fee in connection with a financial instrument responsible for future problems with that instrument. This would help to end the ``keep the fee, pass the risk'' phenomenon which helped to fuel poor underwriting of nonprime mortgages. Moreover, everyone who sells a financial product to an individual should have an enforceable legal obligation to ensure that the product is suitable. Likewise, everyone who advises individuals about financial products should have an enforceable fiduciary duty to those individuals. Executive compensation structures should be changed to avoid overemphasis on short term returns rather than the long term health and stability of the financial institution. We also agree with the recommendation which has been made by regulators that they should engage in a thorough review of regulatory rules to identify any rules which may permit or encourage overreliance on ratings or risk modeling. Consumers Union also supports more accountability for financial institutions who receive public support. Companies that choose to accept taxpayer funds or the benefit of taxpayer-backed programs or guarantees should be required to abandon anti-consumer practices and be held to a high standard of conduct. \22\--------------------------------------------------------------------------- \22\ For example, in connection with the Consumer and Business Lending Initiative, which is to be managed through the Term Asset Backed Securities Facility (TALF), Consumers Union and 26 other groups asked Secretary Geithner on Jan. 29, 2009, to impose eligibility restrictions on program participants to ensure that the TALF would not support the taxpayer financed purchase of credit card debt with unfair terms. That request was made before the program's size was increased from $200 billion to $1 trillion. http://www.consumersunion.org/pdf/TALF.pdf.--------------------------------------------------------------------------- A stronger role for state law and state law enforcement also will enhance accountability. Regulatory oversight and strict enforcement at all levels of government can stop harmful products and practices before they spread. ``All hands on deck,'' including state legislatures, state Attorneys General and state banking supervisors, will help to enforce existing standards, identify problems, and develop new solutions.Conclusion Even the best possible regulatory structure will be inadequate unless we also achieve a change in regulatory culture, better day to day regulation, an end to gaps in regulation, real credit reform, accountability, and effective consumer protection. Creating a systemic risk regulator without reducing household risk through effective consumer protection would be like replacing the plumbing of our financial system with all new pipes and then still allowing poisoned water into those new pipes. The challenges in regulatory reform and modernization are formidable and the stakes are high. We look forward to working with you toward reforming the oversight of financial markets and financial products.LIST OF APPENDICES 1. General Accountability Office figure showing 2006 nonprime mortgage volume of banks ($102 billion), subsidiaries of nationally chartered financial institutions ($203 billion) and independent lenders ($239 billion). 2. Consumers Union's Principles for Regulatory Reform in Consumer Financial Services. 3. Consumers Union's Platform on Mortgage Reform. Appendix 1 Page 24 from GAO Report, GAO 09-0216, A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System. Also found at: http://www.gao.gov/new.items/d09216.pdf. Appendix 2Consumers Union Principles for Regulatory Reform in Consumer Financial Services 1. Every financial regulatory agency must make consumer protection as important as safety and soundness. The crisis shows how closely linked they are. 2. Consumers must have the additional protection of a Financial Product Safety agency whose sole job is their protection, and whose rules create baseline federal standards that apply regardless of the nature of the provider. This agency would have dual jurisdiction along with the functional regulator. States would remain free to set higher standards. 3. State innovation in financial services consumer protection and state enforcement of both federal and state laws must be honored and encouraged. This will require repeal of the OCC's preemption regulations and its rule exempting operating subsidiaries of national banks from state supervision. The OCC should also immediately cease to intervene in cases, or to file amicus briefs, against the enforceability of state consumer protection laws. 4. Every financial services regulator must have: a proactive attitude to find and stop risky, harmful, or unfair practices; prompt, robust, effective complaint handling for individuals; and an active and public enforcement program. 5. Financial restructuring will be incomplete without real credit reform, including: outlawing pricing structures that mislead; requiring underwriting for the ability to repay the loan at the highest interest rate and highest payment that the loan may reach; a requirement that the ``shelter rule'' that ends most purchaser responsibility for problems with a loan be waived by the purchaser of any federally related mortgage loan; a requirement that borrower income be verified; an end to complex pricing structures that obscure the true cost of credit; suitability and fiduciary duties on credit sellers and credit advisors; and an end to steering payments and negative amortization abuses. Appendix 3Consumers Union Mortgage Reform Platform We need strong new laws to make all loans fair. This should include these requirements for every home mortgage: Require underwriting: Every lender should be required to decide if the borrower will be able to repay the loan and all related housing costs at the highest interest rate and the highest payment allowed under the loan. Lenders should be required to verify all income on the loan application. End complex pricing structures that obscure the true cost of the loan. Brokers and lenders should be required to offer only those types of loans that are suitable to the borrower. Brokers and lenders should have a fiduciary obligation to act in the best interest of the borrower. Stop payments to brokers to place consumers in higher cost loans. End the use of negative amortization to hide the real cost of a loan. Require translation of loan documents into the language in which the loan was negotiated. Hold investors accountable through assignee liability for the loans they purchase. Require that everyone who gets a fee for making or arranging a loan is responsible later if something goes wrong with that loan. Adopt extra protections for higher-cost loans. Restore state powers to develop and enforce consumer protections that apply to all consumers and all providers. For more information, see: http:// www.defendyourdollars.org/topic/mortgages. CHRG-111hhrg53234--2 Chairman Watt," Unfortunately, we have been notified that we will have a series of votes, four or five votes pretty soon, so we are going to try to get as far as we can into the process. I am going to go ahead and get started. Let me call this hearing of the Subcommittee on Domestic Monetary Policy and Technology to order. Without objection, all members' opening statements will be made a part of the record, and I will recognize myself for an opening statement, which I will try to get in before we get called for votes, and maybe we can get the opening statements in before we get the call to the Floor. This hearing is entitled, ``Regulatory Restructuring: Balancing the Independence of the Federal Reserve in Monetary Policy With Systemic Risk Regulation.'' Our current regulatory system, created largely as a response to the Great Depression in the 1930's, has proven ineffective and outdated at preventing and addressing the financial crisis we are currently experiencing. Recognizing this, the President recently put forth a proposal for comprehensive financial regulatory reform. This hearing will examine one aspect of that proposal, the part that proposes to delegate to the Federal Reserve Board new powers, including the power to serve as the systemic risk regulator for all large, interconnected financial firms. As the systemic risk regulator, the Federal Reserve would be empowered to structure and implement a more robust supervisory regime for firms with a combination of size, leverage, and interconnectedness that could pose a threat to financial stability. This hearing will examine whether and how the Fed could perform and balance the proposed new authority as systemic risk regulator with its current critical role as the independent authority on monetary policy. While recent events have caused many to reevaluate and question the role and the extent of independence accorded to the Federal Reserve, the Fed's independence from political influence by the Legislative and Executive Branches of Government has long been viewed as necessary to allow the Fed to meet the long-term monetary policy goals of low inflation, price stability, maximum sustainable employment, and economic growth. Most central banks around the world, including the Federal Reserve, the Bank of England, the Bank of Japan, and the European Central Bank, have had a strong tradition of independence in executing monetary policy. Many scholars and commentators agree that an independent central bank that is free from short-term political influence and exhibits the indicia of independence, such as staggered terms for board members, exemption from the appropriations process, and no requirement to directly underwrite government debt, can better execute the long-term goals of monetary policy. The important question that our hearing today is focused upon is whether the Fed can maintain its current role as the independent authority on monetary policy, and take on a new role, a significantly new role, as the systemic risk regulator. Some scholars and commentators argue that the Fed is uniquely positioned to become the systemic regulator because it already supervises bank holding companies, and through its monetary policy function, helps manage microeconomic policy. Others argue that the Fed is already stretched too thin, and has strayed from its core monetary policy function, particularly by using its powers under section 13(3) of the Federal Reserve Act to purchase securities in distressed industries under existing emergency circumstances. As Congress and the President work to enact financial regulatory reform, it is critical for us to examine carefully the extent to which proposed new rules may conflict with existing roles and whether the Fed can effectively juggle all of these roles while performing its vital function as the Nation's independent authority on monetary policy. For our economy to function effectively, the Fed's monetary activities, such as open market operations, discount window lending, and setting bank reserve requirements must be independent and free from political influence. We need to get a clear handle on the extent to which the Administration's proposals could compromise or interfere with what the Fed already is charged to do. I look forward to learning more about how and whether the Fed can effectively carry out additional regulatory responsibilities while maintaining its current role as the independent authority on monetary policy. I now recognize the ranking member of the full committee for 4 minutes, Mr. Bachus from Alabama. " CHRG-111shrg53085--107 Mr. Patterson," Yes, Mr. Chairman, if I may. I think your points go directly to the issue and the truth of the matter as you related to your Connecticut colleagues and I to my banks throughout the mid-South, is that our prudential regulator looks at the entire organization and ought to have a key role, and I think does have a key role, in the basic commercial bank system to not only ensure safety and soundness and compliance with other regulations, but also consumer protection. And that is why the problems generally that we are talking about today came from the nonregulated sector where those gaps are. " fcic_final_report_full--239 Both private and government entities have gone to court. For example, the invest- ment brokerage Charles Schwab has sued units of Bank of America, Wells Fargo, and UBS Securities.  The Massachusetts attorney general’s office settled charges against Morgan Stanley and Goldman Sachs, after accusing the firms of inadequate disclo- sure relating to their sales of mortgage-backed securities. Morgan Stanley agreed to pay  million and Goldman Sachs agreed to pay  million.  To take another example, the Federal Home Loan Bank of Chicago has sued sev- eral defendants, including Bank of America, Credit Suisse Securities, Citigroup, and Goldman Sachs, over its . billion investment in private mortgage-backed securi- ties, claiming they failed to provide accurate information about the securities. Simi- larly, Cambridge Place Investment Management has sued units of Morgan Stanley, Citigroup, HSBC, Goldman Sachs, Barclays, and Bank of America, among others, “on the basis of the information contained in the applicable registration statement, prospectus, and prospective supplements.”  LOSSES: “WHO OWNS RESIDENTIAL CREDIT RISK? ” Through  and into , as the rating agencies downgraded mortgage-backed securities and CDOs, and investors began to panic, market prices for these securities plunged. Both the direct losses as well as the marketwide contagion and panic that ensued would lead to the failure or near failure of many large financial firms across the system. The drop in market prices for mortgage-related securities reflected the higher probability that the underlying mortgages would actually default (meaning that less cash would flow to the investors) as well as the more generalized fear among investors that this market had become illiquid. Investors valued liquidity because they wanted the assurance that they could sell securities quickly to raise cash if neces- sary. Potential investors worried they might get stuck holding these securities as mar- ket participants looked to limit their exposure to the collapsing mortgage market. As market prices dropped, “mark-to-market” accounting rules required firms to write down their holdings to reflect the lower market prices. In the first quarter of , the largest banks and investment banks began complying with a new account- ing rule and for the first time reported their assets in one of three valuation cate- gories: “Level  assets,” which had observable market prices, like stocks on the stock exchange; “Level  assets,” which were not as easily priced because they were not ac- tively traded; and “Level  assets,” which were illiquid and had no discernible market prices or other inputs. To determine the value of Level  and in some cases Level  as- sets where market prices were unavailable, firms used models that relied on assump- tions. Many financial institutions reported Level  assets that substantially exceeded their capital. For example, for the first quarter of , Bear Stearns reported about  billion in Level  assets, compared to  billion in capital; Morgan Stanley re- ported about  billion in Level  assets, against capital of  billion; and Goldman reported about  billion, and capital of  billion. CHRG-110hhrg46596--118 Mrs. Maloney," I agree completely and I intend to legislate that recommendation to make it clear to Treasury that we want transparency and accountability. I would like to ask Mr. Kashkari--I am grateful that the financial system of America did not collapse and that we are moving toward stability of our financial institutions. That was a goal, and we have achieved that, and we are getting stronger every day. But what I am hearing from my constituents is that the next step of getting credit out in the community is not happening. We have put $7.8 trillion into the financial system--10 times the $700 billion of the TARP program. Yesterday, there were 10 car dealers in my office from New York State. They say people want to buy from them, they want to buy their cars, but they cannot get a loan from a bank. We are hearing from constituents who would like to buy houses, but they don't know where to go to get a loan. The money is not getting out into the community. And I would venture that we should look more at what is happening to the money now, as opposed to putting it into the system. I have received numerous phone calls in support of a proposal of Treasury of a 4.5 percent program that would allow for people to buy their first homes. I think what is lacking here is there is not a clarify of programs to the people of where they can go for help. This, I believe, got such a groundswell of support because it was clear: You can go to Treasury, you can get a 4.5 percent, 30-year loan. And economists tell us that key to solving our challenge is helping people stay in their homes and getting the homebuilding, the home purchasing, this segment of our society moving. I want to underscore what many members on this panel have said, that we support moneys going to help people stay in their homes for long-term loans. And if Treasury has an objection to Commissioner Sheila Bair's program, if you feel you can streamline it, you can make it more effective, then do it. But that certainly is a goal. Numerous economists have told us we will not solve this problem --meaning the overall economy--until we stabilize the foreclosures, the 2 million to 5 million foreclosures that are predicted by some economists. But also a factor is the 4.5 percent program to get the economy moving. And I would like to know, are you moving forward with this program? I certainly support it. What is the status of it? And any program that you have that will get lending out to the community. " CHRG-111hhrg56776--201 Mr. Bernanke," I think it's helpful to know what's going on in the whole banking system, because you can learn about the asset quality. You can learn about the impact of regulation. And small banks can be involved in financial crises, as well. So I think there is a lot to be learned from not restricting yourself narrowly to one class of institutions. And I agree with his basic point, that we have to get rid of ``too-big-to-fail,'' and that theme has come up today quite a few times. We have to have a system where the creditors of--and shareholders of a large organization can take losses when the firm can't meet its obligations. Mr. Moore of Kansas. Thank you, Mr. Chairman. Again, thanks to both of you for your service to our country. " CHRG-111shrg49488--66 Mr. Clark," Absolutely. We originate all the mortgages. We do not buy mortgages. We originate our own mortgages. And, therefore, we are very concerned about the underwriting standards because we are going to take the risks. I do believe that the system of holding the mortgages does a couple of things for you. One, it means you have the banking system trying to make sure you have conservative risk, not wild risk. But, second, it actually gives us an asset. The way I always describe our bank is we are not an income statement that generates a balance sheet. We are a balance sheet that generates an income statement. And that means we have a solidity of earnings that is there because we are not originating mortgages, then selling them off, and then saying, well, where am I getting next year's income if we originate more and sell them off. We are actually holding them. And so I think it produces tremendous stability in the system, but it does require a regulatory regime that does not penalize you for capital if, in fact, you hold a low-risk asset like that. Senator McCaskill. Do you think we should have regulations that require people who close mortgages to assume some of the risk? " fcic_final_report_full--291 COMMISSION CONCLUSIONS ON CHAPTER 14 The Commission concludes that some large investment banks, bank holding companies, and insurance companies, including Merrill Lynch, Citigroup, and AIG, experienced massive losses related to the subprime mortgage market be- cause of significant failures of corporate governance, including risk management. Executive and employee compensation systems at these institutions dispropor- tionally rewarded short-term risk taking. The regulators—the Securities and Exchange Commission for the large invest- ment banks and the banking supervisors for the bank holding companies and AIG—failed to adequately supervise their safety and soundness, allowing them to take inordinate risk in activities such as nonprime mortgage securitization and over-the-counter (OTC) derivatives dealing and to hold inadequate capital and liquidity. fcic_final_report_full--19 BEFORE OUR VERY EYES In examining the worst financial meltdown since the Great Depression, the Financial Crisis Inquiry Commission reviewed millions of pages of documents and questioned hundreds of individuals—financial executives, business leaders, policy makers, regu- lators, community leaders, people from all walks of life—to find out how and why it happened. In public hearings and interviews, many financial industry executives and top public officials testified that they had been blindsided by the crisis, describing it as a dramatic and mystifying turn of events. Even among those who worried that the housing bubble might burst, few—if any—foresaw the magnitude of the crisis that would ensue. Charles Prince, the former chairman and chief executive officer of Citigroup Inc., called the collapse in housing prices “wholly unanticipated.”  Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., which until  was the largest single shareholder of Moody’s Corporation, told the Commission that “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “ million Americans.”  Lloyd Blankfein, the chairman and chief executive officer of Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.  Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal Reserve Board since , told the Commission a “perfect storm” had occurred that regulators could not have anticipated; but when asked about whether the Fed’s lack of aggressiveness in regulating the mortgage market during the housing boom was a failure, Bernanke responded, “It was, indeed. I think it was the most severe failure of the Fed in this particular episode.”  Alan Greenspan, the Fed chairman during the two decades leading up to the crash, told the Commission that it was beyond the abil- ity of regulators to ever foresee such a sharp decline. “History tells us [regulators] cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be.”  In fact, there were warning signs. In the decade preceding the collapse, there were many signs that house prices were inflated, that lending practices had spun out of control, that too many homeowners were taking on mortgages and debt they could ill afford, and that risks to the financial system were growing unchecked. Alarm bells  were clanging inside financial institutions, regulatory offices, consumer service or- ganizations, state law enforcement agencies, and corporations throughout America, as well as in neighborhoods across the country. Many knowledgeable executives saw trouble and managed to avoid the train wreck. While countless Americans joined in the financial euphoria that seized the nation, many others were shouting to govern- ment officials in Washington and within state legislatures, pointing to what would become a human disaster, not just an economic debacle. “Everybody in the whole world knew that the mortgage bubble was there,” said Richard Breeden, the former chairman of the Securities and Exchange Commission appointed by President George H. W. Bush. “I mean, it wasn’t hidden. . . . You cannot look at any of this and say that the regulators did their job. This was not some hidden problem. It wasn’t out on Mars or Pluto or somewhere. It was right here. . . . You can’t make trillions of dollars’ worth of mortgages and not have people notice.”  Paul McCulley, a managing director at PIMCO, one of the nation’s largest money management firms, told the Commission that he and his colleagues began to get wor- ried about “serious signs of bubbles” in ; they therefore sent out credit analysts to  cities to do what he called “old-fashioned shoe-leather research,” talking to real es- tate brokers, mortgage brokers, and local investors about the housing and mortgage markets. They witnessed what he called “the outright degradation of underwriting standards,” McCulley asserted, and they shared what they had learned when they got back home to the company’s Newport Beach, California, headquarters. “And when our group came back, they reported what they saw, and we adjusted our risk accord- ingly,” McCulley told the Commission. The company “severely limited” its participa- tion in risky mortgage securities.  CHRG-111shrg54789--102 Mr. Barr," Senator Reed, I think we have seen a system in the past where rule writing was at the Federal Reserve and supervision was spread around in the bank agencies and the system was fundamentally broken. The rule writer had a conflicting mission. The supervisory entities had conflicting missions. None of them thought consumer protection was at the top of what they would do. They would regulate banks based on reputation risk and litigation risk with respect to consumer issues, looking out for the interest of the bank and not consumers. I think we can't have that approach going forward. Senator Reed. Let me raise another issue and that is the funding. Your proposal, how would the CFPA be funded? " CHRG-110hhrg44903--114 Mr. Wilson," Thank you, Mr. Chairman. Gentlemen, I would like to address my question to both of you, if I may. One of the concerns I have had through this whole process has been the oversight and the lack of connection or the not having connection among the oversight groups. So I have two questions. One is, how important is it that the central banks, governments, and supervisors look more carefully at the interaction between accounting, tax, and disclosure, and capital requirements and their effect on the overall leverage and risks across the financial system? " CHRG-111hhrg53240--116 Mr. Carr," Congressman, I appreciate the question because I agree with much of what you have just said. One of the problems that we have in this country is that we have the financial system operating on one side of the ledger and we have special programs for the poor on the other. The way the poor became solid middle class in this country was by having a financial system that built their wealth and public policies working with that financial system, coming largely out of the Great Depression, that built the vast majority of our middle class. We do not have that now. Instead, we have a banking system that looks at consumers and says, how can we exploit them? And that is problematic, and until we change that system such that when a bank and our financial institution is reaching to a consumer specifically to promote the economic mobility of that consumer and build their wealth--if that is not their goal, if that is not what is going to be accomplished by their product, the poor will remain poor and all the Federal subsidies in the world won't help them. That is why it is so critical to put into place an agency that actually combines the knowledge, the collective wisdom of people who actually understand the banking system, the financial system, and understand it is their mission to promote the economic mobility of this country. Because once they are working together, there will be no conflicts of promoting wealth and stability within working families, with safety and soundness of the financial system. And then, Congressman, the other programs that you have talked about, that have failed so miserably so often, those programs will now have a foundation by which they can actually enhance what is happening. But if the markets don't work for the general public, poverty will never be resolved. Dr. Paul. One other quick question. Would you have any objection, personally, to us knowing what is going on at the Federal Reserve and have an audit of the Federal Reserve? " CHRG-109shrg26643--123 Chairman Bernanke," The Federal Reserve together with the other banking regulators already has issued, I believe, its regulations to the banking system concerning management of data. There are really two parts to it. First, that banks are required to have good internal controls, to make sure the data are protected. And second, that banks are required, and other financial institutions are required, to inform customers if there is a data breach that has caused, or is likely to cause, or be a source of fraud. So we have created a structure in the banking system to address these issues, and to my knowledge, I believe that Congress is looking to some extent at our approach as a model for thinking about extending these rules to other kinds of organizations. Senator Sarbanes. And finally this Committee has held a number of hearings on money laundering and terrorism financing. Actually, you know, the Department of Justice has undertaken criminal investigations of bank officials in these areas. But that suggests that the regulatory authorities, the bank regulatory authorities of whom the Fed is one, somehow fell behind the curve, so to speak. What can be done to boost that oversight with respect to money laundering and terrorism financing? " CHRG-110hhrg46596--258 Mr. Kashkari," But if you have a bank that is weak or failing, and that bank is acquired by a healthy bank, that community is often better off, because now credit can still be extended, and branches will still stay open in that community, versus if that bank were allowed to fail and the bank would have to be shut down and dissolved, then that community would be worse off. So prudent mergers and acquisitions can be a healthy part of the financial system. We don't want to overdo it. " fcic_final_report_full--584 April 1, 2010. 144. Office of Thrift Supervision, letter to the SEC, February 11, 2004. 145. Lehman Brothers, Inc., letter to the SEC, March 8, 2004; J.P. Morgan Chase & Co., letter to the SEC, February 12, 2004; Deutsche Bank A.G. and Deutsche Bank Secs., letter to the SEC, February 18, 2004. 146. Harvey Goldschmid, interview by FCIC, April 8, 2010. 147. Closed meeting of the Securities and Exchange Commission, April 28, 2004. 148. In 2005, the Division of Market Regulation became the Division of Trading and Markets. For the sake of simplicity, throughout this report it is referred to as the Division of Market Regulation. 149. Erik Sirri, interview by FCIC, April 1, 2010. Although there are more than 1,000 SEC examiners, collectively they regulate more than 5,000 broker-dealers (with more than 750,000 registered representa- tives) as well as other market participants. 150. Michael Macchiaroli, interview by FCIC, March 18, 2010. 151. The monitors met with senior business and risk managers at each CSE firm every month about general concerns and risks the firms were seeing. Written reports of these meetings were given to the di- rector of market regulation every month. In addition, the CSE monitors met quarterly with the treasury and financial control functions of each CSE firm to discuss liquidity and funding issues. 152. Erik Sirri, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1, ses- sion 3: SEC Regulation of Investment Banks, May 5, 2010. 153. Internal SEC memorandum, Re: “CSE Examination of Bear Stearns & Co. Inc.,” November 4, 2005. 154. Securities and Exchange Commission, Office of Inspector General, “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, Septem- ber 25, 2008, pp. 17–18. 155. Michael Macchiaroli, interview by FCIC, April 13, 2010. 156. Robert Seabolt, email to James Giles, Steven Spurry, and Matthew Eichner, October 1, 2007. 157. Matt Eichner, interview by FCIC, April 14, 2010; SEC, OIG, “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” p. 109. 158. Goldschmid, interview. 159. GAO, “Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions,” GAO-09-739 (Report to Congressional Committees), July 2009, pp. 38–42. 160. Erik Sirri, “Securities Markets and Regulatory Reform,” remarks at the National Economists Club, Washington, D.C., April 9, 2009. 161. Harvey Goldschmid, interview, April 8, 2010. 162. “Chairman Cox Announces End of Consolidated Supervised Entities Program,” SEC press re- lease, September 26, 2008. 163. Mary Schapiro, testimony before the FCIC, First Public Hearing of the Financial Crisis Inquiry Commission, day 2, panel 1: Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 39. 164. The Fed remained the supervisor of JP Morgan at the holding company level. 165. Mark Olson, interview by FCIC, October 4, 2010. 166. Federal Reserve System, “Financial Holding Company Project,” January 25, 2008, p. 3. Chapter 9 1. Warren Peterson, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, pp. 1, 3. 2. Gary Crabtree, principal owner, Affiliated Appraisers, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, p. 2. 581 3. Lloyd Plank, Lloyd E. Plank Real Estate Consultants, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, p. 2. 4. CoreLogic Single Family Combined (SFC) Home Price Index, data accessed August 2010. FCIC calculation of change from January 1997 to April 2006, peak. 5. Professor Robert Shiller, Historical Housing data.. 6. Final Report of Michael J. Missal, Bankruptcy Court Examiner, In RE: New Century TRS Holdings, Chapter 11, Case No. 07-10416 (KJC), (Bankr. D.Del), February 29, 2008, pp. 145, 138, 139–40 (hereafter Missal). 7. Ibid., p. 3. 8. Nomura Fixed Income Research, “Notes from Boca Raton: Coverage from Selected Sessions of ABS CHRG-111hhrg55814--370 Mr. Baker," Thank you, Mr. Chairman. It is a pleasure to be here today. I shall wait to the end of the proceedings to come to a resolution thereon. MFA is the primary advocate for sound business practices in industry professionals in hedge funds, funds of funds, and managed futures, as well as industry service providers. MFA is committed to playing a constructive role in the regulatory reform discussion as it continues, as investors' funds have a shared interest with other market participants and policymakers in seeking to restore investor confidence and achieving a stable financial system. In considering the topic of a Systemic Risk and Resolution Authority, it is important to understand the nature of our industry in taking action. With an estimated $1.5 trillion under management, the industry is significantly smaller than the U.S. mutual fund industry or the $13 trillion U.S. dollar banking industry. Because many hedge funds use little or no leverage, their losses have not contributed to the systemic risk that more highly-leveraged institutions contributed. A recent study found that 26.9 percent of managers do not deploy leverage at all, while an FSA study in 2009 found that, on average over a 5-year period, leverage of funds was between 2 or 3 to 1, significantly below most public perception. The industry's relatively modest size and low leverage, coupled with the expertise of our members at managing financial risk, means we have not been a contributing cause to the current difficulties experienced by the average investor or the American taxpayer. Although funds did not cause the problems in our markets, and though we certainly agree with recent statements by Chairman Bernanke that it is unlikely that any individual hedge fund is systemically relevant, we believe that the industry has a role in being a constructive participant as policymakers develop regulatory systems with the goal of restoring stability to the marketplace. We believe the objectives of systemic risk can be met through a framework that addresses participant, product, and structural issues, which include: a central systemic regulator with oversight of the key elements of the entire system; confidential reporting by every institution, generally to its functional regulator, which would then make appropriate reports to the systemic regulator; prudential regulation of systemically relevant entities, products, and markets; and a clear, single mandate for the systemic risk regulator to take action if the failure of a relevant firm would jeopardize broad aspects of economic function. We believe these authorities are consistent with the authorities contemplated by the discussion draft. We believe the objectives of systemic risk regulation are best met not by subjecting non-banks to the Bank Holding Company Act, but by developing a framework that adopts a tailored regulatory approach that addresses the different risk concerns of the business models, activities, and risks of the systemically significant firms. For example, when firms post collateral when they borrow from counterparties, like hedge funds customarily do and as major market participants will be required to do under the OTC bill recently passed by this committee, the potential systemic risks associated with that borrowing are greatly reduced, a factor that should mitigate in determining what prudential rules should apply to various market activities. We believe that smart regulation, facilitated by the OTC, the Advisor Registration, and the Investor Protection bills recently passed by the committee also will greatly reduce the likelihood that a Resolution Authority framework will even need to be implemented. To the extent that a regulator does need to implement such authority, however, we believe that it should be done in a manner to ensure that a firm's failure does not jeopardize the financial system. However, it should be explicitly stated that this authority should not be used to save firms from failing. It is unclear at the moment whether the authority granted by the proposal would enable assistance to be extended to a firm not leading to resolution of the entity being assisted. There are other issues that have been raised by members' questions and the testimony earlier today that we would also address. But for the sake of time, I shall conclude by saying we believe that the Systemic Risk and Resolution Authority framework discussed above will address the concerns underlying the Systemic Risk and Resolution Authority bills, while minimizing unfair competitive advantages and moral hazards that can result from market participants having an implied government guarantee. It is important this framework be implemented in a manner that allows investors, lenders, and counterparties to understand the relevant rules and have confidence those rules will be applied consistently in the future. When investors do not have that confidence, they are less likely to put their capital at risk. And when market function is impaired, we all pay a price. Thank you, Mr. Chairman. [The prepared statement of Mr. Baker can be found on page 117 of the appendix.] " FOMC20080430meeting--253 251,MR. MEYER.," With respect to the U.K. system during the period of turmoil, banks' initial reaction was to lower their reserve deposits, their contractual commitments. But they came to their senses and realized that holding more rather than less was a more sensible approach, and the Bank of England accommodated the banks' desire both to increase their targets and to widen the bands. " CHRG-111shrg52619--33 Mr. Smith," I would like to emphasize a few points that are contained in it. The first of these points is that proximity, or closeness to the consumers, businesses, and communities that deal with our banks is important. We acknowledge that a modern financial regulatory structure must deal with systemic risks presented by complex global institutions. While this is necessary, sir, we would argue that it is not itself sufficient. A modern financial regulatory structure should also include, and as more than an afterthought, the community and regional institutions that are not systemically significant in terms of risk but that are crucial to effectively serving the diverse needs of our very diverse country. These institutions were organized to meet local needs and have grown as they have met such needs, both in our metropolitan markets and in rural and exurban markets, as well. We would further suggest that the proximity of State regulators and attorneys general to the marketplace is a valuable asset in our efforts to protect consumers from fraud, predatory conduct, and other abuses. State officials are the first responders in the area of consumer protection because they are the nearest to the action and see the problems first. It is our hope that a modernized regulatory system will make use of the valuable market information that the States can provide in setting standards of conduct and will enhance the role of States in enforcing such standards. To allow for this system to properly function, we strongly believe that Congress should overturn or roll back the OTS and OCC preemption of State consumer protection laws and State enforcement. A second and related point that we hope you will consider is that the diversity of our banking and regulatory systems is a strength of each. One size does not fit all, either with regard to the size, scope, and business methods of our banks or the regulatory regime applicable to them. We are particularly concerned that in addressing the problems of complex global institutions, a modernized financial system may inadvertently weaken community and regional banks by under-support for the larger institutions and by burdening smaller institutions with the costs of regulation that are appropriate for the large institutions, but not for the smaller regional ones. We hope you agree with us that community and regional banks provide needed competition in our metropolitan markets and crucial financial services in our smaller and more isolated markets. A corollary of this view is that the type of regulatory regime that is appropriate for complex global organizations is not appropriate for community and regional banks. In our view, the time has come for supervision and regulation that is tailored to the size, scope, and complexity of a regulated enterprise. One size should not and cannot be made to fit all. I would like to make it clear that my colleagues and I are not arguing for preservation of the status quo. Rather, we are suggesting that a modernized regulatory system should include a cooperative federalism that incorporates both national standards for all market participants and shared responsibility for the development and enforcement of such standards. We would submit that the shared responsibility for supervising State charter banks is one example, current example, of cooperative federalism and that the developing partnership between State and Federal regulators under the Secure and Fair Enforcement for mortgage licensing, or SAFE Act, is another. Chairman Dodd, my colleagues and I support this Committee's efforts to modernize our Nation's financial regulatory system. As always, sir, it is an honor to appear before you. I hope that our testimony is of assistance to the Committee and would be happy to answer any questions you may have. Thank you very, very much. " fcic_final_report_full--12 Second, we clearly believe the crisis was a result of human mistakes, misjudg- ments, and misdeeds that resulted in systemic failures for which our nation has paid dearly. As you read this report, you will see that specific firms and individuals acted irresponsibly. Yet a crisis of this magnitude cannot be the work of a few bad actors, and such was not the case here. At the same time, the breadth of this crisis does not mean that “everyone is at fault”; many firms and individuals did not participate in the excesses that spawned disaster. We do place special responsibility with the public leaders charged with protecting our financial system, those entrusted to run our regulatory agencies, and the chief ex- ecutives of companies whose failures drove us to crisis. These individuals sought and accepted positions of significant responsibility and obligation. Tone at the top does matter and, in this instance, we were let down. No one said “no.” But as a nation, we must also accept responsibility for what we permitted to occur . Collectively, but certainly not unanimously, we acquiesced to or embraced a system, a set of policies and actions, that gave rise to our present predicament. * * * T HIS REPORT DESCRIBES THE EVENTS and the system that propelled our nation to- ward crisis. The complex machinery of our financial markets has many essential gears—some of which played a critical role as the crisis developed and deepened. Here we render our conclusions about specific components of the system that we be- lieve contributed significantly to the financial meltdown. • We conclude collapsing mortgage-lending standards and the mortgage securi- tization pipeline lit and spread the flame of contagion and crisis. When housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street. This report catalogues the corrosion of mortgage-lending standards and the securiti- zation pipeline that transported toxic mortgages from neighborhoods across Amer- ica to investors around the globe. Many mortgage lenders set the bar so low that lenders simply took eager borrow- ers’ qualifications on faith, often with a willful disregard for a borrower’s ability to pay. Nearly one-quarter of all mortgages made in the first half of  were interest- only loans. During the same year,  of “option ARM” loans originated by Coun- trywide and Washington Mutual had low- or no-documentation requirements. These trends were not secret. As irresponsible lending, including predatory and fraudulent practices, became more prevalent, the Federal Reserve and other regula- tors and authorities heard warnings from many quarters. Yet the Federal Reserve neglected its mission “to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.” It failed to build the retaining wall before it was too late. And the Office of the Comptroller of the Cur- rency and the Office of Thrift Supervision, caught up in turf wars, preempted state regulators from reining in abuses. CHRG-110shrg46629--34 Chairman Bernanke," They are requirements. That is, they are enforced by examination and supervision of the banks. But the subprime guidance, which is a collaboration of the four banking agencies, applies only to banks and thrifts and not to lenders outside of the banking system, which is what the HOEPA was about, would apply to everything. Senator Brown. If this is about investors protecting their interests, as it should be in part, doesn't failure to escrow create the very risk that prepayment penalties allegedly guard against? " FinancialCrisisInquiry--495 BASS: Right, but the commission’s task is to clean up the system and prevent—from what I read—prevent future crises, right? So if you’re going to end up pumping those—those losses through the public shareholders, it’s equally divisible between banks in the United States, banks outside of the United States and foreign creditors. So they took those risks; they should assume them. And if, in fact, it forces U.S. banks into problems, well, the government’s paying January 13, 2010 for it anyway. Let’s go ahead and just pay a fraction of what we’re paying and let someone else shoulder some of the blame. So your answer’s yes. CHRG-111shrg56376--20 Mr. Tarullo," Mr. Chairman, among the many reasons why Members of this Committee will not be unhappy to see the summer recess come is they will not have to listen to me say, for about the third hearing in a row, that each proposal that comes before us is going to have some advantages and some disadvantages. I do think, as John and Sheila have suggested, that nobody would sit down and write the system we have now if they were starting from scratch. But the system having been in place, you have seen that there are some advantages to splitting bank supervision. I personally think it would be a very bad idea not to have the deposit insurer have a bank examination function, so that the deposit insurer understands how banks are functioning before they fail, and thus be better able to resolve them. I also think that it is important for the Federal Reserve, as the central bank and as the holding company supervisor, to have a window into how banks function. Would there be efficiency gains in some sense from having a single regulator? There probably would be, but I think my colleagues to my right have already pointed out some of the disadvantages as well. " CHRG-110hhrg46593--231 Mr. Manzullo," Thank you, Mr. Chairman. I represent the 16th District of Illinois, which is right on top of the State; and we have a lot of agriculture, a lot of manufacturing, a lot of small independent community banks. And the community bankers are extraordinary people because they have not caused this problem. Their conservative principles, the fact that when you get a loan you sit across a desk and you can judge a person's integrity by looking into their eyes--they represent institutions in this country which really serve to me as models. And, Ms. Blankenship, I have a question for you. We are told that there is a need to use part of the $700 billion financial services package by the auto industry in large part because the financial arms of the big three are unable to issue any more car loans except to customers with a FICO score of greater than 720. In many cases, they said that they just don't have any money at all. I have been informed by several community banks in the district I represent, including my own banker, that they have plenty of money to lend for automobiles. They are very frustrated with the fact that people are saying--and I am going to be very up front. The last panel has done more to instill fear into America and, by some of the outrageous statements, are making it more and more difficult to recover. In fact, they are extending the recovery, starting with my good friend Mr. Paulson from Illinois, the statements that he made in September about how the world would collapse unless he was given $700 billion to buy bad assets. People are not buying automobiles, and they are not going and doing their regular Christmas shopping because of fear. And, all along, the community banks have all kinds of money. My question to you is, are community banks--and I don't want to use the words ``able to fill the gap,'' but are there enough community banks in this country that can work with dealerships and make sure that people receive appropriate and fair and reasonable financing for their automobiles and trucks? Ms. Blankenship. Well, I would-- " CHRG-111shrg57709--246 MANAGED MARKETS The Herbert Gold Society, February 1, 1993 By Christopher Whalen Financial markets and many foreign governments were taken by surprise in early January when New York Federal Reserve Bank President E. Gerald Corrigan suddenly resigned. In the unusual press conference called to announce his decision, Corrigan, who officially leaves the New York Fed in August, made a point of denying that there was any ``hidden agenda'' in his departure from more than 20 years of public service. Yet a good part of his career was not public and, indeed, was deliberately concealed, along with much of the logic behind many far-reaching decisions. Whether you agreed with him or not, Corrigan was responsible for making difficult choices during a period of increasing instability in the U.S. financial system and the global economy. During the Volcker era, as the Fed Chairman received the headlines, his intimate friend and latter day fishing buddy Corrigan did ``all the heavy lifting behind the scenes,'' one insider recalls. Because of his important, albeit behind-the-scenes role, Corrigan's sudden decision to step down is doubly wrapped in mystery. A Democrat politically associated with Establishment Liberal personalities, Corrigan under President Bill Clinton seemed likely to be at the head of the list of prospects to succeed Chairman Greenspan. Thus he sheds the limelight under circumstances and in such a way as will only intensify speculation about numerous pending issues, including his role in the Salomon Brothers scandal, the Iraq-Banco Nazionale del Lavoro affair, the BCCI collapse and widely rumored misconduct in the LDC debt market, to cite only part of a longer list of professional and personal concerns. One nationally known journalist who has closely followed Corrigan's career says that ``there is more to come'' on both the Salomon and BNL fronts, and also predicts that several lesser Fed officials close to Corrigan also may be implicated. In fact, it appears that the New York Fed chief decided to resign in the face of several ongoing congressional and grand jury investigations that when completed might, perhaps, embarrass the publicity shy central bank and compel Chairman Alan Greenspan and the board of directors of the New York Reserve Bank to force him out. The press statement from the Board of Governors in Washington, for example, stated that Corrigan had only just made his decision to resign, but why then the lengthy, 8-month period between the resignation and his departure? In fact, the search committee to find his replacement had begun its work days, perhaps weeks earlier. Even as Corrigan met the press, a personal emissary sent by Corrigan was completing a week-long swing through Europe to inform central bankers privately of the impending retirement, a final courtesy from the man who at first carried messages and later the weight of decisions during over 20 years surveying world financial markets. Many political observers lament the loss of the Fed's most senior crisis manager, yet there is in fact considerable relief inside much of the Federal Reserve System at Corrigan's departure. ``Break out the champagne,'' declared one former colleague. ``Stalin is dead.'' The unflattering nickname refers to Corrigan's often abrasive, dictatorial management style. But another 20-plus year Fed veteran, though no less critical of Corrigan's methods, worries that there is no financial official of real international stature at the central bank for the first time since Paul Volcker left New York to become Fed Chairman in 1979. ``Aside from the rather aloof Greenspan,'' he frets, ``there's no one in Washington or among the regional Reserve Bank presidents who is able to pick up the telephone and know which bankers to call in the event of a crisis. Greenspan knows everyone, but he is no banker.'' Who will replace Gerry Corrigan? Candidates range from Fed Vice Chairman David Mullins, an Arkansas native, to economists and bankers from around the country. Yet to appreciate the scale of the task to select his replacement, it is first necessary to review Corrigan's long career. He probably will be best remembered in his last incarnations as both head of the Cooke bank supervisory committee and the chief U.S. financial liaison to the shaky government of Boris Yeltsin in Moscow, where he and the equally hard-drinking Russian leader often stayed up all night devising schemes to stave off a debt default. The Russian effort is perhaps most interesting to students of the Fed because of the combination of luck and divine providence that brought the New York Fed chief and the Russian leader together in the first place and also because it illustrates many aspects of a two-decade long career that has been largely obscured from public view. But now the age of Corrigan is revealed, indirectly, in the vacuum his departure leaves at the top of the American financial system.The Russian Business Early in the summer of 1991, Treasury Secretary Nicholas Brady, Fed Chairman Greenspan, Corrigan, and several lesser western functionaries traveled to Russia to meet with then-Soviet President Mikhail Gorbachev. The Brady-led economic SWAT team went to Moscow to hear the besieged Soviet leader ask for an assessment of the economic reforms that would be required for eventual International Monetary Fund membership (and the release of billions of dollars in new loans from the IMF a year later). One evening during the visit, as Brady and Greenspan went off to dine with Gorbachev, an aide to Corrigan, who was not invited along for dinner, suggested that it would not be a bad idea to meet ``discreetly'' with Yeltsin. The meeting with the Russian leader was quietly arranged. Yeltsin, it should be remembered, had just completed a disastrous tour of the United States, where he was ignored by the Bush Administration, which saw him as a dangerous, often drunken irresponsible on the fringe of Soviet politics. ``Yeltsin deeply appreciated the courtesy of Corrigan's visit,'' according to one senior Fed official familiar with the details of the trip. About a month later, when the attempted military coup against Gorbachev thrust Yeltsin to the forefront, the Russian President did not forget his new-found dining companion and billiard partner, Gerald Corrigan. In November 1991, the New York Fed chief began a series of ``technical assistance'' trips, which usually included time for trips to the country and visits to such places as Stalin's country house or dacha. He made many of his Russian trips in the company of a female Fed official that one peer described as the central bank's answer to James Baker's Margaret Tutwiller. In January 1992, Corrigan hosted a dinner for 200 bankers and other close friends in Yeltsin's honor at the New York Fed's beautiful Italian-revival building at 33 Liberty Street in lower Manhattan, in the shadow of Chase Manhattan Bank and a stone's throw from the House of Morgan. The two now-intimate friends reportedly danced and tossed back shots of vodka till the wee hours of the morning in the bank's magnificent dining room. Through 1991, as the once stalwart communist Yeltsin became deeply committed to ``free market reform,'' Corrigan began to advise Russia's leader on economic matters. This role was formalized in February 1992, after the fact, when the Fed's Board of Governors in Washington effectively appointed Corrigan ``czar'' to oversee American technical assistance to Moscow. Corrigan assembled a team of high-level financial experts from the New York financial community and led them to Russia at Yeltsin's request, to study and recommend further financial reforms. In May 1992, this team became part of a formal network called the ``Russia-U.S. Forum,'' of which Corrigan is co-chair and which includes such establishment fixtures as David Rockefeller and Cyrus Vance as directors. Significantly, Vance is a two-term member of the board of directors of the New York Fed and part of the search committee to find a replacement for Corrigan. Thus the New York Fed chief, who was already the senior U.S. bank regulator, also assumed the role of financial liaison to the Yeltsin regime. Together with Corrigan's long-time mentor, former Fed Chairman Volcker, who ironically acted as adviser to the Russian government after years of steering the world through the international debt crisis, Corrigan has been perhaps the most influential Western financial expert on the scene in Russia, particularly after James Baker moved to the White House in August 1992 to direct the abortive Bush reelection effort. Yet were helping Russia move toward a market-based economy really Washington's first priority, the fate that brought Yeltsin and Corrigan together would have to be seen as one of those crazy events in history when the wrong person was in the right place at the wrong time. ``The oddest thing that is going on right now is that Gerry Corrigan is taking to Moscow a bunch of people from the big money center banks to tell them how to run a banking system,'' financial author Martin Mayer noted during a seminar on banking at Ohio State University last summer. ``The Russians don't need that kind of help.'' Perhaps it is just a coincidence, but Corrigan's resignation comes as Mayer is about to publish a new book later this year on the Salomon Brothers scandal that reveals the New York Fed's central role in the debacle. Yet Corrigan's willingness to tolerate Salomon's market shenanigans is not surprising. By his own admission, Corrigan has never entirely or even partially trusted in free markets, and the Fed's conduct in the Salomon affair was an illustration of this viewpoint put into practice. The New York Fed knew that something was afoot in the government bond market but turned a blind eye to Salomon's machinations rather than risk the ``stability'' of the sales of Treasury paper. Corrigan is a classic interventionist who sees the seemingly random workings of a truly free market as dangerously unpredictable. The intellectual author and sponsor of such uniquely modernist financial terms such as ``too big to fail,'' which refers to the unwritten government policy to bail out the depositors of big banks, and ``systemic risk,'' which refers to the potential for market disruption arising from inter-bank claims when a major financial institutions fails, Corrigan's career at the Fed was devoted to thwarting the extreme variations of the marketplace in order to ``manage'' various financial and political crises, a role that he learned and gradually inherited from former Chairman Volcker. At a July 1, 1991 conference on restructuring financial markets, Corrigan said that relying entirely on market forces actually posed a risk to the world financial system. ``There is a tendency to think that market forces must be good,'' he opined, and said also that the ``challenge'' for regulators will be how to ``balance free market forces'' with the ``dictates of stability in the financial structure.'' And as Salomon and a host of other examples illustrate, Corrigan worked very hard to ensure that stability, regardless of the secondary impact on markets or the long-term cost. A career of almost day-to-day crisis control stretched back to the Hunt Brothers silver debacle in 1980, but especially to the collapse of Drysdale Government Securities in 1982, the Mexican debt crisis (1982-1990) and the October 1987 market crash. Russia was Corrigan's greatest and last test, yet despite claims of fostering private sector activity in Russia or stability in domestic financial markets, in fact his first and most important priority over two decades of service was consistently bureaucratic: to help heavily indebted countries and their creditor banks navigate a financial minefield that was neither of his making nor within his power to remove. Like Volcker before him, Gerald Corrigan cleaned up the messes left behind by the big banks and politicians in Washington, and tried to keep a bad situation from getting any worse.Volcker's Apprentice Corrigan's unlikely rise to the top of the American financial system started in 1976 when as corporate secretary of the N.Y. Fed he was befriended by then-President Volcker. At the time, other senior officers of the New York Reserve Bank still were a bit stand-offish toward Volcker because of policy disagreements, most notably after America's abandonment of gold for international settlements at Camp David in August 1971, a move Volcker supported (he actually participated in the drafting of the plan). But Corrigan extended himself for the new president and quickly became his trusted adviser and friend, and the man doing the difficult jobs behind the scenes as Volcker attracted the limelight as the crisis manager. When Volcker was appointed Fed Chairman late in the summer of 1979, Corrigan followed him to Washington as the chairman's aide and hands-on situation manager (although he remained on the New York Fed's payroll and was subsequently promoted). He was quickly thrown into the crisis control fray when Bunker and Herbert Hunt's attempt to manipulate the silver market blew up into a $1.3 billion disaster the following year. Corrigan managed the unwinding of silver positions, providing the moral suasion necessary to convince reluctant banks to furnish credit to brokers who made bad loans to the Hunts to finance their silver purchases. In 1982, when Drysdale Government Securities collapsed, Corrigan was again the man on the scene to do the cleanup job, working to avoid the worst effects of one of the ugliest financial debacles in the post war period. Drysdale was the first in a series of shocks that year which included the Mexican debt default and the collapse of Penn Square Bank. Drysdale threatened not only the workings of the government securities market, but the stability of a major money center bank, Chase Manhattan, which saw its stock plummet when rumors began to fly as to the magnitude of losses. Corrigan fashioned a combination of Fed loans of cash and collateral, and other expedients, to make the crisis slowly disappear, even as Volcker again received public credit for meeting the crisis. It was about this time that Corrigan, who had never shown any inclination toward outdoor sports (although he is an avid pro-football fan), discovered a love for fly fishing, a favorite pastime of Volcker. He joined a select group of cronies such as current New York Fed foreign adviser and former Morgan Stanley partner Ed Yeo and then-IMF managing director Jacques de Larosiere, who would go on long fishing trips. We may never know what was discussed while this select group let their lines dangle into the water, but fishing no doubt took up far less than most of the time. Later in 1982 Volcker, who was by then supervising the unfolding Penn Square situation, pushed for Corrigan to take the open presidency of the Minneapolis Fed. (Volcker later admitted wanting to keep the badly insolvent Penn Square open for fear of wider market effects, but the FDIC closed down the now infamous Oklahoma bank, paying out only on insured deposits.) Significantly, as Volcker promoted Corrigan's career within the Fed, he took extraordinary measures to prevent the nomination or appointment of respected economists and free market advocates like W. Lee Hoskins and Jerry L. Jordan to head other Reserve Banks (both Hoskins and later Jordan were appointed to the Cleveland Reserve Bank's presidency after Volcker's departure in 1987). Hoskins in particular was the antithesis of Volcker, an unrepentant exponent of conservative, sound money theory who advocated making zero inflation a national goal. He left the Cleveland Fed last year to become president of the solid Huntington Bank in Columbus (which interestingly was among the last institutions to approve new bank loans for Chrysler in 1992). Hoskins and other free market exponents believe that ill-managed banks should be allowed to fail and that Federal deposit insurance hurts rather than protects the financial system by allowing banks to take excessive risks that are, in effect, subsidized by the American taxpayer. But this free market perspective, which represented mainstream American economic thought before the New Deal, is at odds with the Volcker-Corrigan view of avoiding ``systemic risk'' via public sops for large banks and other, more generalized types of government intervention in the ``private'' marketplace. Volcker moved to protect his bureaucratic flank in 1984 when he nominated Corrigan as a replacement for Anthony Solomon as president at the New York Fed, an event that required almost as much lobbying as was latter needed to block the appointment of Hoskins to head the St. Louis Fed in 1986. The cigar chomping Fed chairman got on a plane to call a rare Sunday meeting of the Reserve Bank's board, where he reportedly pounded the table and warned of being outnumbered by Reagan-era free market-zealots. The St. Louis Fed's board caved in to Volcker's demands and Hoskins was passed-over, although he would be appointed President of the Cleveland Fed in late 1987, after Volcker no longer was Federal Reserve Board Chairman. Significantly, Corrigan's impending selection in 1984 caused several more conservative line officers and research officials to flee the New York Reserve Bank. Roger Kubarych, one of the deputy heads of research in New York and a widely respected economist on Wall Street (he's Henry Kaufman's chief economist), actually resigned the day Corrigan's appointment was formally announced, fulfilling an earlier vow not to serve under Volcker's apprentice that symbolized earlier internal Fed disputes.The Neverending Crisis From the first day he took over as head of the New York Fed in 1985, Corrigan's chief priority was ``managing'' the LDC debt crisis and in particular its devastating effects on the New York money center banks. Even in the late 1980s, when most scholars and government officials admitted that loans to countries like Brazil, Argentina and Mexico would have to be written off, as J.P. Morgan did in 1989, Corrigan continued to push for new lending to indebted countries in an effort to bolster the fiction that loans made earlier could still be carried at par or book value, 100 cents on the dollar. Even today, when some analysts declare the debt crisis to be over, the secondary market bid prices for LDC debt range from 65 cents for Mexico to 45 cents for Argentina and 25 cents for Brazil. ``Anything approaching a `forced' write down of even a part of the debt--no matter how well dressed up--seems to me to run the risks of inevitably and fatally crushing the prospects for fresh money financing that is so central to growth prospects of the troubled LDCs and to the ultimate restoration of their credit standing,'' Corrigan wrote in the New York Fed quarterly review in 1988. ``A debt strategy that cannot hold out the hope of renewed debtor access to market sources of external finance is no strategy at all.'' And of course, in the case of Mexico, debt relief has been followed by massive new lending and short-term investment, albeit to finance a growing external trade imbalance ($15 billion in deficit during the first 9 months of 1992 alone) that is strikingly similar to the import surge which preceded the 1982 debt default. Likewise bankrupt Russia, which is supposedly cutoff from new Western credit, has received almost $18 billion in new western loans over the past 12 months--loans guaranteed by the taxpayers of the G-7 countries. But in addition to pressing for new loans to LDC countries, Corrigan worked hard at home to manage the debt crisis, bending accounting rules, delaying and even intervening in the closing of bank examinations, resisting regulatory initiatives such as market value accounting for banks' investment securities portfolios and initially promoting the growth of the interbank loans, swaps and other designer ``derivative'' assets now traded for short-term profit in the growing secondary market. In particular, Corrigan played a leading role in affording regulatory forbearance to a number of large banks with fatal levels of exposure to heavily indebted countries in Latin America. But no member of the New York Clearing House has received more special treatment than Citibank, the lead bank of the $216 billion total asset Citicorp organization. When former Citicorp chairman Walter Wriston said that sovereign nations don't go bankrupt, this in response to questions about his bank's extensive financial risk exposure because of lending in Latin America, his supreme confidence in the eventual outcome of the LDC debt crisis was credible because he and other financiers knew that senior Fed officials like Volcker and Corrigan would do their best to blunt the impact of bad LDC loans on the balance sheets and income statements of major banking institutions. In 1989, for example, as Wriston's successor, John Reed, was in Buenos Aires negotiating a debt-for-equity swap to reduce his bank's credit exposure in Argentina, Corrigan pressured bank examiners in New York to keep open the bank's examination for 14 months. This unprecedented intervention in a regularly scheduled audit contradicted the Fed's own policy statements in 1987 to the effect that large banks would be examined every 6 months, with a full-scope examination every year. Corrigan's decision (he and other Fed officials refuse to discuss regulatory issues as a matter of standing policy) probably was made in order to avoid charges against earnings by forcing the bank to post higher reserves against its illiquid Third World loan portfolio, an action that would later be taken anyway as Argentina slid further down the slope of inflation and political chaos. Yet in a recent internal memo, Corrigan declared the debt crisis ``resolved,'' even as LDC debt continues to grow, both in nominally and in real, inflation-adjusted terms. Public sector debt has fallen in Mexico, for example, accumulation of new private loans and short-term investment has driven total foreign debt over $120 billion, not-withstanding the abortive Brady Plan, while real wages in Mexico continue to deteriorate. This is about $30 billion more than Mexico's total debt level following the Brady Plan debt exchange in 1989. It is significant to note that while Corrigan and other officials pushed the Baker plan after 1985 (essentially a new money lending program) to help ``buy time'' for commercial banks, as Volcker did before him, there remain literally thousands of unsecured commercial creditors of Mexico, Brazil and other LDCs who have little hope of ever seeing even the meager benefits such as World Bank guarantees on interest payments accorded to commercial banks under the Brady scheme. Indeed, because of its debt reduction aspects there remains doubt as to whether Corrigan even fully endorsed the abortive Brady Plan.Systemic Risk & Fiat Money As vice chairman of the Federal Open Market Committee, a position by law held by the New York Fed chief, Corrigan consistently supported the forces pushing for easy money in recent years in order to reflate the domestic economy and eastern real estate markets, and thereby to bolster the sagging balance sheets of insolvent money center behemoths. In fairness, it must be said that Mr. Corrigan, for the most part, was merely following Chairman Greenspan's lead on those monetary policy votes. Since becoming a Reserve Bank president in 1982, he never dissented in an FOMC vote against the chairman's position under either Volcker or Greenspan. Yet as Bill Clinton seems destined to discover, embracing inflationism today in order to accommodate Federal deficits, and bail out badly managed commercial banks and real estate developers, has its price tomorrow in terms of maintaining long-term price and financial market stability. Several of the nation's largest commercial banks, which are headquartered in Corrigan's second Fed district, are or until recently have been by any rational, market-oriented measure insolvent and should have been closed or merged away years ago. Concern about the threat to the financial markets of ``systemic risk'' is used to keep big banks alive, and also as a broad justification for all types of market intervention. The reasoning behind ``systemic risk'' goes something like this: If Russia defaults on its debts, large banks (mostly in Europe) will fail, causing other banks and companies to lose money and also fail. Therefore, new money must keep flowing to countries like Russia, Mexico, Brazil and Argentina so that they may remain current on private debts to commercial lenders, essentially the old-style pyramid or Ponzi scheme on an international scale, funded by taxpayers in America, Europe and Japan via inflation and public sector debt. When Corrigan gave a speech earlier this year warning about the risks inherent in derivative, off-balance sheet instruments such as interest rate swaps, many market participants wondered aloud if the New York Fed chief really understands the market he once promoted but now so fears. ``Off-balance sheet activities have a role, but they must be managed and controlled carefully,'' he told a mystified audience at the New York State Bankers Association in February. ``And they must be understood by top management as well as traders and rocket scientists.'' Swap market mavens were right to wonder about Corrigan's grasp of derivative securities, but they might better ask whether Corrigan appreciates the connection between embracing easy money and inflation to bail out the big banks, and the expansion of derivative markets. In fact, the growth of the swaps market in particular and financial innovation generally, is fueled by paper dollars created by monetary expansion, credit growth that Corrigan has long and repeatedly advocated within the FOMC's closed councils. From $2 trillion in 1990, the derivatives market grew to $3.8 trillion at the end of last year (Citicorp is one quarter of the total swaps market) and may double again before the end of 1994. And yet in basic, purely financial terms, there is no difference between an interest rate swap with a counterparty incapable of understanding the risk, a loan to Brazil, and the commercial real estate loans that fueled the Olympia & York disaster; all are simply vehicles for marketing credit in a market awash in paper, legal tender greenbacks created by an increasingly politicized Federal Reserve Board. In addition to the exponential growth in markets such as interest rate swaps, another side effect of expansionary monetary policy has been an increase in market volatility generally. When the great mountain of dollars created by the Fed during the previous decade suddenly moved out of U.S. equities on Black Monday, October 19, 1987, the New York Fed under Corrigan reportedly urged private banks to purchase stock index futures to stabilize cash prices on the New York Stock Exchange. Corrigan bluntly told commercial banks to lend to brokers in order to help prop the market up, and dealers were even allowed to borrow collateral directly from the Fed in order to alleviate a short-squeeze. Orchestrating such a financial rescue is still intervention in the free market, albeit of an indirect nature. In October 1987, banks in Europe and Japan had refused to lend Treasury paper to counterparties in New York, many of whom had been taken short by customers and other dealers during the frenzied flight to quality that occurred, from stocks into AAA-rated U.S. Government debt. The Fed saved may dealers from grave losses by lending securities they could not otherwise obtain, but this seemingly legitimate response to a market upheaval still represents government inspired meddling in the workings of a supposedly private market. Traders who sell short a stock or bond that they cannot immediately buy back in the market at a lower price are no better than gamblers who have none to blame save themselves for such stupidity and should seek the counsel of a priest or bartender. But in an illustration of the broadly corporativist evolution of Fed policy, as manifested in the government bond market, Corrigan sought broader powers to support the dealer community. In fact, in the wake of the bond market collateral squeeze in 1987 (and again during the ``mini crash'' in October 1989), the New York Fed chief pushed for and late last year obtained authority from Congress to lend directly to broker-dealers in ``emergencies,'' thus allowing the central bank to provide direct liquidity support to the U.S. stock market the next time sellers badly outnumber buyers. When it came time to explain the 1987 debacle to the Congress and the American people, Corrigan was more than willing to help the private citizen drafted to oversee the task, former New Jersey Senator Nicholas Brady, who after being appointed to the Presidential commission created to study the crash, became Treasury Secretary in 1988 when James Baker left the government to run the Bush election campaign. Yet Corrigan assisted the work of Brady's hand-picked assistants, Harvard professor Robert Glauber, who later became under secretary of the Treasury for Finance, and David Mullins, who also joined Brady's Treasury and is now a Bush-appointee as Vice Chairman of the Fed Board of Governors. Mullins and Glauber worked on the Brady report in offices provided by the New York Fed and reportedly dined regularly with Corrigan, who offered them his informed view of how financial markets work. When the Salomon scandal erupted in the Spring and Summer of 1991, Corrigan was again the key man on the scene to manage the fallout from a debacle that has still been only partially unveiled. Following 1986, when regulatory responsibility for the government bond market had been explicitly given to the SEC, the Fed, at Corrigan's instruction, had largely curtailed its surveillance of the market for Treasury debt, particularly the informal ``when-issued'' market in Treasury paper before each auction. And yet when the Salomon scandal broke open, it was apparent that the hands-on ``management'' of markets prescribed by Corrigan had failed to prevent one of the great financial scandals of the century. ``Neither in Washington nor in New York did the Fed seem aware that the dangers of failure to supervise this market had grown exponentially in 1991,'' Mayer notes in an early draft of his upcoming book on the Salomon debacle. ``Like the Federal Home Loan Bank Board in its pursuit of making the S&Ls look solvent in 1981-82, the Fed had adopted tunnel-vision policies to save the nation's banks. And just as excessive kindness to S&Ls in the early 1980s had drawn to the trough people who should not have been in the thrift business, Fed monetary policies in the early 1990s created a carnival in the government bond business.'' The Salomon crisis was not the only bogie on the scope in 1991. During December 1990, the Federal Reserve Bank of New York, working in concert with several private institutions, fashioned a secret rescue package for Chase Manhattan Bank when markets refused to lend money to the troubled banking giant. While Chase officials vociferously deny that any bailout occurred, the pattern of discount window loans during the period and off-the-record statements by officials at the Fed and several private banks suggest very strongly that Corrigan's personal intervention prevented a major banking crisis at the end of 1990. Rational observers would agree that the collapse of a major banking institution is not a desirable outcome, but the larger, more fundamental issue is whether any private bank, large or small, should be subject to the discipline of the marketplace. In the case of Citibank, Chase and numerous other smaller institutions, Corrigan, like Volcker before him, answered this question with a resounding ``no.'' The corporativist tendencies of this extra-legal arrangement amounts to the privatization of profits and the socialization of losses.A Question Of Principles The real issue raised by Corrigan and his supporters within the Fed bureaucracy has been not what they believe, but the fact that they did not seem to have any basic core beliefs with which to guide regulatory actions and policy recommendations during years of difficult domestic and international crises. Other than seeking to avoid a market-based resolution to bank insolvencies and other random events in the marketplace, for example, there is no discernible logic to ``too big to fail.'' While this attitude may be useful to elected officials, appointed higher ups and the CEOs of large banks, it cannot help confusing an American public that still believes that concepts like free markets and the rule of law matter. There is not, for example, any explicit statutory authority supporting the doctrine of ``too big to fail,'' nor has Congress given the Fed authority to support the market for government bonds or even private equity via surreptitious purchases of stock index futures, as was alleged in 1987 and on several occasions since. In the case of the conflict between monetary accommodation for big money center banks and complaining about the explosive growth of derivative products, for example, or warning about banking capital levels while allowing regulatory forbearance and financial accommodation for brain dead money center institutions, Corrigan's positions are riven with logical inconsistencies and interventionist prescriptives that, as the Salomon scandal also illustrates, fail to address the underlying problems. But it may be unfair to place all or even part of the blame for this incongruity at his feet alone. Since beginning his work under Volcker in 1976, Corrigan has met and at least temporarily resolved each foreign and domestic crisis with various types of short-term expedients designed to maintain financial and frequently political stability. The rarefied atmosphere of crisis management leaves small time for recourse to first principles. In this respect, Corrigan must be seen as a pathetic figure, an errand boy doing difficult jobs for politicians and servile Fed Chairmen in Washington who have been unwilling to take the hard decisions needed to truly end the multiple crises that affected the American-centered world financial system since the 1960s abroad and the 1970s at home. By at once advocating new lending to LDCs while softening regulatory treatment for heavily exposed money center institutions, Corrigan was at the forefront of efforts to forestall the day of financial reckoning for the big banks, whether from Third World loans, domestic crises arising from real estate loans, or highly leveraged transactions. However, if Russia, Mexico or some other financial trouble spot boils over after next summer, Gerry Corrigan will have gone fishing. And he will leave behind a very large pair of much-traveled boots that Alan Greenspan and the Clinton Administration quickly must fill. ______ CHRG-111hhrg54869--100 The Chairman," The gentleman from North Carolina, Mr. Miller. Mr. Miller of North Carolina. Thank you, Mr. Volcker. Last fall when Lehman collapsed and AIG was rescued, I felt like I was not a sufficiently conscientious member of this committee, because I so little understood credit default swaps which had played such a huge role in all that. And then I came to realize that no one understood them, which made me feel a little better about my own level of conscientiousness, but maybe feel worse for the economy of the country and of the world. In your testimony, you identified credit default swaps as something that had exacerbated the risks that our entire economy faced, the Nation's economy and the world's economy. The usual justification is risk management. They are like insurance. But the great, great bulk of credit default swaps and other derivatives are between parties, none of whom have any risk to manage. They have no interest in the underlying whatever it is. You, in your testimony, said some kinds of risky behavior should not be allowed of institutions that are systemically important. Do you think credit default swaps, for instance, where nobody in the contract has any interest in the underlying security, should be allowed of systemically important institutions? " CHRG-111shrg56415--10 Mr. Smith," Chairman Johnson and Ranking Member Crapo, members of the Subcommittee, I am Joseph A. Smith, Jr. I am North Carolina Commissioner of Banks and Chairman of the Conference of State Bank Supervisors, on whose behalf I am testifying. Thank you very much, as always, for the opportunity. The members of CSBS and our Federal partners, the FDIC and the Federal Reserve, supervise 73 percent of the banks in the United States, accounting for approximately 30 percent of total banking assets. Our banks are not, as a rule, systemically significant. However, they are locally significant in the markets they serve, which includes virtually all of the United States. State chartered banks provide healthy competition in urban markets and are often the only banks in rural and exurban markets. While there are pockets of strength in some parts of the country, the majority of my colleagues have characterized banking conditions in their States as, and I quote, ``gradually declining.'' This should be no surprise, given that traditional banks are a reflection of the overall health of the economy. What cannot be ignored is that the return to health of our largest banks is the direct result of unprecedented, extraordinary efforts by Congress and Federal regulators to ensure their success. The majority of banks, however, have not been the beneficiaries of this assistance and are experiencing a harshly, harshly procyclical regulatory environment, as required by Federal law. This explains the tale of two industries you are likely hearing from banks in your State versus the news you hear from Wall Street. What can or should be done about this? My colleagues and I submit that the place to start is with a vision of what we, the industry, policymakers, regulators, and other stakeholders, want the U.S. banking market to look like after the current troubles have subsided. In our view, the desirable outcome is a banking industry that continues to be competitive, with thousands of banks, rather than hundreds or tens, diverse, of banks of various sizes, operating strategies, and customer focuses, and strong, with capital, liquidity, and risk management sufficient to meet the challenges of the marketplace. This is not an argument for the status quo. In fact, my colleagues and I are in general agreement with our Federal colleagues that our banks have been too concentrated in commercial real estate and too dependent on non-core deposits. Where we sometimes disagree with them is on the severity with which we judge banks in a down market, the result of which is, in our view, to make bad situations worse. I would hasten to add that our disagreements are of degree, not kind. We generally agree with the diagnosis. The treatment is sometimes debatable. To address the current stress of our banks, CSBS respectfully suggests, one, that on-the-ground supervisors be given greater latitude to assess the condition of banks based on reasonable economic assumptions rather than assumptions of the end of the world. Two, that clear rules of the road be established for private equity investments and that supervisory applications by strategic investors be expedited once clearly established thresholds have been met. Three, that the acquisition of distressed banks by healthy banks be expedited and at least considered for capital purchase investments under the TARP program. Fourth, that troubled banks be allowed to reduce their dependence on brokered deposits in a gradual and orderly way. And fifth, that Congress seriously consider revisions to the Prompt Corrective Action and Least Cost Resolution provisions of FDICIA, which have limited regulatory discretion in the handling of distressed institutions. While we don't think that our suggestions will solve all the problems of the banking industry, we do think they can reduce the number of failures and the attendant cost to the Deposit Insurance Fund, which is, let it be remembered, funded by healthy banks. We believe our approach can reduce at least the pace of decline in the commercial real estate market with potential positive effects on the economy and the recovery. Importantly, it can help preserve the diversity of our financial system that is critical to the future health and even viability of our State and local economies. Once again, thank you for this opportunity to appear before you. I would be happy to answer any questions you may have. Thank you, sir. Senator Johnson. Thank you, Mr. Smith. " Mr. Candon," STATEMENT OF THOMAS J. CANDON, DEPUTY COMMISSIONER, VERMONT DEPARTMENT OF BANKING, INSURANCE, SECURITIES, AND HEALTH CARE ADMINISTRATION, ON BEHALF OF THE NATIONAL ASSOCIATION OF STATE CHRG-111shrg53085--109 Mr. Attridge," Right. Banking is a risk business, and in dealing with our customers, we can assess the risk. We get their financial information and make a decision whether they are a good loan or not. The problem is there are a lot of other investments that we have to make. All banks have an investment portfolio that is partly for liquidity, partly for investment purposes. And we are relying or have been relying in the past that a rating agency and others, brokerage firms, have assessed the quality of the investments we are buying. And that has kind of broken down, to the point where we are asking people, you know, are you sure that there is nothing in this package of, you know, mortgage-backed securities that we are buying--even though they are Fannie Mae/Freddie Mac rated, are you sure that there are no nonqualifying assets. And that is where the system is broken. I think that is what a systemic regulator has to oversee. " CHRG-110hhrg46591--102 Mr. Johnson," I will be brief. Since I believe that the financial regulatory system should be consolidated around bank holding companies, I think you need one bank holding company regulator. I think the Federal Reserve is already doing that. It should continue to be the regulator there. I think that their resources are inadequate and their expertise in supervision is weak and we need to concentrate on that much more. For securitization, which covers a lot of finance, you have the SEC. Transparency, securitization, and supervising the rules of running a clearing system should be an SEC-like function. You already have one. I think it could be strengthened. But there needs to be coordination between a bank holding company regulator and someone overseeing the securities markets. There should be mandated coordination to avoid turf battles. " CHRG-111shrg50814--21 Chairman Dodd," I should have mentioned in prefacing my question, I am, at least for my part, anyway, grateful to the administration for stepping up on the housing issue, the $75 billion that has been committed in the mitigation on foreclosures. I wish we had done that a year ago. It might have made the situation less dramatic than it is today, but I welcome that move, as well. With that, let me turn to Senator Shelby, and look at that, right on the money here, so 5 minutes. Senator Shelby. I will try to do the same, Mr. Chairman. Thank you. Adequacy of bank capital, I would like to get into that. Mr. Chairman, regulators from each part of the banking industry, including the Federal Reserve, have testified multiple times before the Banking Committee in the past few years that the banking industry was healthy and strong, yet we are now discussing taking very drastic measures to recapitalize the very same system. A lot of people wonder, where were the regulators in the past 5 or 6 years, including the Federal Reserve. For example, in 2004, before the Banking Committee, FDIC Chairman Powell said, and I quote, ``I am pleased to report''--that is to the Banking Committee--``that the FDIC insured institutions are as healthy and sound as they have ever been.'' Additionally, in 2004, OTS Director James Gilleran stated before the Banking Committee, and I quote, ``It is my pleasure to report on a thrift industry that is strong and growing in asset size. While we continue to maintain a watchful eye on interest rate risk in the thrift industry, profitability, asset quality, and other key measures of financial health are at or near record levels.'' Also before this committee in 2004, Comptroller of the Currency John Hawke testified, ``National banks continue to display strong earnings, improving credit quality following the recent recession and sound capital positions.'' He even said that banks have adopted better risk management techniques. In 2005, your predecessor of the Fed, Chairman Alan Greenspan, said before the Banking Committee here, ``Nationwide banking and widespread securitization of mortgages make financial intermediation less likely to be impaired than it was in some previous episodes of lethal house price correction.'' In fact, as recently as 2008, Chairman of the FDIC Bair testified and said, and I quote, ``The vast majority of institutions remain well capitalized, which will help them withstand the difficult challenges in 2008 while broader economic conditions improve.'' Comptroller Dugan, Comptroller of the Currency, said here before the Banking Committee in 2008, and I will quote, ``Despite these strains, the banking system remains fundamentally sound, in part because it entered this period of stress in a much stronger condition.'' Finally, in 2008, Federal Reserve Vice Chairman Kohn testified before this Committee, and I quote, ``The U.S. banking system is facing some challenges, but it remains in sound overall condition, having entered the period of recent financial turmoil with solid capital and strong earnings. The problems in the mortgage and housing markets have been highly unusual and clearly some banking organizations have failed to manage their exposures well and have suffered losses as a result. But in general, these losses should not threaten their viability.'' Chairman Bernanke, are your capital measures and amounts of capital adequate? You are regulator of the largest banks. What does the present state of the banking industry tell us about our capital regime, and what does it mean if banks are adequately capitalized, yet somehow we need to spend billions, if not trillions, of dollars to stabilize the system? " CHRG-111shrg53822--46 Mr. Stern," Yes, and, you know, as I commented a little bit earlier, I do think that identifying those situations is an important responsibility and a challenging one. But as I commented, even when you identify those things, taking timely action is very challenging, especially in good times, by the way, when it looks as if everything is operating smoothly, and the rationale for such a divestiture, for example, would not be immediately accepted. Senator Reed. I think you are absolutely right. I mean, I think that the irony here is it is the good times where the seeds are sown for the bigger harvest of the future, and it is hard in practice. Let me ask just a final point. One of the problems we have is we have talked about the leverage and the capital ratios of regulated entities. But what about the embedded leverage of some of their counterparties, the hedge funds, so that what looks like an appropriate loan based on the capital of the regulated entity becomes, you know, much less acceptable? How do we deal with that? Ms. Bair. Hopefully, if it is a regulated bank, they should be looking at their counterparty exposure. If their counterparty is overleveraged, then that might not be a transaction they should do. One area that a systemic risk council, with the regulators coming together, should look at is how leverage constraints apply across the board. It is very difficult to have even higher capital standards than we have now for banks. If there are other major parts of the banking sector that can lever up much higher, you are going to be creating incentives to drive activity into less regulated venues. We need some minimal standards that apply across markets, and leverage is probably one area we need to review. Senator Reed. Let me just follow up quickly. This systemic council of regulators I think--well, let me ask you: Should they also have sort of the responsibility to have an analytical staff that would try to anticipate issues? Coming from my other Committee, the Armed Services Committee, we spend a lot of time and a lot of money gaming what could happen, what might not happen, what are the pressures on systems? That I do not believe exists in any sort of consistent way within financial regulation. Ms. Bair. We do it within our respective spheres. We do that internally at the FDIC with insured depository institutions. So I absolutely think that there should be an analytical staff. That would be a key part of the council to enable it to collect the data and analyze it and identify issues to try to get ahead of them. Senator Reed. Thank you very much. Thank you, Mr. Chairman. " CHRG-111hhrg53234--74 Mr. Kohn," We would work closely with them. We already do work with the other banking regulators on FFIEC. We would be part of this council that the Treasury has looking at systemic risk and identifying systemic activities, systemic problems. We have close working relationships with the SEC, and I see that continuing. We basically rely on them for supervision of the individual institutions. But I think this would give us some authority to make sure not only that the individual institution is safe, but that the system is safe, too. " FOMC20081029meeting--68 66,MR. LOCKHART.," Another question for Nathan on swap lines is how this works exactly. If the pattern holds and Mexico, for example, supports its banking system--in the case of Mexico it is a little different from others, in that all of the large banks are foreign-owned (Citibank owns Banamex, and the Spanish banks own the other two or three large banks)-- where does our responsibility stop and theirs begin? Is it possible for the subsidiary of a U.S. bank or a Spanish bank to draw dollar liquidity in Mexico and with fungible dollars move that around the world? Or does it in one manner or another stay in Mexico? " CHRG-111shrg53822--52 Chairman Dodd," Thank you very much, Senator. Before I turn to Senator Bennett, just to inform my colleagues and others who are gathered here today, there has been a little change in the order on the floor of the Senate. Several of our colleagues have to be at the White House for a meeting. We are going to begin at 10:40 having three votes regarding the housing bill. And then there will be a break, and they are going to bring up the defense procurement bill for opening statements for an hour. And then we will come back to finish up the remaining votes and final passage on the housing bill sometime after 11:30, in which case what I am going to suggest is that Senator Warner has graciously agreed to take over the chair and the gavel--which means you can only conduct a hearing. You cannot pass any bills, Mark. Then we will start the second panel--obviously complete with this panel, and we thank both of our witnesses. We will recess and then come back for the second panel. And I apologize to them, but I cannot control the order of business on the floor of the Senate. So we will come back and have to finish up. But we can get started, anyway, with the second panel, if that is appropriate, Mark. Senator Bennett. Senator Bennett. Thank you very much, Mr. Chairman, and thanks to the two witnesses. I apologize for not having been here for your testimony. I had other assignments. One of the things that has come out of this experience we are going through that I had not realized before--maybe both of you did--is that, in addition to bank and traditional kinds of banking activities, at least Citi performs a series of functions that are very profitable and are systemically absolutely essential--that is, the evening sweeps, the transactions that go on, et cetera. I understand that as much as 80 percent of some of these almost clerical functions worldwide run through Citi in one way or another. And if City were allowed to fail as a bank, it would be unable to perform these services that it performs for the system as a whole, and I have been pondering that ever since I found out about it as to how that impacts this whole question of what we do with City or any other organization. Now, as I have talked with some people outside of Citi about it, they have said, ``Senator, that is a very profitable business, and there would be plenty of people who would step forward and say we will be happy to perform it.'' Well, it is one thing for them to say, ``Yes, we will be happy to perform it,'' and it is another thing mechanically for them to be able to perform it in a seamless fashion that does not create tremendous difficulties. So I would like your response to that. Then the other thing that occurs to me that I have learned about all of this, I will not quote the numbers because I will get them wrong, but during this period of time, again picking on City, where they have taken enormous losses, they have at the same time paid a very significant amount of taxes, because the IRS rules are different from the accounting rules, and when you have an enormous loss that comes from mark-to-market, the IRS says, no, we will not allow that to happen until the assets are actually sold; so that we have had, to me, the enormous anomaly of having tremendous injections of cash into City to keep them viable, at the same time that Citi is making tremendous contributions or payments into the Treasury in the form of taxes. And I have a little bit of a hard time understanding why that makes much sense. So I would appreciate your responses to those two issues that have come up as we have deal with the realities of the meltdown that we have experienced. Ms. Bair. Well, I never comment on open, operating institutions, so I will try to address some of the issues in a generic way. Senator Bennett. Yes, put them in a generic way. Ms. Bair. Where an institution performs activities that have systemic significance so that if they just ceased and repudiated those obligations you would have a systemic situation. Congress long ago gave us the authority to set up a bridge bank to maintain functions that are perhaps profitable and have value, but also need to be continued to avoid systemic risk. This mechanism allows us to move good parts of an institution into a bridge bank, which then can be sold back to the private sector. The problem assets or other loans or securities that may be causing losses are retained in the receivership. This kind of generic situation is why bankruptcy does not work, because you do not have that bridge bank process. You do not have a way to continue these types of important systemic functions as you try to wind down and resolve the institution. We do not have this authority for holding companies. But we do have that kind of mechanism that we use now for banks. " CHRG-111shrg56415--13 Mr. Tarullo," Senator, other than the fact that each presents a significant and troubled portfolio of assets for financial institutions, I think there are some salient differences. First, and I think of particular interest to many Members of this Committee, the places in which the mortgages are relatively concentrated do vary. As I noted in my opening statement, although large financial institutions certainly do have CRA exposures on their books, proportionately speaking the exposures are to a much more significant extent on the books of smaller and regional institutions, and oftentimes--not always, but oftentimes, those exposures are geographically concentrated. You have a small bank that tends to lend in a fairly small area. If the commercial real estate market there goes bad, then there is a problem. So, that is number one. Number two, in commercial real estate, generally speaking you don't have a 30-year fixed mortgage, as you do with residential mortgages. Instead, you have loans that need to be rolled over as a project proceeds or as a completed project is paid down, and that means you have a refinancing problem. So this year and next, we have got about $500 billion each year that is going to need to be refinanced and that creates a set of challenges that are perhaps no more serious than, but different from, the case with residential mortgages. Third, I would say that while there is some similarity, there are some different ways in which the situation plays out. We had subprime mortgages. We had Alt-A mortgages, we had prime mortgages, which as you know, Senator, presented ultimately the same set of problems, but at different times. In the commercial real estate arena, we have got very different kinds of lending, and there is an important distinction between construction and development loans, where essentially the builder is just starting to put something on the property, on the one hand, and so-called income-producing properties, a completed hotel or a multi-unit residential structure, where there is an income stream. The most serious problems are going to be in the former category, with the construction and development loans, which have no income stream. You are going to have problems in the second category, but that is something you can at least try to work with in some cases. Senator Johnson. Ms. Matz, I know that the NCUA is currently in the process of finalizing new rules for its corporate credit unions. Are you considering changes regarding the concentration of risks that corporate credit unions can have? Ms. Matz. Thank you for asking that question. As I think you are aware, when I was on the NCUA Board in 2002, I was the lone member who voted against the corporate rule at that time because I felt it didn't provide adequate parameters on investment authority and concentration of risk. So, we won't make that mistake again. At our Board meeting in November, we will take up the proposed corporate rule and we will address the riskiest area, which we consider the investment authority. We will set limits on the types of securities and the concentration of securities that corporates can invest in. We will address capital. We will have stringent requirements for capital retention that will be comparable to Basel I. We will set requirements for asset liability management so that asset cash-flow and liability cash-flows match. And we will have new governance rules, which are not included in the current regulation. So, I believe we will address the issues that led to the problems we are having today. Senator Johnson. Ms. Bair, do you have any concerns about smaller institutions having risk concentrated in one product area or one geographic area? Ms. Bair. Getting back to some of the regulatory reform issues that this Committee will be looking at, I think the community banking sector is very important to our economy and very important to our country. I do worry that because of competitive pressures and uneven playing fields, that they have become highly concentrated in commercial real estate loans and small business lending. Those are their niche areas where they have been able to hold ground against the larger banks as well as the shadow sector. I would like to see them be able to diversify their balance sheet, especially in consumer retail, and get back into providing those financial services. So, I do think that this is important. But in the near term, clearly, there is a lot of commercial real estate on the books of smaller banks. For the most part, they have managed those exposures well. Some, though, are more distressed than others, and clearly, commercial real estate will be a bigger driver of bank failures going forward. Senator Johnson. Senator Crapo. Senator Crapo. Thank you very much, Mr. Chairman. There are a lot of issues that I would like to explore with this panel, but in my first round, at least here, I want to focus on one, and that is, as I think everybody knows, amidst all the issues that we are dealing with here in Congress, one of them, one of the big ones that I expect we will be dealing with more aggressively soon is the overall financial regulatory restructuring that is being proposed. I would like to get the opinion of the members of the panel with regard to their thoughts on one aspect of that, and that is the proposal that we consolidate all of the banking regulators into one single Federal banking regulatory agency. I don't know that in my 7 minutes I can get through the whole panel, but let us start with you, Ms. Bair. Ms. Bair. Thank you, Senator. My position is out there already. We have not liked this idea. The proposal was pushed in 2006 as an FSA-type model, although I know some of the ideas kicked around were a little different from FSA. We fear regulatory consolidation regardless of where it might be located. Clearly there may be some room for streamlining of bank regulation, but concentrating all the power with a single entity is a tremendous bet. If they do the right thing, then maybe we are OK. But if they do the wrong thing, we are really in the soup. In particular, taking the FDIC out of the supervisory process and the process of setting the capital standards and the underwriting standards, et cetera, would go in a different direction from where this Committee would like to go. We are not perfect by any means, but we are a conservative voice. Since we have a tremendous exposure as deposit insurer, our record shows that we are conservative when it comes to supervisory measures. Being an examiner also gives us a constant stream of information about banking trends, which helps us a lot in setting insurance premiums as well as helping our examiners prepare for working with the State regulators or the Federal chartering regulators when banks get into trouble and have to be wound down and put into resolution. So, we are very concerned about it. We fear it would weaken the FDIC. It could overall weaken banking regulation. Senator Crapo. Thank you. Mr. Dugan, do you have an opinion on this? " CHRG-111shrg55278--106 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System July 23, 2009 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I appreciate the opportunity to discuss how to improve the U.S. financial regulatory system so as to contain systemic risk and to address the related problem of too-big-to-fail financial institutions. Experience over the past 2 years clearly demonstrates that the United States needs a comprehensive strategy to help prevent financial crises and to mitigate the effects of crises that may occur. The roots of this crisis lie in part in the fact that regulatory powers and capacities lagged the increasingly tight integration of conventional lending activities with the issuance, trading, and financing of securities. This crisis did not begin with depositor runs on banks, but with investor runs on firms that financed their holdings of securities in the wholesale money markets. An effective agenda for containing systemic risk thus requires adjustments by all our financial regulatory agencies under existing authorities. It also invites action by the Congress to fill existing gaps in regulation, remove impediments to consolidated oversight of complex institutions, and provide the instruments necessary to cope with serious financial problems that do arise. In keeping with the Committee's interest today in a systemic risk agenda, I will identify some of the key administrative and legislative elements that should be a part of that agenda. Ensuring that all systemically important financial institutions are subject to effective consolidated supervision is a critical first step. Second, a more macroprudential outlook--that is, one that takes into account the safety and soundness of the financial system as a whole, as well as individual institutions--needs to be incorporated into the supervision and regulation of these firms and financial institutions more generally. Third, better and more formal mechanisms should be established to help identify, monitor, and address potential or emerging systemic risks across the financial system as a whole, including gaps in regulatory or supervisory coverage that could present systemic risks. A council with broad representation across agencies and departments concerned with financial supervision and regulation is one approach to this goal. Fourth, a new resolution process for systemically important nonbank financial firms should be created that would allow the Government to wind down a troubled systemically important firm in an orderly manner. Fifth, all systemically important payment, clearing, and settlement arrangements should be subject to consistent and robust oversight and prudential standards. The role of the Federal Reserve in a reoriented financial regulatory system derives, in our view, directly from its position as the Nation's central bank. Financial stability is integral to the achievement of maximum employment and price stability, the dual mandate that Congress has conferred on the Federal Reserve as its objectives in the conduct of monetary policy. Indeed, there are some important synergies between systemic risk regulation and monetary policy, as insights garnered from each of those functions informs the performance of the other. Close familiarity with private credit relationships, particularly among the largest financial institutions and through critical payment and settlement systems, makes monetary policy makers better able to anticipate how their actions will affect the economy. Conversely, the substantial economic analysis that accompanies monetary policy decisions can reveal potential vulnerabilities of financial institutions. While the improvements in the financial regulatory framework outlined above would involve some expansion of Federal Reserve responsibilities, that expansion would be an incremental and natural extension of the Federal Reserve's existing supervisory and regulatory responsibilities, reflecting the important relationship between financial stability and the roles of a central bank. An effective and comprehensive agenda for addressing systemic risk will also require new responsibilities for other Federal agencies and departments, including the Treasury, Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and Federal Deposit Insurance Corporation (FDIC).Consolidated Supervision of Systemically Important Financial Institutions The current financial crisis has clearly demonstrated that risks to the financial system can arise not only in the banking sector, but also from the activities of other financial firms--such as investment banks or insurance organizations--that traditionally have not been subject, either by law or in practice, to the type of regulation and consolidated supervision applicable to bank holding companies. While effective consolidated supervision of potentially systemic firms is not, by itself, sufficient to foster financial stability, it certainly is a necessary condition. The Administration's recent proposal for strengthening the financial system would subject all systemically important financial institutions to the same framework for prudential supervision on the same consolidated or groupwide basis that currently applies to bank holding companies. In doing so, it would also prevent systemically important firms that have become bank holding companies during the crisis from reversing this change and escaping prudential supervision in calmer financial times. While this proposal is an important piece of an agenda to contain systemic risk and the ``too-big-to-fail'' problem, it would not actually entail a significant expansion of the Federal Reserve's mandate. The proposal would entail two tasks--first identifying, and then effectively supervising, these systemically important institutions. As to supervision, the Bank Holding Company Act of 1956 (BHCA) designates the Federal Reserve as the consolidated supervisor of all bank holding companies. That act provides the Federal Reserve a range of tools to understand, monitor, and, when appropriate, restrain the risks associated with an organization's consolidated or groupwide activities. Under this framework, the Federal Reserve has the authority to establish consolidated capital requirements for bank holding companies. In addition, subject to certain limits I will discuss later, the act permits the Federal Reserve to obtain reports from and conduct examinations of a bank holding company and any of its subsidiaries. It also grants authority to require the organization or its subsidiaries to alter their risk-management practices or take other actions to address risks that threaten the safety and soundness of the organization. Under the BHCA, the Federal Reserve already supervises some of the largest and most complex financial institutions in the world. In the course of the financial crisis, several large financial firms that previously were not subject to mandatory consolidated supervision--including Goldman Sachs, Morgan Stanley, and American Express--became bank holding companies, in part to assure market participants that they were subject to robust prudential supervision on a consolidated basis. While the number of additional financial institutions that would be subject to supervision under the Administration's approach would of course depend on standards or guidelines adopted by the Congress, the criteria offered by the Administration suggest to us that the initial number of newly regulated firms would probably be relatively limited. One important feature of this approach is that it provides ongoing authority to identify and supervise other firms that may become systemically important in the future, whether through organic growth or the migration of activities from regulated entities. Determining precisely which firms would meet these criteria will require considerable analysis of the linkages between firms and markets, drawing as much or more on economic and financial analysis as on bank supervisory expertise. Financial institutions are systemically important if the failure of the firm to meet its obligations to creditors and customers would have significant adverse consequences for the financial system and the broader economy. At any point in time, the systemic importance of an individual firm depends on a wide range of factors. Obviously, the consequences of a firm's failure are more likely to be severe if the firm is large, taking account of both its on- and off-balance sheet activities. But size is far from the only relevant consideration. The impact of a firm's financial distress depends also on the degree to which it is interconnected, either receiving funding from, or providing funding to, other potentially systemically important firms, as well as on whether it performs crucial services that cannot easily or quickly be executed by other financial institutions. In addition, the impact varies over time: the more fragile the overall financial backdrop and the condition of other financial institutions, the more likely a given firm is to be judged systemically important. If the ability of the financial system to absorb adverse shocks is low, the threshold for systemic importance will more easily be reached. Judging whether a financial firm is systemically important is thus not a straightforward task, especially because a determination must be based on an assessment of whether the firm's failure would likely have systemic effects during a future stress event, the precise parameters of which cannot be fully known. For supervision of firms identified as systemically important to be effective, we will need to build on lessons learned from the current crisis and on changes we are already undertaking in light of the broader range of financial firms that have come under our supervision in the last year. In October, we issued new consolidated supervision guidance for bank holding companies that provides for supervisory objectives and actions to be calibrated more directly to the systemic significance of individual institutions and bolsters supervisory expectations with respect to the corporate governance, risk management, and internal controls of the largest, most complex organizations. \1\ We are also adapting our internal organization of supervisory activities to take better advantage of the information and insight that the economic and financial analytic capacities of the Federal Reserve can bring to bear in financial regulation.--------------------------------------------------------------------------- \1\ See Supervision and Regulation Letter 08-9, ``Consolidated Supervision of Bank Holding Companies and the Combined U.S. Operations of Foreign Banking Organizations'', and the associated interagency guidance.--------------------------------------------------------------------------- The recently completed Supervisory Capital Assessment Process (SCAP) reflects some of these changes in the Federal Reserve's system for prudential supervision of the largest banking organizations. This unprecedented process specifically incorporated forward-looking, cross-firm, and aggregate analyses of the 19 largest bank holding companies, which together control a majority of the assets and loans within the financial system. Importantly, supervisors in the SCAP defined a uniform set of parameters to apply to each firm being evaluated, which allowed us to evaluate on a consistent basis the expected performance of the firms, drawing on individual firm information and independently estimated outcomes using supervisory models. Drawing on this experience, we will conduct horizontal examinations on a periodic basis to assess key operations, risks, and risk-management activities of large institutions. We also plan to create a quantitative surveillance program for large, complex financial organizations that will use supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses across large firms will enhance our understanding of the potential impact of adverse changes in the operating environment on individual firms and on the system as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and accounting and legal experts. This program will be distinct from the activities of on-site examination teams so as to provide an independent supervisory perspective, as well as to complement the work of those teams. To be fully effective, consolidated supervisors must have clear authority to monitor and address safety and soundness concerns and systemic risks in all parts of an organization, working in coordination with other supervisors wherever possible. As the crisis has demonstrated, the assessment of nonbank activities is essential to understanding the linkages between depository and nondepository subsidiaries and the risk profile of the organization as a whole. The Administration's proposal would make useful modifications to the provisions added to the law in 1999 that limit the ability of the Federal Reserve to monitor and address risks within an organization and its subsidiaries on a groupwide basis. \2\--------------------------------------------------------------------------- \2\ The Administration's proposal also would close the loophole in current law that allowed certain investment banks, as well as other financial and nonfinancial firms, to acquire control of a federally insured industrial loan company (ILC) while avoiding the prudential framework that Congress established for the corporate owners of other full-service insured banks. The Board has for many years supported such a change.---------------------------------------------------------------------------A Macroprudential Approach to Supervision and Regulation The existing framework for the regulation and supervision of banking organizations is focused primarily on the safety and soundness of individual organizations, particularly their insured depository institutions. As the Administration's proposal recognizes, the resiliency of the financial system could be improved by incorporating a more explicit macroprudential approach to supervision and regulation. A macroprudential outlook, which considers interlinkages and interdependencies among firms and markets that could threaten the financial system in a crisis, complements the current microprudential orientation of bank supervision and regulation. Indeed, a more macroprudential focus is essential in light of the potential for explicit regulatory identification of systemically important firms to exacerbate the ``too-big-to-fail'' problem. Unless countervailing steps are taken, the belief by market participants that a particular firm is too-big-to-fail, and that shareholders and creditors of the firm may be partially or fully protected from the consequences of a failure, has many undesirable effects. It materially weakens the incentive of shareholders and creditors of the firm to restrain the firm's risk taking, provides incentives for financial firms to become very large in order to be perceived as too-big-to-fail, and creates an unlevel competitive playing field with smaller firms that may not be regarded as having implicit Government support. Creation of a mechanism for the orderly resolution of systemically important nonbank financial firms, which I will discuss later, should help remediate this problem. In addition, capital, liquidity, and risk-management requirements for systemically important firms will need to be strengthened to help counteract moral hazard effects, as well as the greater potential risks these institutions pose to the financial system and to the economy. We believe that the agency responsible for supervision of these institutions should have the authority to adopt and apply such requirements, and thus have clear accountability for their efficacy. Optimally, these requirements should be calibrated based on the relative systemic importance of the institution, a different measure than a firm's direct credit and other risk exposures as calculated in traditional capital or liquidity regulation. It may also be beneficial for supervisors to require that systemically important firms maintain specific forms of capital so as to increase their ability to absorb losses outside of a bankruptcy or formal resolution procedure. Such capital could be in contingent form, converting to common equity only when necessary to mitigate systemic risk. A macroprudential approach also should be reflected in regulatory capital standards more generally, so that banks are required to increase their capital levels in good times in order to create a buffer that can be drawn down as economic and financial conditions deteriorate. The development and implementation of capital standards for systemically important firms is but one of many elements of an effective macroprudential approach to financial regulation. Direct and indirect exposures among systemically important firms are an obvious source of interdependency and potential systemic risk. Direct credit exposures may arise from lending, loan commitments, guarantees, or derivative counterparty relationships among institutions. Indirect exposures may arise through exposures to a common risk factor, such as the real estate market, that could stress the system by causing losses to many firms at the same time, through common dependence on potentially unstable sources of short-term funding, or through common participation in payment, clearing, or settlement systems. While large, correlated exposures have always been an important source of risk and an area of focus for supervisors, macroprudential supervision requires special attention to the interdependencies among systemically important firms that arise from common exposures. Similarly, there must be monitoring of exposures that could grow significantly in times of systemwide financial stress, such as those arising from OTC derivatives or the sponsorship of off-balance-sheet financing conduits funded by short-term liabilities that are susceptible to runs. One tool that would be useful in identifying such exposures would be the cross-firm horizontal reviews that I discussed earlier, enhanced to focus on the collective effects of market stresses. The Federal Reserve also would expect to carefully monitor and address, either individually or in conjunction with other supervisors and regulators, the potential for additional spillover effects. Spillovers may occur not only due to exposures currently on a firm's books, but also as a result of reactions to stress elsewhere in the system, including at other systemically important firms or in key markets. For example, the failure of one firm may lead to deposit or liability runs at other firms that are seen by investors as similarly situated or that have exposures to such firms. In the recent financial crisis, exactly this sort of spillover resulted from the failure of Lehman Brothers, which led to heightened pressures on other investment banks. One tool that could be helpful in evaluating spillover risks would be multiple-firm or system-level stress tests focused particularly on such risks. However, this type of test would greatly exceed the SCAP in operational complexity; thus, properly developing and implementing such a test would be a substantial challenge.Potential Role of a Council The breadth and heterogeneity of the U.S. financial system have been great economic strengths of our country. However, these same characteristics mean that common exposures or practices across a wide range of financial markets and financial institutions may over time pose risks to financial stability, but may be difficult to identify in their early stages. Moreover, addressing the pervasive problem of procyclicality in the financial system will require efforts across financial sectors. To help address these issues, the Administration has proposed the establishment of a Financial Services Oversight Council composed of the Treasury and all of the Federal financial supervisory and regulatory agencies, including the Federal Reserve. The Board sees substantial merit in the establishment of a council to conduct macroprudential analysis and coordinate oversight of the financial system as a whole. The perspective of, and information from, supervisors on such a council with different primary responsibilities would be helpful in identifying and monitoring emerging systemic risks across the full range of financial institutions and markets. A council could be charged with identifying emerging sources of systemic risk, including: large and rising exposures across firms and markets; emerging trends in leverage or activities that could result in increased systemic fragility; possible misalignments in asset markets; potential sources of spillovers between financial firms or between firms and markets that could propagate, or even magnify, financial shocks; and new markets, practices, products, or institutions that may fall through the gaps in regulatory coverage and become threats to systemic stability. In addition, a council could play a useful role in coordinating responses by member agencies to mitigate emerging systemic risks identified by the council, and by helping coordinate actions to address procylicality in capital regulations, accounting standards (particularly with regard to reserves), deposit insurance premiums, and other supervisory and regulatory practices. In light of these responsibilities and its broad membership, a council also would be a useful forum for identifying financial firms that are at the cusp of being systemically important and, when appropriate, recommending such firms for designation as systemically important. Finally, should Congress choose to create default authority for regulation of activities that do not fall under the jurisdiction of any existing financial regulator, the council would seem the appropriate instrumentality to determine how the expanded jurisdiction should be exercised. A council could be tasked with gathering and evaluating information from the various supervisory agencies and producing an annual report to the Congress on the state of the financial system, potential threats to financial stability, and the responses of member agencies to identified threats. Such a report could include recommendations for statutory changes where needed to address systemic threats due to, for example, growth or changes in unregulated sectors of the financial system. More generally, a council could promote research and other efforts to enhance understanding, both nationally and internationally, of the underlying causes of financial instability and systemic risk and possible approaches to countering such developments. To fulfill such responsibilities, a council would need access to a broad range of information from its member financial supervisors regarding the institutions and markets under their purview, as well as from other Government agencies. Where the information necessary to monitor emerging risks was not available from a member agency, a council likely would need the authority to collect such information directly from financial institutions and markets. \3\--------------------------------------------------------------------------- \3\ To facilitate information collections and interagency sharing, a council should have the clear authority for protecting confidential information subject, of course, to applicable law, including the Freedom of Information Act.---------------------------------------------------------------------------Improved Resolution Process A key element to addressing systemic risk is the creation of a new regime that would allow the orderly resolution of systemically important nonbank financial firms. In most cases, the Federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy code does not sufficiently protect the public's strong interest in ensuring the orderly resolution of a nonbank financial firm whose failure would pose substantial risks to the financial system and to the economy. Indeed, after the Lehman and AIG experiences, there is little doubt that there needs to be a third option between the choices of bankruptcy and bailout. The Administration's proposal would create such an option by allowing the Treasury to appoint a conservator or receiver for a systemically important nonbank financial institution that has failed or is in danger of failing. The conservator or receiver would have a variety of authorities--similar to those provided the FDIC with respect to failing insured banks--to stabilize and either rehabilitate or wind down the firm in a way that mitigates risks to financial stability and to the economy. For example, the conservator or receiver would have the ability to take control of the management and operations of the failing firm; sell assets, liabilities, and business units of the firm; and repudiate contracts of the firm. These are appropriate tools for a conservator or receiver. However, Congress may wish to consider adding some constraints as well--such as requiring that shareholders bear losses and that creditors be entitled to at least the liquidation value of their claims. Importantly, the proposal would allow the Government, through a receivership, to impose ``haircuts'' on creditors and shareholders of the firm, either directly or by ``bridging'' the failing institution to a new entity, when consistent with the overarching goal of protecting the financial system and the broader economy. This aspect of the proposal is critical to addressing the ``too-big-to-fail'' problem and the resulting moral hazard effects that I discussed earlier. The Administration's proposal appropriately would establish a high standard for invocation of this new resolution regime and would create checks and balances on its potential use, similar to the provisions governing use of the systemic risk exception to least-cost resolution in the Federal Deposit Insurance Act (FDI Act). The Federal Reserve's participation in this decision-making process would be an extension of our long-standing role in protecting financial stability, involvement in the current process for invoking the systemic risk exception under the FDI Act, and status as consolidated supervisor for large banking organizations. The Federal Reserve, however, is not well suited, nor do we seek, to serve as the resolution agency for systemically important institutions under the new framework. As we have seen during the recent crisis, a substantial commitment of public funds may be needed, at least on a temporary basis, to stabilize and facilitate the orderly resolution of a large, highly interconnected financial firm. The Administration's proposal provides for such funding needs to be addressed by the Treasury, with the ultimate costs of any assistance to be recouped through assessments on financial firms over an extended period of time. We believe the Treasury is the appropriate source of funding for the resolution of systemically important financial institutions, given the unpredictable and inherently fiscal nature of this function. The availability of such funding from Treasury also would eliminate the need for the Federal Reserve to use its emergency lending authority under section 13(3) of the Federal Reserve Act to prevent the failure of specific institutions.Payment, Clearing, and Settlement Arrangements The current regulatory and supervisory framework for systemically important payment, clearing, and settlement arrangements is fragmented, with no single agency having the ability to ensure that all systemically important arrangements are held to consistent and strong prudential standards. The Administration's proposal would provide the Federal Reserve certain additional authorities for ensuring that all systemically important payment, clearing, and settlement arrangements are subject to robust standards for safety and soundness. Payment, settlement, and clearing arrangements are the foundation of the Nation's financial infrastructure. These arrangements include centralized market utilities for clearing and settling payments, securities, and derivatives transactions, as well as decentralized activities through which financial institutions clear and settle such transactions bilaterally. While payment, clearing, and settlement arrangements can create significant efficiencies and promote transparency in the financial markets, they also may concentrate substantial credit, liquidity, and operational risks. Many of these arrangements also have direct and indirect financial or operational linkages and, absent strong risk controls, can themselves be a source of contagion in times of stress. Thus, it is critical that systemically important systems and activities be subject to strong and consistent prudential standards designed to ensure the identification and sound management of credit, liquidity, and operational risks. The proposed authority would build on the considerable experience of the Federal Reserve in overseeing systemically important payment, clearing, and settlement arrangements for prudential purposes. Over the years, the Federal Reserve has worked extensively with domestic and foreign regulators to develop strong and internationally recognized standards for critical systems. Further, the Federal Reserve already has direct supervisory responsibility for some of the largest and most critical systems in the United States, including the Depository Trust Company and CLS Bank and has a role in overseeing several other systemically important systems. Yet, at present, this authority depends to a considerable extent on the specific organizational form of these systems as State member banks. The safe and efficient operation of payment, settlement, and clearing systems is critical to the execution of monetary policy and the flow of liquidity throughout the financial sector, which is why many central banks around the world currently have explicit oversight responsibilities for critical systems. Importantly, the proposed enhancements to our responsibilities for the safety and soundness of systemically important arrangements would complement--and not displace--the authority of the SEC and CFTC for the systems subject to their supervision under the Federal securities and commodities laws. We have an extensive history of working cooperatively with these agencies, as well as international authorities. For example, the Federal Reserve works closely with the SEC in supervising the Depository Trust Company and also works closely with 21 other central banks in supervising the foreign exchange settlements of CLS Bank.Consumer Protection A word on the consumer protection piece of the Administration's plan may be appropriate here, insofar as we have seen how problems in consumer protection can in some cases contain the seeds of systemic problems. The Administration proposes to shift responsibility for writing and enforcing regulations to protect consumers from unfair practices in financial transactions from the Federal Reserve to a new Consumer Financial Protection Agency. Without extensively entering the debate on the relative merits of this proposal, I do think it important to point out some of the benefits that would be lost through this change. Both the substance of consumer protection rules and their enforcement are complementary to prudential supervision. Poorly designed financial products and misaligned incentives can at once harm consumers and undermine financial institutions. Indeed, as with subprime mortgages and securities backed by these mortgages, these products may at times also be connected to systemic risk. At the same time, a determination of how to regulate financial practices both effectively and efficiently can be facilitated by the understanding of institutions' practices and systems that is gained through safety and soundness regulation and supervision. Similarly, risk assessment and compliance monitoring of consumer and prudential regulations are closely related, and thus entail both informational advantages and resource savings. Under Chairman Bernanke's leadership, the Federal Reserve has adopted strong consumer protection measures in the mortgage and credit card areas. These regulations benefited from the supervisory and research capabilities of the Federal Reserve, including expertise in consumer credit markets, retail payments, banking operations, and economic analysis. Involving all these forms of expertise is important for tailoring rules that prevent abuses while not impeding the availability of sensible extensions of credit.Conclusion Thank you again for the opportunity to testify on these important matters. The Federal Reserve looks forward to working with Congress and the Administration to enact meaningful regulatory reform that will strengthen the financial system and reduce both the probability and severity of future crises. ______ FinancialCrisisReport--6 Documents obtained by the Subcommittee reveal that WaMu launched its high risk lending strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices because higher risk meant the securities paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk. The Subcommittee investigation indicates that unacceptable lending and securitization practices were not restricted to Washington Mutual, but were present at a host of financial institutions that originated, sold, and securitized billions of dollars in high risk, poor quality home loans that inundated U.S. financial markets. Many of the resulting securities ultimately plummeted in value, leaving banks and investors with huge losses that helped send the economy into a downward spiral. These lenders were not the victims of the financial crisis; the high risk loans they issued were the fuel that ignited the financial crisis. (2) Regulatory Failure: Case Study of the Office of Thrift Supervision The next chapter focuses on the failure of the Office of Thrift Supervision (OTS) to stop the unsafe and unsound practices that led to the demise of Washington Mutual, one of the nation’s largest banks. Over a five year period from 2004 to 2008, OTS identified over 500 serious deficiencies at WaMu, yet failed to take action to force the bank to improve its lending operations and even impeded oversight by the bank’s backup regulator, the FDIC. Washington Mutual Bank was the largest thrift under the supervision of OTS and was among the eight largest financial institutions insured by the FDIC. Until 2006, WaMu was a profitable bank, but in 2007, many of its high risk home loans began experiencing increased rates of delinquency, default, and loss. After the market for subprime mortgage backed securities collapsed in July 2007, Washington Mutual was unable to sell or securitize its subprime loans and its loan portfolio fell in value. In September 2007, WaMu’s stock price plummeted against the backdrop of its losses and a worsening financial crisis. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis, followed by the bank’s closure. OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, asset quality, and appraisal practices, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but never did. OTS failed to respond with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually rated WaMu as financially sound. The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to correct identified problems 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 in its use of safe and sound practices. 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 would be corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results. CHRG-111shrg56376--91 Mr. Bowman," I would just simply point out the fact that thrifts do currently enjoy the ability to branch interstate without restriction, and in terms of the impact upon the community banks, my impression has been that that privilege that thrifts currently enjoy has had some impact, but I am not certain how great. Senator Martinez. My colleague from Montana brought up the testimony that we have in writing from Mr. Ludwig, and I wanted to go into another area of his testimony that I found very interesting. He makes the point, and I am sure he could make it much better than I if he were making it, which he may get a chance to do later, but that he would suggest avoiding a two-tier regulatory system that elevates the largest ``too-big-to-fail'' institutions over smaller institutions, and he makes the point that perhaps there would be also two-tier regulators, the best regulators in one system, the others in another, and so anyway, he would urge not to create a ``too-big-to-fail'' category because it would, in fact, be contrary to what he thinks would be the best interest of not creating a bias in the system that would be in favor of those institutions considered too big to fail at the expense of those that were not viewed too big to fail. Again, could I just get a comment from each of you on that. Ms. Bair. Well, I think there are a couple of questions there. One is whether there should be so-called ``Tier 1'' entities that are officially designated as too-big-to-fail, regardless of who regulates them. There may be some combination of OCC and Federal Reserve Board oversight. And second, whether, as part of regulatory consolidation, you want to have a regulator based on size as opposed to charter. I think on the former, we have some concerns about designating institutions formally as Tier 1. I think you can probably say who is not, based on asset size--who may not be systemic. But I think to have a clear line of who is systemically important, does contribute to moral hazard. Especially if you don't have a resolution mechanism, it would be quite problematic. But I do believe the assumption is to have stronger capital and leverage constraints for those very large institutions than for the smaller institutions. In terms of bank regulation, unlike consolidated holding company supervision, I think you should maintain a Federal charter and a State charter. That generally breaks out along size lines, but not always. We have some fairly large State-chartered entities. The OCC has many community banks, as well. But the charter choice, I think, is good to maintain--not different regulatory policies, but policies that are perhaps more reflective of local conditions. With State charters, I think having some sensitivity and more immediacy of being able to deal with a State-level banking supervisor is helpful. So I would maintain regulation based on State or Federal chartering as opposed to employing size limitations. Senator Martinez. I know we have a vote and I don't know how much time we have left, so I will leave it at that, Mr. Chairman. " fcic_final_report_full--413 THE FORECLOSURE CRISIS CONTENTS Foreclosures on the rise: “Hard to talk about any recovery” ..............................  Initiatives to stem foreclosures: “Persistently disregard” .....................................  Flaws in the process: “Speculation and worst-case scenarios” ...........................  Neighborhood effects: “I’m not leaving” .............................................................  FORECLOSURES ON THE RISE: “HARD TO TALK ABOUT ANY RECOVERY ” Since the housing bubble burst, about four million families have lost their homes to foreclosure  and another four and a half million  have slipped into the foreclosure process or are seriously behind on their mortgage payments. When the economic damage finally abates, foreclosures may total between  million and more than  million, according to various estimates.  The foreclosure epidemic has hurt families and undermined home values in entire zip codes, strained school systems as well as community support services, and depleted state coffers. Even if the economy began suddenly booming the country would need years to recover. Prior to , the foreclosure rate was historically less than . But the trend since the housing market collapsed has been dramatic: In , . of all houses, or  out of , received at least one foreclosure filing.  In the fall of ,  in every  outstanding residential mortgage loans in the United States was at least one payment past due but not yet in foreclosure—an ominous warning that this wave may not have crested.  Distressed sales account for the majority of home sales in cities around the country, including Las Vegas, Phoenix, Sacramento, and Riverside, California.  Returning to the , borrowers whose loans were pooled into CMLTI - NC: by September , many had moved or refinanced their mortgages; by that point, , had entered foreclosure (mostly in Florida and California), and  had started loan modifications. Of the , still active loans then,  were seriously past due in their payments or currently in foreclosure.  The causes of foreclosures have been analyzed by many academics and govern- ment agencies. Two events are typically necessary for a mortgage default. First, monthly payments become unaffordable owing to unemployment or other financial  hardship, or because mortgage payments increase. And second (in the opinion of many, now the more important factor), the home’s value becomes less than the debt owed—in other words, the borrower has negative equity. “The evidence is irrefutable,” Laurie Goodman, a senior managing director with Amherst Securities, told Congress in : “Negative equity is the most important predictor of default. When the borrower has negative equity, unemployment acts as one of many possible catalysts, increasing the probability of default.”  CHRG-110hhrg46593--35 Mr. Bernanke," Yes. We only lend to good quality banks. We lend on a recourse basis, that is post, post, post collateral, and if the collateral were to be insufficient, then the bank itself is still responsible. We have never lost a penny doing this. I think it is a totally standard practice for central banks around the world, and it is very constructive to provide liquidity to the financial system. " CHRG-111hhrg52261--161 Mr. MacPhee," Our bank has basically used Fannie and Freddie secondary market for liquidity purposes and for helping out with our capital situation. We tend to retain most of our loans in our bank. We still do a 5-year balloon mortgage for our customers, and I think--one of the things that we have to do as a community bank is, relationship banking rather than transactional banking. So the structure out there for most community bankers that I deal with, it is important to have securitization and collateralization and selling off to the secondary market to keep liquidity in the system. " FinancialCrisisInquiry--173 Thank you. CHAIRMAN ANGELIDES: Terrific. I just have a little time left here. They’ll tell me how much. Oh, I don’t believe that. Oh, there you go. They added one minute just because I frowned. I’ll be brief. I just have two questions very quickly. Today to the extent that what do you think are the still persistent biggest risks that exist today in the financial system? Is there still fragility? Very quickly, yes? MAYO: Yes. I would say I mean I have four D’s. One is de- leveraging. We’re seeing consumer loans go down. You’re seeing commercial loans go down. Loan growth is not happening yet. One reason is because I don’t think all the bad assets have been sold. And so until that takes place, we’ve been talking about that for two years, still hasn’t happened yet. De-leveraging. Number two, de-risking. Not just the de-risking of assets, but also the de-risking of liabilities, several trillion dollars of bank bonds that mature over the next three years that’ll have to be refinanced. That’ll be an issue at the same time that some of the government debts have to be refinanced. Number three would be deposit insurance or resolving all the potential failed banks. And then number four, the deposit service charges where a lot of attention on that recently that could hurt earnings down the road. So those are issues. And as far as—yes? CHAIRMAN ANGELIDES: And the first two are pro-cyclical in a sense? I mean, well... The continuing problems that exist. CHRG-111hhrg53244--36 Mr. Bernanke," Well, for a good bit of the recent years the commercial real estate market was actually pretty strong even as the residential market was weakening. But as the recession has gotten worse in the last 6 months or so, we are seeing increased vacancy, declining rents, falling prices, and so more pressure on commercial real estate which is raising the risk of lending to commercial real estate. So that is certainly a negative. As I was mentioning to the chairman, the facilities for refinancing commercial real estate, either through banks or through the commercial mortgage-backed securities market, seem more limited; and so we are somewhat concerned about that sector and paying close attention to it. We are taking the steps that we can through the banking system and through the securitization markets to try to address it. " CHRG-111shrg56376--126 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SHEILA C. BAIRQ.1. What is the best way to decrease concentration in the banking industry? Is it size limitations, rolling back State preemption, higher capital requirements, or something else?A.1. We must find ways to impose greater market discipline on systemically important institutions. We believe there are several ways to decrease concentration levels in the banking industry without the Federal Government setting size limits on banks. For example, certain requirements, such as higher capital and liquidity levels, could be established to mirror the heightened risk they pose to the financial system. Assessments also could be used as incentives to contain growth and complexity, as well as to limit concentrations of risk and risk taking. However, one of the lessons of the past few years is that regulation alone is not enough to control imprudent risk taking within our dynamic and complex financial system. You need robust and credible mechanisms to ensure that market players will actively monitor and keep a handle on risk taking. In short, we need to enforce market discipline for systemically important institutions. To end ``too big to fail,'' we need an orderly and highly credible mechanism that is similar to the process we use to resolve FDIC-insured banks. In such a process, losses would be borne by the stockholders and bondholders of a holding company, and senior managers would be replaced. There would be an orderly resolution of the institution, but no bail-out. Open bank assistance should not be used to prop up any individual firm.Q.2. Treasury has proposed making the new banking regulator a bureau of the Treasury Department. Putting aside whether we should merge the current regulators, does placing the new regulator in Treasury rather than as a separate agency provide enough independence from political influence?A.2. We believe independence is an essential element of a sound supervisory program. Supervisors must have the authority and resources to gather and evaluate sufficient information to make sound supervisory decisions without undue pressures from outside influences. The FDIC and State banking supervisors, who often provide a different and unique perspective on the operations of community banks, have worked cooperatively to make sound supervisory decisions without compromising their independence. As currently structured, two of the Federal banking agencies, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) are bureaus within the U.S. Department of the Treasury. Although subject to general Treasury oversight, the OCC and OTS have a considerable amount of autonomy within the Treasury with regard to examination and enforcement matters. Unlike Treasury, the bureaus within the U.S. Department of OCC and OTS are funded by examination and other fees assessed on regulated entities, and they have independent litigating authority. The other three Federal banking agencies--Governors of the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve, and the National Credit Union Association, are fully independent agencies, self-funded though assessments or other fees, and have independent litigating authority. To the extent the OTS and OCC would be merged into a single regulator under Treasury, continued independence could be maintained through nonappropriated funding sources, independent litigating authority, and independent decision-making authority, such as currently afforded to the OCC and OTS.Q.3. Given the damage caused by widespread use of subprime and nontraditional mortgages--particularly low documentation mortgages--it seems that products that are harmful to the consumer are also harmful to the banks that sell them. If bank regulators do their job and stop banks from selling products that are dangerous to the banks themselves, other than to set standards for currently unregulated firms, why do we need a separate consumer protection agency?A.3. As currently proposed, the new Consumer Financial Protection Agency (CFPA) would be given sole rulemaking authority for consumer financial protection statutes over all providers of consumer credit, including those outside the banking industry. The CFPA would set a floor on consumer regulation and guarantee the States' ability to adopt and enforce stricter (more protective) laws for institutions of all types, regardless of charter. It also is proposed that the CFPA would have consumer protection examination and enforcement authority over all providers of consumer credit and other consumer products and services--banks and nonbanks. Giving the CFPA the regulatory and supervisory authority over nonbanks would fill in the existing regulatory and supervisory gaps between nonbanks and insured depository institutions and is key to addressing most of the abusive lending practices that occurred institutions and is key to addressing most of during the current crisis. In addition, the provision to give the CFPA sole rulewriting authority over consumer financial products and services would establish strong, consistent consumer protection standards among all providers of financial products and services and eliminate potential regulatory arbitrage that exists because of Federal preemption of certain State laws. However, the Treasury proposal could be made even more effective with a few targeted changes. As recent experience has shown, consumer protection issues and the safety and soundness of insured institutions go hand-in-hand and require a comprehensive, coordinated approach for effective examination and supervision. Separating Federal banking agency examination and supervision (including enforcement) from consumer protection examination and supervision could undermine the effectiveness of each with the unintended consequence of weakening bank oversight. As a Federal banking supervisor and the ultimate insurer of $6 trillion in deposits, the FDIC has the responsibility and the need to ensure consumer protection and safety and soundness are properly integrated. The FDIC and other Federal banking agencies should retain their authority to examine and supervise insured depository institutions for consumer protection standards established by the CFPA. The CFPA should focus its examination and enforcement resources on nonbank providers of products and services that have not been previously subject to Federal examinations and standards. The CFPA also should have back-up examination and enforcement authority to address situations where it determines the Federal banking agency supervision is deficient.Q.4. Since the two most recent banking meltdowns were caused by mortgage lending, do you think it is wise to have a charter focused on mortgage lending? In other words, why should we have a thrift charter?A.4. Over several decades, financial institutions with thrift charters have provided financing for home loans for many Americans. In recent years, Federal and State banking charters have expanded into more diversified, full service banking operations that include commercial and residential mortgage lending. However, it is understandable that the lack of diversification and exposure to the housing market could raise concerns about the thrift charter. Market forces have reduced the demand for thrift charters. Given the dwindling size of the Federal thrift industry, it makes sense to consider merging the Federal thrift charter into a single Federal depository institution charter.Q.5. Should banking regulators continue to be funded by fees on the regulated firms, or is there a better way?A.5. We believe the banking industry should pay for its supervision, but the Federal bank supervision funding process should not disadvantage State-chartered depository institutions and the dual banking system. State-chartered banks pay examination fees to State banking agencies. The Federal banking agencies are self-funded through assessments, exam fees, and other sources. This arrangement helps them remain independent of the political process and separates them from the Federal budget appropriations.Q.6. Why should we have a different regulator for holding companies than for the banks themselves?A.6. We do not believe it is always necessary to have a different regulator for the holding company and the bank. Numerous one-bank holding companies exist where the bank is essentially the only asset owned by the holding company. In these cases, there is no reason why bank regulators could not also serve as holding company regulators as it is generally more efficient and prudent for one regulator to evaluate both entities. In the case of more complex multibank holding companies, one can argue it is more effective for the primary Federal regulators to examine the insured depository institutions while the Federal Reserve evaluates the parent (as a source of strength) and the financial condition of the nonbank subsidiaries. Yet even for a separate holding company regulator, the prudential standards it applies should be at least as strong as the standards applied to insured banks.Q.7. Assuming we keep thrifts and thrift holding companies, should thrift holding companies be regulated by the same regulator as bank holding companies?A.7. Similar to the answer to Question 6, it may not be necessary for small thrifts that are owned by what are essentially shell holding companies to have a separate holding company regulator. While one can argue that more complex organizations merit a separate holding company regulator, even in this structure we believe prudential standards applied to a holding company should be at least as strong as those applied to an insured entity.Q.8. The proposed risk council is separate from the normal safety and soundness regulator of banks and other firms. The idea is that the council 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 council, how would you make sure the rules were being enforced the same across the board?A.8. The proposed risk 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 market participants cannot arbitrage regulatory standards in ways that pose systemic risk. The council should evaluate different capital standards that apply to commercial banks, investment banks, investment funds, and others to determine the extent to which these standards circumvent regulatory efforts to contain excess leverage in the system. The council should ensure that prompt corrective action and capital standards are harmonized across firms. For example, large financial holding companies should be subject to tougher prompt corrective action standards under U.S. law and be subject to holding company capital requirements that are no less stringent than those for insured banks. 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. To be successful, the council must have sufficient authority to require some uniformity and standardization in those areas where appropriate. ------ CHRG-111shrg56376--204 Mr. Ludwig," If I might, Senator, go a little farther, I would say that the comment--I forget whether it was Senator Corker or someone made, that, in fact, what happens when you have to make a decision at the corporate level, you ultimately decide what box to put it in for capital reasons or tax reasons, et cetera, and what happens then at the supervisory level--so I find something wrong in the bank. I can't go to that other entity. That other entity is not being supervised, and in fact, if you look at this current debacle, a great deal of the problem in the larger financial institutions was not in the technical bank. The bank was infected by it. It was actually in the nonbank affiliates that were hard to get to and it was hard to look at the animal as a whole. And if you are really going to be an effective supervisor--after all, everybody has the same interest, a healthier institution--you have got to do the whole piece. Senator Merkley. Thank you all. I am over my time. I will just close by echoing concerns about the community banks and also about our credit union system, where they have rules that have constrained their risk, not using prepayment penalties, having interest rate caps, and so forth. They are a little nervous about being rolled into a system with an unfamiliar regulator and perhaps paying fees disproportionate to the risk they impose on the system, and so our community banks and our credit unions may--are a little disturbed that they might not have been so much of the problem but may get rolled into a disadvantageous set of rules, and so of great interest. Thank you. " CHRG-111shrg50564--10 Mr. Volcker," Well, that is a complicated question that goes to some of Senator Shelby's concerns about what caused the crisis. If I were analyzing this crisis in a substantial way, you have to go back to the imbalances in the economy, not just in financial markets. But as you know, the United States has been consuming more than it has been producing for some years, and its savings have practically disappeared, and that was made possible by, among other things, a very fluid flow of savings from abroad, low interest rates--very easy market conditions, low interest rates, which in turn incited the great world of financial engineering to develop all kinds of complex instruments to afford a financing for businesses, and particularly in this case for individuals, homebuyers, that went on to exceed basically their capacity to pay. And it was all held up by rising house prices for a while, as you know, and everybody felt better when the house prices were rising, but that could not happen forever. And when house prices stopped rising, the basic fragility in that system was exposed. So you had an underlying economic problem, but on top of that, you had a very fragile, as it turned, highly engineered financial system that collapsed under the pressure. I think of it as we built up kind of a Potemkin Village with very fancy structures, but they were not very solid. " CHRG-111shrg61651--138 PREPARED STATEMENT OF BARRY L. ZUBROWChief Risk Officer and Executive Vice President, JPMorgan Chase and Co. February 4, 2010 Good morning Chairman Dodd, Ranking Member Shelby, Members of the Committee. My name is Barry Zubrow, and I am the Chief Risk Officer and Executive Vice President of JPMorgan Chase and Co. Thank you for the opportunity to appear before the Committee today to discuss the Administration's recent proposals to limit the size and scope of activities of financial firms. While the history of the financial crisis has yet to be written conclusively, we know enough about the causes--poor underwriting, too much leverage, weak risk management, excessive reliance on short-term funding, and regulatory gaps--to recognize that we need substantial reform and modernization of the regulatory structure for financial firms. Our current framework was patched together over many decades; when it was tested, we saw its flaws all too clearly. We at JPMorgan Chase strongly support your efforts to craft and pass meaningful regulatory reform legislation that will provide clear, consistent rules for our industry. It is our view that the markets and the economy reflect continued uncertainty about the regulatory environment. I believe that economic recovery would be fostered by passage of a bill that charts a course for strong, responsible economic leadership from U.S. financial institutions. However, the details matter a great deal, and a bill that creates uncertainty or undermines the competitiveness of the U.S. financial sector will not serve our shared goal of a strong, stable economy. At a minimum, reform should establish a systemic regulator responsible for monitoring risk across our financial system. Let me be clear that responsibility for a company's actions rests solely with the company's management. However, had a systemic regulator been in place and closely watching the mortgage industry, it might have identified the unregulated pieces of the mortgage industry as a critical point of failure. It might also have been in a position to recognize the one-sided credit derivative exposures of AIG and the monoline insurers. While it may be unrealistic to believe that a systemic regulator could prevent future problems entirely, such a regulator may be able to mitigate the consequences of some failures and prevent them from collectively becoming catastrophic. As we at JPMorgan Chase have stated repeatedly, no firm--including our own--should be too big to fail. The goal is to regulate financial firms so they don't fail; but when they run into trouble, all firms should be allowed to fail, regardless of their size or interconnections to other firms. To ensure that this can happen--especially in times of crisis--regulators need enhanced resolution authority to wind down failing firms in a controlled way that does not put taxpayers or the broader economy at risk. Such authority can be an effective mechanism that makes it absolutely clear that there is no financial safety net for managements or shareholders. Under such a system, a failed bank's shareholders should lose their investments; unsecured creditors should be at risk and, if necessary, wiped out. A regulator should be able to terminate management and boards and liquidate assets. Those who benefited from mismanaging risks or taking on inappropriate risk should feel the pain. Other aspects of the regulatory system also need to be strengthened--including consumer protection, capital standards and the oversight of the OTC derivatives market--but I emphasize systemic risk regulation and resolution authority specifically because they provide a useful framework for consideration of the most recent proposals from the Administration.Restrictions on Proprietary Trading and Bank Ownership of Private Equity and Hedge Funds Two weeks ago, the Administration proposed new restrictions on financial firms. The first would prohibit banks from ``owning, investing in or sponsoring a hedge fund or a private equity fund, or proprietary trading operations'' that are not related to serving customers. The new proposals are a divergence from the hard work being done by legislators, central banks and regulators around the world to address the root causes of the financial crisis and establish robust mechanisms to properly regulate systemically important financial institutions. While there may be valid reasons to examine these activities, there should be no misunderstanding: the activities the Administration proposes to restrict did not cause the financial crisis. In no case were bank-held deposits threatened by any of these activities. Indeed, in many cases, those activities diversified financial institutions' revenue streams and served as a source of stability. The firms that failed did so largely as a result of traditional lending and real estate-related activities. The failures of Wachovia, Washington Mutual, Countrywide, and IndyMac were due to defaulting subprime mortgages. Bear Stearns, Lehman, and Merrill Lynch were all damaged by their excessive exposure to real estate credit risk. Further, regulators currently have the authority to ensure that risks are adequately managed in the areas the Administration proposes to restrict. Regulators and capital standards-setting bodies are empowered, and must utilize those powers, to ensure that financial companies of all types are appropriately capitalized at the holding company level (as we are at JPMorgan Chase). While bank holding companies may engage in proprietary trading and own hedge funds or private equity firms, comprehensive rules are in place that severely restrict the extent to which insured deposits may finance these activities. And regulators have the authority to examine all of these activities. Indeed, existing U.S. rules require that firms increase the amount of capital they hold as their private equity investments increase as a percentage of capital, effectively restraining their private equity portfolios. While regulators have the tools they need to address these activities in bank holding companies, we need to take the next logical step of extending these authorities to all systemically important firms regardless of their legal structure. If the last 2 years have taught us anything, it is that threats to our financial system can and do originate in nondepository institutions. Thus, any new regulatory framework should reach all systemically important entities--including investment banks--whether or not they have insured deposit-based business; all systemically important institutions should be regulated to the same rigorous standard. If we leave outside the scope of rigorous regulation those institutions that are interconnected and integral to the provision of credit, capital and liquidity in our system, we will be right back where we were before this crisis began. We will return to the same regime in which Bear Stearns and Lehman Brothers both failed and other systemically important institutions nearly brought the system to its knees. We cannot have two tiers of regulation for systemically important firms. As I noted at the outset, it is also very important that we get the details right. Thus far, the Administration has offered few details on what is meant by ``proprietary trading.'' Some traditional bank holding company activities, including real estate and corporate lending, expose these companies to risks that have to be managed by trading desks. Any individual trade, taken in isolation, might appear to be ``proprietary trading,'' but in fact is part of the mosaic of serving clients and properly managing the firm's risks. Restricting activities that could loosely be defined as proprietary trading would reduce the safety and soundness of our banking institutions, raise the cost of capital formation, and restrict the availability of credit for businesses, large and small--with no commensurate benefit in reduced systemic risk. Similarly, the Administration has yet to define ``ownership or sponsorship'' of hedge fund and private equity activities. Asset managers, including JPMorgan Chase, serve a broad range of clients, including individuals, universities, and pensions, and need to offer these investors a broad range of investment opportunities in all types of asset classes. In each case, investments are designed to meet the specific needs of the client. Our capital markets rely upon diversified financial firms equipped to meet a wide range of financing needs for companies of all sizes and at all stages of maturity, and the manner in which these firms are provided financing is continually evolving in response to market demand. Codifying strict statutory rules about which firms can participate will distort the market for these services--and result in more and more activities taking place outside the scope of regulatory scrutiny. Rather, Congress should mandate strong capital and liquidity standards, give regulators the authority they need to supervise these firms and activities, and conduct rigorous oversight to ensure accountability. While we agree that the United States must show leadership in regulating financial firms, if we take an approach that is out of sync with other major countries around the world without demonstrable risk-reduction benefits, we will dramatically weaken our financial institutions' ability to be competitive and serve the needs of our clients. Asset management firms (including hedge funds and private investment firms) play a very important role in today's capital markets, helping to allocate capital between providers and users. The concept of arbitrarily separating different elements of the capital formation process appears to be under consideration only in the U.S. Forcing our most competitive financial firms to divest themselves of these business lines will make them less competitive globally, allowing foreign firms to step in to attract the capital and talent now involved in these activities. Foreign banks will gain when U.S. banks cede the field.Concentration Limits The second of the recent Administration proposals would limit the size of financial firms by ``growth in market share of liabilities.'' Again, while the Administration has not provided much detail, the proposal appears to be based on the assumption that the size of financial firms or concentration within the financial sector contributed to the crisis. If you consider the institutions that failed during the crisis, some of the largest and most consequential failures were stand-alone investment banks, mortgage companies, thrifts, and insurance companies--not the diversified financial firms that presumably are the target of this proposal. It was not AIG's and Bear Stearns' size but their interconnection to other firms that prompted the Government to step in. In fact, JPMC's capabilities, size, and diversity were essential to our withstanding the crisis and emerging as a stronger firm--and put us in a position to acquire Bear Stearns and Washington Mutual when the Government asked us to. Had we not been able to purchase these companies, the crisis would have been far worse. With regard to concentration specifically, it is important to note that the U.S. financial system is much less concentrated than the systems of most other developed nations. Our system is the 2nd least concentrated among OECD countries, just behind Luxembourg; the top 3 banks in the U.S. held 34 percent of banking assets in 2007 vs. an average for the rest of the OECD of 69 percent. An artificial cap on liabilities will likely have significant negative consequences. For the most part, banks' liabilities and capital support the asset growth of its loan and lending activities. By artificially capping liabilities, banks may be incented to reduce the growth of assets or the size of their existing balance sheet, which in turn would restrict their ability to make loans to consumers and businesses, as well as to invest in Government debt. Capping the scale and scope of healthy financial firms cedes competitive ground to foreign firms and to less regulated, nonbank financial firms--which will make it more difficult for regulators to monitor systemic risk. It would likely come at the expense of economic growth at home. No other country in the world has a Glass-Steagall regime or the constraints recently proposed by the Administration, nor does any country appear interested in adopting one. International bodies have long declined to embrace such constraints as an approach to regulatory reform.Conclusion We have consistently endorsed the need for meaningful regulatory reform and have worked hard to provide the Committee and others with information and data to advance such reform. We agree that it is critically important to eliminate any implicit financial ``safety net'' by assuring appropriate capital standards, risk management and regulatory oversight on a consistent and cohesive basis for all financial firms, and, ultimately, having a robust regime that allows any firm to fail if it is mismanaged. While numerical limits and strict rules may sound simple, there is great potential that they would undermine the goals of economic stability, growth, and job creation that policymakers are trying to promote. The better solution is modernization of our financial regulatory regime that gives regulators the authority and resources they need to do the rigorous oversight involved in examining a firm's balance sheet and lending practices. Effective examination allows regulators to understand the risks institutions are taking and how those risks are likely to change under different economic scenarios. It is vital that policymakers and those with a stake in our financial system work together to overhaul our regulatory structure thoughtfully and well. Clearly such work needs to be done in harmony with other countries around the world. While the specific changes required by reform may seem arcane and technical, they are critical to the future of our whole economy. We look forward to working with the Committee to enact the reforms that will position our financial industry and economy as a whole for sustained growth for decades to come. Thank you." fcic_final_report_full--51 Almost , commercial banks and thrifts failed in what became known as the S&L crisis of the s and early s. By comparison, only  banks had failed between  and . By , one-sixth of federally insured depository institu- tions had either closed or required financial assistance, affecting  of the banking system’s assets.  More than , bank and S&L executives were convicted of felonies.  By the time the government cleanup was complete, the ultimate cost of the crisis was  billion.  Despite new laws passed by Congress in  and  in response to the S&L crisis that toughened supervision of thrifts, the impulse toward deregulation contin- ued. The deregulatory movement focused in part on continuing to dismantle regula- tions that limited depository institutions’ activities in the capital markets. In , the Treasury Department issued an extensive study calling for the elimination of the old regulatory framework for banks, including removal of all geographic restrictions on banking and repeal of the Glass-Steagall Act. The study urged Congress to abolish these restrictions in the belief that large nationwide banks closely tied to the capital markets would be more profitable and more competitive with the largest banks from the United Kingdom, Europe, and Japan. The report contended that its proposals would let banks embrace innovation and produce a “stronger, more diversified finan- cial system that will provide important benefits to the consumer and important pro- tections to the taxpayer.”  The biggest banks pushed Congress to adopt Treasury’s recommendations. Op- posed were insurance agents, real estate brokers, and smaller banks, who felt threat- ened by the possibility that the largest banks and their huge pools of deposits would be unleashed to compete without restraint. The House of Representatives rejected Treasury’s proposal in , but similar proposals were adopted by Congress later in the s. In dealing with the banking and thrift crisis of the s and early s, Con- gress was greatly concerned by a spate of high-profile bank bailouts. In , federal regulators rescued Continental Illinois, the nation’s th-largest bank; in , First Republic, number ; in , MCorp, number ; in , Bank of New England, number . These banks had relied heavily on uninsured short-term financing to ag- gressively expand into high-risk lending, leaving them vulnerable to abrupt with- drawals once confidence in their solvency evaporated. Deposits covered by the FDIC were protected from loss, but regulators felt obliged to protect the uninsured deposi- tors—those whose balances exceeded the statutorily protected limits—to prevent po- tential runs on even larger banks that reportedly may have lacked sufficient assets to satisfy their obligations, such as First Chicago, Bank of America, and Manufacturers Hanover.  CHRG-111shrg50564--2 Chairman Dodd," The Committee will come to order. Let me thank all of my colleagues, and I think you all understood we intended, obviously, at some time earlier to have this hearing a little earlier. But as I think all of you may know, we had an interesting session on our side of the aisle, gathering today to listen to some of our new economic team under President Obama, as well as the President himself and others, talk about many of the issues that are confronting the country, not the least of which was the issue of the subject matter of this hearing, the modernization of the U.S. financial regulatory system. I am particularly honored and delighted to have Paul Volcker here with us, who has been a friend for many years, someone I have admired immensely for his contribution to our country. How we will proceed is, because we are getting underway much later than normal for the conducting of Senate hearings, with the indulgence of my colleagues, I will make some opening comments myself, turn to Senator Shelby, and then we will go right to you, if we could, Chairman Volcker. Then I will invite my colleagues and tell them that any opening comments that they do not make for themselves, we will include them in the record as if given. And since there are not many of us here, we can move along pretty quickly, I hope, as well. So, with that understanding, we will get underway and, again, I thank all of you for joining us here today. Today, we continue the Senate Banking Committee's examination of how to modernize our outdated financial regulatory system. We undertake this examination in the midst of a deepening recession and the worst financial crisis since the Great Depression in the 20th century. We must chart a course forward to restore confidence in our Nation's financial system upon which our economy relies. Our mission is to craft a framework for 21st century financial regulation, informed by the lessons we have learned from the current crisis and designed to prevent the excesses that have wreaked havoc with homeowners and consumers, felled financial giants, and plunged our economy into a recession. This will not be easy, as we all know. We must act deliberately and thoughtfully to get it right. We may have to act in phases given the current crisis. But inaction is not an option at all, and time is not neutral. We must move forcefully and aggressively to protect consumers, investors, and others within a revamped regulatory system. Last Congress, this Banking Committee built a solid foundation upon which we will base our work today, and I want to once again thank Dick Shelby, former Chairman of this Committee, and my colleagues, both Democrats and Republicans, who played a very, very constructive role in the conduct of this Committee that allowed us to proceed as we did. Subcommittees and Committees held 30 hearings to identify the causes and consequences of this crisis, from predatory lending and foreclosures, to the collapse of Bear Stearns, the role of the credit rating agencies, the risks of derivatives, the regulation of investment banks and the insurance industry, and the role and condition of banks and thrifts. The lessons we have learned thus far have been rather clear, and let me share some of them with you. Lesson number one: consumer protection matters. The current crisis started with brokers and lenders making subprime and exotic loans to borrowers unable to meet their terms. As a former bank regulator recently remarked to me, ``Quite simply, consumers were cheated.'' Some lenders were so quick to make a buck and so certain they could pass the risk on to the next guy, they ignored all standards of prudent underwriting. The consumer was the canary in the coal mine, but no one seemed to notice. Lesson number two: regulation is fundamental. Many of the predatory lenders were not regulated. No one was charged with minding the store. But soon the actions of these unregulated companies infected regulated institutions. Banks and their affiliates purchased loans made by mortgage brokers or the securities or derivatives backed by these loans, relying on credit ratings that turned out to be wildly optimistic. So we find that far from being the enemy of well-functioning markets, reasonable regulation is fundamental to sound and efficient markets, and necessary to restore the shaken confidence in our system at home and around the globe. Lesson number three: regulators must be focused, aggressive, and energetic cops on the beat. Although banks and thrifts made fewer subprime and exotic loans than their unregulated competitors, they did so with impunity. Their regulators were so focused on banks' profitability, they failed to recognize that loans so clearly unsafe for consumers were also a threat to the banks' bottom line. If any single regulator recognized the abusiveness of these loans, no one was willing to stand up and say so. And with the Fed choosing not to use its authority to ban abusive home mortgages, which some of us have been calling for, for years, the regulators were asleep at the switch. Lesson number four: risks must be understood in order to be managed. Complex instruments, collateralized debt obligations, credit default swaps designed to manage the risks of the fault loans that backed them turned out to magnify that risk. The proliferation of these products spread the risk of subprime and Alt-A loans like an aggressive cancer through the financial system. Institutions and regulators alike failed to appreciate the hidden threat of these opaque instruments, and the current system of regulators acting in discrete silos did not equip any single regulator with the tools to identify or address enterprise or systemwide risks. On top of that, CEOs had little incentive to ferret out risks to the long-term health of their companies because too often they were compensated for short-term profits. I believe these lessons should form the foundation of our effort to shape a new, modernized, and, above all, transparent structure that recognizes consumer protection and the health of our financial system are inextricably linked. And so in our hearing today and those to come--and there will be many--I will be looking for answers to these questions. What structure best protects the consumer? What additional regulations are needed to protect consumers from abusive practices? We will explore whether to enhance the consumer protection mission of the prudential regulators or create a regulator whose sole job is protecting the American consumer. How do we identify and supervise the institutions and products on which the health of our financial system depends? Financial products must be more transparent for consumers and institutional investors alike. But heightened supervision must not stifle innovation of financial actors and markets. Third, how do we ensure that financial institution regulators are independent and effective? We cannot afford a system where regulators withhold bold and necessary action for fear that institutions will switch charters to avoid stricter supervision. We should consider whether a single prudential regulator is preferable to the alphabet soup of regulators that we have today. Fourth, how should we regulate companies that pose a risk to our system as a whole? Here we must consider whether to empower a single agency to be the systemic risk regulator. If that agency is the Federal Reserve Board, we must be mindful of ensuring the independence and integrity of the Fed's monetary policy function. Some have expressed a concern--which I share, by the way--about overextending the Fed when they have not properly managed their existing authority, particularly in the area of protecting consumers. Fifth, how should we ensure that corporate governance fosters more responsible risk taking by employees? We will seek to ensure that executives' incentives are better aligned with the long-term health of their companies, not simply short-term profits. Of course, my colleagues and our witnesses today may suggest other areas. I do not mean to suggest this is the beginning and end-all of the questions that need to be asked, and I welcome today's witnesses' as well as our colleagues' contributions to this discussion and the questions that ought to be addressed. I look forward to moving forward collaboratively in this historic endeavor to create an enduring regulatory framework that builds on the lessons of the past, restores confidence in our financial system, and recognizes that our markets and our economy will only be as strong as those who regulate them and the laws by which they abide. That is the responsibility of this Committee. It is the Republican of this Congress. It is the responsibility of the administration. I will recognize Senator Shelby for an opening comment and ask my colleagues if they might withhold statements, at least at the outset, so we can get to our witnesses. With that, I turn to Senator Shelby. CHRG-111shrg55117--95 Mr. Bernanke," I do not think so. I think they are much more likely to be complementary. For example, our prudential work in banks and our monetary policy work involves a great deal of information about financial institutions and markets, as does our consumer protection work, and all that feeds into the systemic risk work. So I think in terms of operational activities, the kinds of people we would have, the expertise we would have, I think they are mostly complementary. And I think they are complementary in a policy perspective as well. For example, I think you need to have good prudential supervision and good consumer protection to have good systemic stability. I think you have to have good systemic stability in order to have full employment and price stability, which is the objective of monetary policy. So I think, in general, they tend to be complementary. I do not see any serious conflicts of interest or inconsistencies between those mandates. Senator Merkley. Well, frankly, your response frightens me because I think there are occasions that they are in conflict, at least the pressures of the players within the system. You may have practices that are quite profitable for the banking system that a person looking at it from a consumer protection point of view might say that disclosure really is not complete or fairness is not complete. Indeed, some of the many things that we have been addressing recently in regard to the compensation of how mortgages are issued, prepayment penalties, the way loans are packaged and resold, the way they are rated within the system--all of these things may be profitable in ways that strengthen the banks but weaken the position of consumers. And I think at least to be able to carry out these missions simultaneously, one has to be conscious and aware of the inherent conflicts that arise and have a plan for how one addresses those. " CHRG-111shrg53085--35 Chairman Dodd," Thank you very, very much. I appreciate again your testimony here this morning. It has been very helpful. Let me start the questioning. First of all, while I haven't cosponsored the bill that Senator Schumer and Senator Durbin have on financial product safety, I think there is some real value in the idea. I also think there is general consensus among our colleagues that we need to fix regulatory arbitrage, where banks shopping around for the regulator of least resistance. I am trying to sort of sense just in conversations where our commonality of interest is. I think there is general consensus in the community banks, Mr. Attridge. I hear that all the time here--That people appreciate it when they speak to their own community banks. We should be more careful about how we characterize banking generally and look through what has been going on at the community level. Let me get to the issue of systemic risk. Mr. Whalen, your point about systemic risks is not a bad idea, that is, using the plural to talk about it, and also the issue of resolution management for nondepository institutions. I have some real reservations about the idea of the Federal Reserve. I just don't like the idea of a systemic risks regulator talking to itself. I think there is a danger when you are not listening to other voices when it comes to systemic risks, then you only hear your own voice. And as you are examining the issue of systemic risks, whether it is just by the size of the institution or the products and practices they are engaging in, there are various ideas that one ought to apply. Dan Tarullo, I thought, was very good the other day before this committee talking about how he would define systemic risk and the importance of looking at it from various perspectives. I, for one, would be intrigued with looking at alternative ideas, one of which has been raised by Gene Ludwig, who I think all of us are familiar with here. He raised the idea of a council, where it would be made up of the Fed, the OCC, the FDIC, possibly others, and where you would have a professional staff that would be analyzing systemic risk and rotating chairmanships with Treasury and others, so no one agency would necessarily dominate it. This is an idea that is interesting as an alternative to the Fed or some others that have been suggested. I would like, if you might, Mr. Whalen, to comment on this concept and if you think it has any value. " CHRG-110hhrg45625--185 Mr. Bernanke," Let me just take that. First of all, in the general plan we are trying to strengthen the whole banking system, not just banks that are in trouble. If we deal with banks in trouble, that is a different issue. The FIDICIA law applies to that. One of the big problems here we have been confronting over the last year is while there is a well-designed set of principles for dealing with banks in trouble, for nonbanks, whether they be investment banks or insurance companies, or what have you, we don't have those rules. Ms. Brown-Waite. But did you apply it to the banks? " CHRG-111hhrg51698--153 Mr. Pomeroy," Thank you, Mr. Chairman. I appreciate the hearing and found the panel to be really excellent in all of the perspectives advocated. I used to be a state insurance commissioner. Honest to God, I have trouble getting my mind around the kind of unreserved risk that we passed throughout the economy on these CDSs. In the end, and over the years, we would have people at this table lauding the innovation occurring in the financial services marketplace, how it enhanced liquidity of our markets, how it allowed our economy to grow. Well, we now know the truth. It grew like a great big souffle. It was air, over-leveraged air; and it collapsed. Worse yet, here we are well into the collapse, at the highest unemployment registered in decades, and we don't even know if we are down to the bottom of that darn souffle yet. So what has happened by all this innovation, in my opinion, has not been something that has served some terrific end. The notion that we are going to allow credit for risk ceded without any looking at whether or not there is a creditworthy partner providing the backstop, to me is just mind-boggling. " CHRG-111hhrg55814--444 Mr. Wallison," As I have testified to this committee before, I don't think any institution can create systemic risk, no matter what its size, unless it is an insured commercial bank. Ms. D'Arista. No, I think size is important. Yes, activities must be regulated. I have advocated that for many years. But management of a very large institution runs another problem that has to be addressed. " FinancialCrisisReport--88 Community Impact. Long Beach’s poor quality loans not only proved unprofitable for many investors, they were often devastating for the borrowers and their communities. Mr. Killinger testified at the Subcommittee hearing that WaMu, “entered the subprime business with our purchase of Long Beach Mortgage in 1999 to better serve an underserved market.” 269 But the unfortunate result of many Long Beach loans was that they left communities reeling from widespread foreclosures and lost homes. In November 2008, the Office of the Comptroller of the Currency (OCC) which oversees all nationally chartered banks, identified the ten metropolitan areas across the United States with the highest rates of foreclosure for subprime and Alt A mortgages originated from 2005 through 2007. 270 Those ten areas were, in order: Detroit, Cleveland, Stockton, Sacramento, Riverside/San Bernardino, Memphis, Miami/Fort Lauderdale, Bakersfield, Denver, and Las Vegas. The OCC then identified the lenders with the highest foreclosure rates in each of those devastated cities. Long Beach had the worst foreclosure rate in four of those areas, and was near the worst in five more, with the lone exception being Las Vegas. The OCC data also showed that, overall in the ten metropolitan areas, Long Beach mortgages had the second worst foreclosure rate of all the lenders reviewed, with over 11,700 foreclosures at the time of the report. Only New Century was worse. (2) WaMu Retail Lending Washington Mutual’s problems were not confined to its subprime operations; they also affected its retail operations. WaMu loosened underwriting standards as part of its High Risk Lending Strategy, and received repeated criticisms from its regulators, as outlined in the next chapter, for weak underwriting standards, risk layering, excessive loan error and exception rates, appraisal problems, and loan fraud. In August 2007, more than a year before the collapse of the bank, WaMu’s President Steve Rotella emailed CEO Kerry Killinger saying that, aside from Long Beach, WaMu’s prime home loan business “was the worst managed business I had seen in my career.” 271 (a) Inadequate Systems and Weak Oversight One reason for WaMu’s poor lending practices was its failure to adequately monitor the hundreds of billions of dollars of residential loans being issued each year by its own loan 268 Id. at 90. 269 Id. at 86. 270 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the Office of the Comptroller of the Currency, http://www.occ.treas.gov/news-issuances/news-releases/2009/nr-occ-2009-112b.pdf, Hearing Exhibit 4/13-58. 271 8/23/2007 email from Mr. Rotella to Mr. Killinger, JPM_WM00675851, Hearing Exhibit 4/13-79. personnel. From 1990 until 2002, WaMu acquired more than 20 new banks and mortgage companies, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach. WaMu struggled to integrate dozens of lending platforms, information technology systems, staffs, and policies, whose inconsistencies and gaps exposed the bank to loan errors and fraud. CHRG-111hhrg55814--389 Mr. Ryan," I want to thank the committee for this opportunity to appear today. We believe that systemic risk regulation and resolution authority are the two most important pieces of legislation focused on avoiding another financial crisis and solving the ``too-big-to-fail'' problem. I testified in support of a systemic risk regulator before this committee nearly a year ago. It is vital to the taxpayers, the industry, and the overall economy that policymakers get this legislation right. We believe that the revised discussion draft gets most aspects right. We support the general structure it sets up, but given its breadth and its complexity and the short time we have had to review it, we have already identified a number of provisions in the revised draft that we believe could actually increase systemic risk instead of reduce it. We understand your need to act quickly, but please try to do no harm through the legislative process. My written testimony provides details on the proposals weaknesses. We urge the committee to take the time to correct them. We will work day and night to suggest constructive changes. Just two examples. We support the idea of an oversight council. We think it should be chaired by the Secretary of the Treasury. We believe it will be beneficial to have input from a number of key financial regulatory agencies. We're also pleased to see that the Federal Reserve would be given a strong role in the regulation of systemically important financial companies. But we are not sure of the size and composition of the council. We're concerned that the influence of agencies with the greatest experience and stake in systemic risk will be diluted and possibly undermined with a lesser stake. This structure must be reviewed carefully to ensure the council is designed to achieve its goal of identifying and minimizing systemic risk. Second, resolution authority. We strongly support this new authority, essential to contain risk during a financial crisis and to solve the ``too-big-to-fail'' problem. The bank insolvency statute is the right model for certain aspects of this new authority. A Federal agency should be in charge of the process. It should be able to act quickly to transfer selected assets and limit the liabilities to third party. It should have the option of setting up a temporary bridge company to hold assets and liabilities that cannot be transferred to a third party so that they can be unwound in an orderly fashion. But the bank insolvency statute is the wrong model for claims processing and for rules dividing up the left-behind assets and liabilities of non-bank financial companies. The right model is the Bankruptcy Code. The Code contains a very transparent judicial claims process and neutral rules governing creditors rights that markets understand and rely upon. By contrast, the bank insolvency statute, the Federal Deposit Insurance Act, contains a very opaque administrative claims process and creditor-unfriendly rules. These may be appropriate for banks, where the FDIC as the insurer of bank deposits is typically the largest creditor. But the bank insolvency claims process and creditor-unfriendly rules are inappropriate for non-banks which fund themselves in the capital markets, not with deposits. So there is a very important reason to preserve the bankruptcy model for claims processed for non-banks. If you don't, the new resolution authority will seriously disrupt and permanently harm the credit markets for non-banks, increasing systemic risk instead of reducing it. We urge the committee to revise the resolution authority so that it takes the best parts of the bank insolvency model and the best parts of the bankruptcy model. That way it will reflect the strengths of both models without reflecting either of their weaknesses. We and our insolvency experts stand ready to work with you immediately to improve the highly complex and technical resolution authority section. Finally, we also question whether the FDIC has the necessary experience to exercise resolution authority over the large, complex, interconnected, and cross-border financial groups that are the targets of this legislation. We believe that adding the Federal Reserve to the FDIC board is a step in the right direction, but in order to ensure that the right experience is brought, we think we need a new primary Federal resolution authority. And I thank you very much, Mr. Chairman, for your courtesy. [The prepared statement of Mr. Ryan can be found on page 188 of the appendix.] " CHRG-110hhrg46596--253 Mr. Barrett," Thank you, Mr. Chairman. Gentlemen, thank you are being here today. I was reading the legislation. The explicit intent is to immediately restore liquidity and stability in the financial system in the United States, and I believe that. That is why I voted for it. Are we, Mr. Kashkari, have we passed the point where our banking system, our financial system is catastrophe proof? Are we past that point? " CHRG-111shrg55278--95 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you Mr. Chairman. At the core of the Administration's financial regulatory reform proposal is the concept of systemic risk. The President believes that it can be regulated and that the Fed should be the regulator. As we begin to consider how to address systemic risk, my main concern is that while there appears to be a growing consensus on the need for a systemic risk regulator, there is no agreement on how to define systemic risk, let alone how to manage it. I believe that it would be legislative malfeasance to simply tell a particular regulator to manage all financial risks without having reached some consensus on what systemic risk is and whether it can be regulated at all. Should we reach such a consensus, we then must be very careful not to give our markets a false sense of security that could actually exacerbate our ``too-big-to-fail'' problem. If market participants believe that they no longer have to closely monitor risks presented by financial institutions, the stage will be set for our next economic crisis. If we can decide what systemic risk is and that it is something that should and can be regulated, our next question should be: Who should regulate it? Unfortunately, the Administration's proposal largely places the Federal Reserve in charge of regulating systemic risk. It would grant the Fed authority to regulate any bank, securities firm, insurer, investment fund or any other type of financial institution that the Fed deems a systemic risk. The Fed would be able to regulate any aspect of these firms, even over the objections of other regulators. In effect, the Fed would become a regulatory leviathan of unprecedented size and scope. I believe that expanding the Fed's powers in this manner could be very dangerous. The mixing of monetary policy and bank regulation has proven to be a formula for taxpayer-funded bailouts and poor monetary policy decisions. Giving the Fed ultimate responsibility for the regulation of systemically important firms will provide further incentive for the Fed to hide its regulatory failures by bailing out troubled firms. Rather than undertaking the politically painful task of resolving failed institutions, the Fed could take the easy way out and rescue them by using its lender-of-last-resort facilities or open market operations. Even worse, it could undertake these bailouts without having to obtain the approval of Congress. In our system of Government, elected-officials should make decisions about fiscal policy and the use of taxpayer dollars, not unelected central bankers. Handing over the public purse to an enhanced Fed is simply inconsistent with the principles of democratic Government. Augmenting the Federal Reserve's authority also risks burdening it with more responsibility than one institution can reasonably be expected to handle. In fact, the Federal Reserve is already overburdened with its responsibility for monetary policy, the payment system, consumer protection, and bank supervision. I believe anointing the Fed as the systemic risk regulator will make what has proven to be a bad bank regulator even worse. Let us not forget that it was the Fed that pushed for the adoption of the flawed Basel II capital accords, which would have drained our banking system of capital. It was the Fed that failed to adequately supervise Citigroup and Bank of America, setting the stage for bailouts in excess of $400 billion. It was the Fed that failed to adopt mortgage underwriting guidelines until well after this crisis was underway. It was the Fed that said there was no need to regulate derivatives. It was also the Fed that lobbied to become the regulator of financial holding companies as part of Gramm-Leach-Bliley. The Fed won that fight and got the additional authority it sought. Ten years later, however, it is clear that the Fed has proven that it is incapable of handling that responsibility. Ultimately, if we are able to reach some sort of agreement on systemic risk and whether it can be managed, I strongly believe that we should consider every possible alternative to the Fed as the systemic risk regulator. Thank you Mr. Chairman. ______ CHRG-111shrg56376--229 PREPARED STATEMENT OF EUGENE A. LUDWIG Chief Executive Officer, Promontory Financial Group, LLC September 29, 2009Introduction Chairman Dodd, Ranking Member Shelby, and other distinguished Members of the Senate Banking Committee; I am honored to be here today to address the important subject of financial services regulatory reform. I want to commend you and the other Members of the Committee and staff for the serious, thoughtful, and productive way in which you have examined the causes of the financial crisis and the need for reform in this area. Today, there are few subjects more important than reform of the financial services regulatory mechanism. Notwithstanding the fine men and women who work tirelessly at our financial regulatory agencies, the current outdated structure of the system has failed America. At this time last year, we were living through a near meltdown of the world's financial system, triggered by weaknesses generated here in the United States. Two of our largest investment banks and our largest insurance company failed. Our two giant GSE's failed. Three of our largest banking organizations were merged out of existence to prevent them from failing. But the problem is not just about an isolated incident of 1 year's duration. Over the past 20-plus years we have witnessed the failure of hundreds of U.S. banks and bank holding companies. The failures have included national banks, State member banks, State nonmember banks and savings banks, big banks and small banks, dozens if not hundreds of banks supervised by every one of our regulatory agencies. By the end of this year alone, I believe over 100 U.S. banks will have failed, costing the deposit insurance fund tens of billions of dollars. And, I judge that before this crisis is over we will witness the failures of hundreds more. In the face of this irrefutable evidence, it is impossible to say something is not seriously wrong. Now is the time to act boldly and bring American leadership back to this system. A failure to act boldly and wisely will condemn America either to a loss of leadership in this critical area of our economy and/or additional instances of the kinds of financial system failures that we have been living through increasingly over the past several decades, the most pronounced instance of which is currently upon us. No one should underestimate the complexity of accomplishing the needed reforms, though in truth the changes that are needed are surprisingly straightforward from a conceptual perspective. The Administration's financial services regulation White Paper is commendable and directionally correct. It identifies the major issues in this area and provides momentum for reform. In my view, certain essential refinements to the plan laid out in the White Paper are needed; the need for revisions and refinements is an inevitable part of the policymaking process. I also want to commend the Treasury Department of former Secretary Henry Paulson for having developed its so-called ``blueprint,'' which also has added important and positive elements to the debate in this area. Financial services regulatory reform is not fundamentally a partisan issue. It is fundamentally a professional issue. And, under the leadership of you and your staffs Chairman Dodd and former Ranking Member Shelby the traditions of the Senate Banking Committee, which for decades has prided itself on a balanced bipartisan look at the facts and the needs of the country has continued. In this regard, it should be noted that many of the matters I cover below, including importantly the need for an end-to-end consolidated banking regulator, have been championed over the years by Members of the Senate Banking Committee, including its Chairmen, from both sides of the aisle. Similarly, many of these concepts, including the need for an end-to-end consolidated institutional supervisor, have been championed by Treasury Secretaries over the years from both political parties. I have set out below the seven critical steps that are needed to fix the American Financial Regulatory system and to refine the approaches put forth by both the current and previous Treasury Departments. Being so direct is no doubt somewhat presumptuous on my part, but I have been fortunate in my career to have worked in multiple capacities with the financial services industry and consumer organizations in this country and abroad, including as a regulator, money-center bank executive, board member, major investor in community banks, and chairman and board member of community development and consumer-related organizations. So what has gone so wrong? Let me begin by saying what the problem is not. First, the problem is not the failure to have thousands of talented people working in bank and bank holding company supervision. I can testify from personal experience that we do indeed have exceptionally fine and able men and women in all our regulatory agencies. Second, our banks and bank holding companies are not subject to weak regulations. On the contrary, though not without flaws, our codes of banking regulations are no less stringent than those in countries that have weathered the current and past crises well. Third, it is not because America has weaker bankers than in the countries that have been more successful at dealing with the current crisis. On the contrary, we have a right to take pride in America's banks and bankers many of whom work harder than their peers abroad, have higher standards than their peers abroad and contribute more to their communities in civic projects than their peers abroad. Of course, we have had isolated cases of regulators and bankers that failed in their duties. However, 20-plus years with hundreds of bank failures through multiple economic cycles is not the result of a few misguided souls. So what is the problem with financial institution safety and soundness in the United States and how can we fix it? To my mind, the answer is relatively straightforward, and I have outlined it in the seven areas I cover below.Needed Reforms1. Streamline the current ``alphabet soup'' of regulators by creating a single world class financial institution specific, end to end, regulator at the Federal level while retaining the dual banking system. a. Introduction. We must dramatically streamline the current alphabet soup of regulators. The regulatory sprawl that exists today is, as this Committee well knows, a product of history, not deliberation. The recent financial crisis has accentuated many of the shortcomings of the current regulatory system. Indeed, it is worth noting that our dysfunctional regulatory structure exists virtually nowhere else. And, I am not aware of any scholar or any country that believes it is the paradigm of financial regulatory structuring; nor am I aware of one country anywhere that wants to copy it. b. How Our Regulatory Structure Fails: There are at least seven ways in which our current regulatory structure fails: Needless Burdens That Weaken Safety and Soundness Focus. First, a profusion of regulators, such as we have in the United States, adds too much needless burden to the financial services system. Additional burdens where they do not add value are not neutral. They actually diminish safety and soundness. Many banking organizations today have several regulatory agencies to contend with and dozens--in a few cases--hundreds of annual regulatory examinations with which to cope. At the same time, top management's time is not infinite. It is important to streamline and target regulatory oversight, and accordingly top management talent's focus to address those issues that most threaten safety and soundness. Lack of Scale Needed To Address Problems in Technical Areas. Second, under our current regulatory structure, not one of the institutional regulators is sufficiently large or comprehensive enough in their supervisory coverage to adequately ensure institutional safety and soundness. Typically, no regulator today engages in end-to-end supervision as different parts of the larger financial organizations are supervised by different regulatory entities. And gaining scale in regulatory specialties of importance, for example, risk metrics, or capital markets activities, is severely hampered by the too small and fractured nature of supervision today in America. Regulatory Arbitrage. Third, the existence of multiple regulatory agencies is fertile ground for regulatory arbitrage, thereby seriously undercutting strong prudential regulation and supervision. Delayed Rulemaking. Fourth, rulemaking while often harmonized at least among the banking supervisors is slow to advance because of squabbles among the financial services regulators that can last for years at a time. Regulatory Gaps. Fifth, because our regulatory structure is a hodgepodge, for all its multiple regulators and inefficiencies, it is not truly ``end-to-end'' and has been prone to serious gaps between regulatory agency responsibilities where there is little or no supervision. And these gaps are often exploited by financial institutions, overburdened by too much regulation in other areas--weeds take root and flourish in the cracks of the sidewalk. Limitations on Investigations. Sixth, where an experienced and talented bank regulator believes he or she has found a problem in the bank, that individual or his or her regulatory agency cannot follow the danger beyond the legalistic confines of the chartered bank itself. ``Hot pursuit'' is not allowed in bank regulation today. We count on our bank examiners to function as a police force of sorts. But even when our bank detectives and cops sniff out trouble, they may have to quit following the trail when they hit ``the county line'' where another agency's jurisdiction begins. Like county sheriffs, examiners sometimes can do little more than plead with the examiners in the neighboring jurisdiction to follow up on the matter. Diminished International Leadership. Seventh, our hydra- headed regulatory system, with periodic squabbles among its various components, increasingly undercuts our moral force around the world, leading to a more fractured and less hospitable regulatory environment for U.S.-based financial services providers.Let me elaborate on two of these points--the counterproductive nature of excess burdens and regulatory arbitrage: Counterproductive Burdens. Today, a large financial institution that has a bank in its chain is in almost all cases subject to regulation by a bank regulator, the Federal bank regulator, (the Federal component of which will be the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corporation, or the Office of Thrift Supervision) and in many cases by a State bank regulator. Many banking organizations have national banks, State banks and savings banks in their chains, so they are subject to all these bank supervisors. In addition, every institution with a bank in its chain must have either the Federal Reserve or the OTS as its bank holding company and nonbank affiliate regulator. In all cases, financial services companies with bank affiliates are subject to the FDIC as an additional supervisor. But the list does not stop there. Additional supervision may be performed by the State Attorneys General, the Securities and Exchange Commission, and the Financial Industry Regulatory Authority. For Bank Secrecy Act, Foreign Corrupt Practices Act, and anti-money-laundering matters there is a supervisory role for the Financial Crimes Enforcement Network and Office of Foreign Asset Control. Also, the insurance company subsidiaries of bank holding companies may be subject to regulation by State insurance regulators in each of the States. In addition, at times, even the Federal Trade Commission serves as a supervisor. And, the Justice Department sometimes becomes involved in what historically might have been considered civil infractions of various rules. Even the accounting standard setting agencies directly or through the SEC, get into the act. This alphabet soup of regulators results in multiple enforcement actions, often for the same wrong, and dozens of examinations, which as I have noted for our largest institutions may literally total in the hundreds in a year. There are so many needless burdens caused by this cacophony of regulators, rules, examinations and enforcement activities that many financial services companies shift their business outside the United States whenever possible. But the burden is not in and of itself what is most concerning. The worst feature of our current system is that for all the different regulators, the back-up supervision and the volumes of regulation has not produced superior safety and soundness results. On the contrary, based on the track record of at least the last 20-plus years, it has produced less safety and soundness than some simplified foreign systems. As the current crisis and the past several debacles have shown, our current expensive and burdensome system does not work. Regulatory Arbitrage. Financial institutions that believe their current regulator is too tough can change regulatory regimes by simply flipping charters and thus avoid strong medicine prescribed by the previous prudential supervisor. Indeed, even where charter flipping does not actually occur, the threat of it has pernicious implications. Sometimes stated directly, sometimes indirectly, often by the least well-run banking organization, the threat of charter flipping eats away at the ability of examiners and ultimately the regulatory agency to be the clear-eyed referee that the system needs them to be. And, regulatory arbitrage is greatly increased by the funding disequilibrium in our system whereby the Comptroller's office must charge its banks more since State-chartered banks are in effect subsidized by the FDIC or the Fed. The practical significance of this disequilibrium cannot be overstated. c. Misconceptions. There have been a number of misconceptions about what a consolidated end-to-end institutional supervisor is and what it is not, as well as the history of this kind of prudential regulator. Not a Super Regulator. First, an end-to-end consolidated institutional supervisor is not a ``super regulator'' along the lines of Britain's FSA. A consolidated institutional prudential regulator does not regulate financial markets like the FSA. The SEC and the CFTC do that. A consolidated institutional regulator does not establish consumer protection rules like the FSA. A new consumer agency or the Federal Reserve does that. A consolidated institutional supervisor does not itself have resolution authority or authority with respect to the financial system as a whole. The FDIC does, and perhaps the Fed, the Treasury and a new systemic council would also do that. The consolidate institutional regulator would focus only on the prudential issues applicable to financial institutions like The Office of the Superintendent of Financial Institutions (OSFI) in Canada and the Australian Prudential Regulatory Authority (APRA), both of which have been successful regulators, including during this time of crisis, something I discuss in greater detail below. An Agency That Charters and Supervises National Entities Cannot Regulate Smaller Institutions. Second, there has been a misconception that a consolidated regulator that regulates enterprises chartered at the national level cannot fairly supervise smaller community organizations. In fact, even today the OCC currently supervises well over 1,000 community-banking organizations whose businesses are local in character. And, it is worth adding that these small, community organizations that are supervised by the OCC, choose this supervision when they clearly have the right to select a State charter with a different supervisory mechanism. The OCC, it must also be noted, supervises some of the largest banks in the United States. If the OCC unfairly tilted supervision toward the largest institutions or otherwise, it is hard to imagine that it would have smaller institutions volunteer for its supervision. Entity That Regulates Larger Institutions Cannot Regulate Smaller Institutions. Third, there is a misconception that a consolidated regulator that regulates larger enterprises cannot regulate smaller enterprises or will tilt the agency's focus in favor of larger enterprises. In fact, whether consolidated or not, all our current financial regulators regulate financial institutions with huge size disparities. Today, all our Federal regulators make meaningful accommodations so that they can regulate large institutions and smaller institutions, recognizing that often the business models are different. In fact, as will be discussed in greater detail, it is important to regulate across the size perspective for several reasons. It means the little firms are not second-class citizens with second-class regulation. It means that the agency has regulators sufficiently sophisticated who can supervise complex products that can exist in some smaller institutions as well as larger institutions. Checks and Balances. Fourth, some have worried that a consolidated institutional supervisor would not have the benefit of other regulatory voices. This would clearly not be the case as a consolidate institutional supervisor would fulfill only one piece of the regulatory landscape. The Federal Reserve, Treasury, SEC, FDIC, CFTC, FINRA, FINCEN, OFAC, and FHFA would continue to have important responsibilities with respect to the financial sector. In addition, proposals are being made to add additional elements to the U.S. financial regulatory landscape, the Systemic Risk Council and a new Financial Consumer agency. This would leave 8 financial regulators at the Federal level and 50 bank regulators, 50 insurance regulators and 50 securities regulators at the State level. I would think that this is a sufficient number of voices to ensure that the consolidated institutional supervisor is not a lone voice on regulatory matters. Need To Supervise for Monetary Authority and Insurance Obligations. Fifth, some have also claimed that the primary work of the Federal Reserve (monetary policy, payments system and acting as the bank of last resort) and the FDIC (insurance) would be seriously hampered if they did not have supervisory responsibilities. The evidence does not support these claims. 1. A review of FOMC minutes does not suggest much if any use is made of supervisory data in monetary policy activities. In the case of the FDIC, it has long relied on a combination of publicly available data and examination data from other agencies. 2. There are not now to my knowledge any limitations on the ability of the Federal Reserve or the FDIC to collect any and all information from the organizations they are now supervising, whether or not they are supervising them. 3. And whether or not the Federal Reserve or the FDIC is supervising an entity, it can accompany another agency's examination team to obtain relevant data or review relevant practices. 4. If the FDIC or the Federal Reserve does not have adequate cooperation on gathering information, Congress can make clear by statute that this must be the case. 5. The Federal Reserve's need for data goes well beyond the entities it supervises and indeed where the majority of the financial assets have been located. Hedge funds, private equity funds, insurance companies, mortgage brokers, etc., etc., are important areas of the financial economy where the Fed has not gathered data to date and yet these were important areas of the economy to understand in the just ended crisis. Should not these be areas where Federal Reserve Data gathering power are enhanced? Is this not the first order of business? Does the Federal Reserve need to supervise all of these institutions to gather data? 6. Even if the FDIC were not the supervisor of State chartered banking entities, the FDIC would have backup supervisory authority and be able to be resident in any bank it chose. 7. There is scant information that suggests the Federal Reserve or FDIC's on-site activities, were instrumental in stemming the current crises or bank failures. Again, it is important to emphasize, this is not a reflection on these two exceptional agencies or their extraordinarily able and dedicated professionals. It is a reflection of our dysfunctional, alphabet soup supervisory structure. No Evidence That Consolidated Supervision Works. Sixth, some have claimed that because the U.K.'s FSA has had bank failures on its watch, a consolidated institutional regulator does not work and would not work in the U.S. As noted above, the U.K. FSA is a species of super-regulator with much broader authorities than a mere consolidated regulator. It is also worth noting that neither in the U.K. nor elsewhere is the debate over supervision one that extols the U.S. model. Rather, the debate tends to be simply over whether the consolidated supervisor should be placed within the central bank or elsewhere. More importantly, it should be emphasized that there are regulatory models around the world that have been extremely successful using a consolidated institutional regulator model. Indeed, two countries with the most successful track record through the past crisis, Canada and Australia, have end-to-end, consolidate regulators. In Canada the entity is OSFI and in Australia APRA. Both entities perform essentially the same consolidated institutional prudential supervisory function in their home countries. In both cases they exist in governmental structures where there are also strong central banks, deposit insurance, consumer protections, separate securities regulators and strong Treasury Departments. Canada and Australia's regulatory systems work very well and indeed, that they have not just a successful consolidated end-to-end supervisor but a periodic meeting of governmental financial leaders that has many of the attributes systemic risk council, discussed below. Would It Do Damage To The Dual Banking System? Seventh, there was considerable concern in the 1860s and 1870s that a national charter and national supervision would do away with the State banking system. It did not. Similar fears arose when the Federal Reserve and FDIC became a Federal examination supervisory component of State-chartered banking. These fears were also unfounded. Both the Federal Reserve and the FDIC are national instrumentalities that provide national examination every other year and more frequently when an institution is troubled. A new consolidated supervisor at the Federal level would merely pick up the FDIC and Federal Reserve examination and supervisory authorities. d. Proposal. Accordingly, I strongly urge the Congress to create one financial services institutional regulator. In urging the Congress to take this step, I believe that several matters should be clarified: Institutional Not Market Regulator. I am not suggesting that we merge the market regulators--the Commodities Futures Trading Commission, the SEC, and FINRA--into this new institutional regulatory mechanism. The market regulators should be allowed to continue to regulate markets--as a distinct functional task with unique demands and delicate consequences. Rather, I am suggesting that all examination, regulation, and enforcement that focus on individual, prudential financial regulation of financial institutions should be part of one highly professionalized agency. Issue Is Structure Not People. As a former U.S. Comptroller of the Currency, who would see his former agency and position disappear into a new consolidated agency, the creation of this new regulator is not a proposition I offer lightly. I fully understand the pride each of our Federal financial regulatory agencies takes in its unique history and responsibility. As I have said elsewhere in this testimony, I have nothing but the highest regard for the professionalism and dedication the hard- working men and women who make up these agencies bring to their jobs every day. The issue is not about individuals, nor is it about historic agency successes. Rather, it is all about a system of regulation that has outlived the period where it can be sufficiently effective. Indeed, perpetuating the current antiquated system makes it harder for the fine men and women of our regulatory agencies to fully demonstrate their talents and to advance as far professionally as they are capable of advancing. Retention of Dual Banking System. In proposing a consolidated regulatory agency, I am not suggesting that we should do harm to our dual banking system as noted above. Chartering authority is one thing; supervision and regulation are quite another matter. The State charter can and should be retained; the power of the States to confer charters is deeply imbedded in our federalist system. There is nothing to prevent States from examining the institutions subject to their charters. On the contrary, one would expect the States to perform the same regulatory and supervisory functions in which they engage today. As noted, the new consolidated regulatory agency would simply pick up the Federal component of the State examination and regulation, currently performed by the Federal Reserve and the FDIC. Funding. This new consolidated financial institutional regulatory agency should be funded by all firms that it examines, eliminating arbitrage, which often masquerades as attempts to save examination fees. Importance of Independence. Importantly, this new consolidated supervisory agency needs to be independent. It needs to be a trusted, impartial, professional referee. This is important for several reasons. It is absolutely essential for the agency to be taken seriously that it be free from the possible taint of the political process. It must not be possible for politically elected leader to decide how banking organizations are supervised because of political considerations. Time and again, when the issue of bank supervision and the political process has been considered by Congress, Congress has opted to keep the regulatory mechanisms independent. Independence also bespeaks of attracting top talent to head the agency, and this is of considerable importance. If the head of the agency is not someone who is as distinguished and experienced as the head of the SEC, Treasury Secretary or Chairman of the Federal Reserve, if it is not someone with this level of Government seniority and distinction, the agency will not function at the level it needs to function to do the kind of job we need in a complex world. e. Architecture of Reform Proposals/Congressional Oversight. Enterprises perform best where they have clear missions, and there are not other missions to add confusion. The consolidated end-to-end supervisor would have a clear mission and would fit nicely with the proposals below where the roles and responsibilities of all parts of our regulatory system would be simplified and targeted. The Federal Reserve would be in charge of monetary policy, back-stop bank and payments system activities. The FDIC would continue to be the deposit insurer. The SEC and CFTC market regulators. The Systemic Council would identify and seek to mitigate potential systemic events. And a consumer organization would be responsible for consumer issue rule setting. This allows for much more effective Congressional oversight. Congress will be able to focus on each agency's responsibilities with greater effectiveness when one agency engages in a disparate set of activities.2. Avoid a two-tier regulatory system that elevates the largest ``too- big-to-fail'' institutions over smaller institutions. Eliminating the alphabet soup of regulators should not give rise to a two-class system where our largest banking organizations, deemed ``too big to fail,'' are regulated separately from the rest. To do that has several deleterious outcomes: a. Public Utilities or Favored Club. A two-class system means either the largest institutions become, in essence, public utilities subject to rules--such as higher capital charges, inflexible product and service limitations, and compensation straitjackets--or, they become a special favored club that siphons off the blue chip credits, the best depositors, the safest business, the best examiners and supervisory service whereby the community banking sector has to settle for the leftovers. Both outcomes are highly undesirable. b. Smaller Institutions Should Not Be Second Class Citizens. I can assure you that over time, condemning community banking to the leftovers will make them less safe, less vibrant and less innovative. Even today, tens, indeed hundreds of billions of dollars have been used to save larger institutions, even nonbanks, and yet we think nothing of failing dozens of community banks. Over 90 banks have failed since the beginning of 2009, and they were overwhelmingly community banks; the number is likely to be in the hundreds before this crisis is over. c. Two-Tier Supervisory System Exacerbates ``Too-Big-To-Fail'' Problem. Creating a two tier supervisory system and designating some institutions, as ``too big to fail'' is a capitulation to the notion that some institutions should indeed be allowed to function in that category. To me, this is a terrible mistake. We are enshrining some institutions with such importance due to their size and interconnected characteristics that we are implicitly accepting the notion that our Nation's economic well-being is in their hands, not in the hands of the people and their elected officials. d. Danger of Second Class Supervisory System for Smaller Organizations. As a practical matter, a two-tier system makes it less likely that top talent will be available to supervise smaller institutions. At the end of the day, who wants to work for the second regulator that has no ability to ever regulate the institutions that are essentially defined as mattering most to the Nation? e. Size Is Not the Only Differentiating Characteristic. Finally, just because we might have one prudentially oriented financial services supervisor does not mean that we should not differentiate supervision to fit the size and other characteristics of the institutions being supervised. On the contrary, we should tailor the supervision so that community banks and other kinds of organizations--for example, trust banks or credit card banks--are getting the kind of professional supervision they need, no more and no less. But such an avoidance of a one-size-fits-all supervisory model is far from elevating a class of financial institution into the ``too-big-to-fail'' pantheon. In sum, I urge the Congress not to create a ``too-big-to-fail'' category of financial institutions, directly or indirectly, either through the regulatory mechanism or by rule. On the contrary, I urge the Congress to take steps to avoid the perpetuation of such a bias in our system.3. It is essential to have a resolution mechanism that can resolve entities, however large and interconnected. Essential Nature of the Problem. It cannot be overstressed just how important it is to develop a mechanism to safely resolve the largest and most interconnected financial institutions. If we do not have such a mechanism in place and functioning, we either condemn our largest institutions to become a species of public utility, less innovative and less competitive globally, or we have to create artificial measures to limit size, diversity, and perhaps product offerings. If we choose the first alternative and go the public utility route, we are in effect admitting that some institutions are ``too big to fail,'' and thus unbalancing the rest of our financial services sector. Moreover, adopting either alternative would change not only the fabric of our financial system, but the free-market nature of finance and the economy in the United States. Complexity of the Undertaking. An essential aspect to eliminating the perception and reality of institutions that are ``too big to fail'' is to ensure that we have a resolution mechanism that can handle the failure of very large and/or very connected institutions without taking the chance of creating a systemic event. However, it is worth emphasizing that creating such a resolution mechanism will require careful legislative and regulatory efforts. Resolving institutions is not easy. To step back for a moment, it is quite striking that the seizure of even a relatively small bank, (e.g., a bank with $60 million in assets) is a very substantial undertaking. With the precision of a SWAT team, dozens of bank examiners and resolutions experts descend on even a small institution that is to be resolved, and they work nearly around the clock for 48 hours, turning the bank inside out as they comb through books and records and catalogue everything from cash to customer files. Imagine magnifying that task to resolve a bank that is 10 times, 100 times, or 1,000 times larger than my community bank example. A Resolution Mechanism Can Be Created To Resolve the Problem. The FDIC has capably discharged its duties as the receiver of even some very large banks, but significantly revised processes and procedures will have to be created to deal with the largest, most interconnected and geographically diverse institutions with broad ranges of product offerings. With that said, having worked both as a director of the FDIC and in the private sector as a lawyer with some bankruptcy experience, I am reasonably confident that we can create the necessary resolution mechanism. Several aspects to creating a resolution mechanism for the largest banks that deserve particular attention are enumerated below: a. Costs Should Not Be Borne By Smaller Institutions. We have to be careful that the costs of resolution of such institutions are not borne by smaller or healthier institutions, particularly at the time of failure when markets generally may be disrupted. This means all large institutions that might avail themselves of such a mechanism should be paying some fees into a fund that should be available when resolution is needed. b. Treasury Backstop. Furthermore, such a fund should be backstopped by the Treasury as is the FDIC Deposit Insurance Fund (DIF). We should not be calling on healthy companies to fill up the fund quickly, particularly during periods of financial turmoil. An unintended consequence of current law is that we have been requiring healthy community banks to replenish the deposit insurance fund during the banking crisis, making matters worse by making the good institutions weaker and less able to lend. We should change current law so that this is no longer the case with respect to the DIF, and this certainly should not be the case with a new fund set up to deal with larger bank and nonbank failures. c. Resolution Decisions. The ultimate decision to resolve at least the largest financial institutions should be the province of a systemic council, which I will discuss in greater detail shortly. The decision should take into account both individual institutional concerns and systemic concerns. Our current legal requirements for resolving the troubled financial system is flawed in that it is one-dimensional, causing the FDIC to make the call on the basis of what would pose the ``least cost to the DIF,'' not on the basis of the least cost to the economy, or to the financial system. I emphasize that this is not a criticism of the FDIC; that agency is doing what it has to do under current law. My criticism is of the narrowness of the law itself. d. Resolution Mechanics. In terms of which agency should be in charge of the mechanics of resolution itself, there are a number of ways the Congress could come out on this question, all of which have pluses and minuses. Giving the responsibility to the FDIC makes sense in that the FDIC has been engaged successfully in resolving banking organizations and so has important resolutions expertise. One could also argue that the primary regulator that knows the institution best should be in charge of the resolution, calling upon the DIF for money and back up. The primary regulators do in fact have some useful resolutions and conservatorship experiences, though they have not typically been active in the area, in part due to the lack of a dedicated fund for such purposes. Or one could argue for a special agency, like the RTC, perhaps under the control of the new systemic risk council. I have not settled in my own mind which of these models works best, except to be certain that the institution in charge of resolutions has to be highly professional and that a special process must be in place to deal with the extraordinary issues presented by the failure of an extremely large and interconnected financial institution. In sum, I urge Congress to create a new function that can require the resolution of a large, complex financial institution. This new function can be handled as part of the responsibilities of the Systemic Risk Council discussed below. The mechanism that calls for resolution of a large troubled financial institution need not be the same institution that actually engages in the resolution activity itself. Any of the FDIC, the primary regulator and/or a new resolution mechanism could do the job of actually resolving a large troubled institution if properly organized for the purpose, though certainly much can be said for the FDIC's handling of this important mechanical function, given its expertise in the area generally. Even more important, it is absolutely key that we clarify existing law so that the decision--and the mechanics--to resolve a troubled institution is a question first of financial stability for the system and then a question of least-cost resolution.4. A new systemic risk identification and mitigation mechanism must be created by the Federal Government; A financial council is best suited to be responsible for this important function. Nature of the Problem. The financial crisis we have been living through makes clear beyond a doubt that systemic risk is no abstraction. Starting in the summer of 2007, we experienced just how the rumblings of a breakdown in the U.S. subprime housing market could ripple out to Germany and Australia and beyond. Last year, we witnessed the devastating effects the demise of Lehman Brothers, a complex and interconnected financial company, could have on the financial system and the economy as a whole. The entire international financial system almost came to a standstill post Lehman Brothers failure. Notwithstanding the magnitude of the problem and the possible outcomes of a Lehman Brothers failure, our financial regulatory mechanism was caught relatively unaware. For more than a year preceding the Lehman Brothers catastrophe our regulatory mechanism was in denial, considering the problem to be a relatively isolated subprime housing problem. The same failure to recognize the signs of an impending crisis can be laid at the feet of the regulatory mechanism prior to the S&L crisis, the 1987 stock market meltdown, the banking crisis of the early 1990s, the emerging market meltdown of 1998, and the technology crisis of 2000-2001. No agency of Government has functioned as an early warning mechanism, nor adequately mitigated systemic problems as they were emerging. Only after the systemic problem was relatively full blown have forceful steps been taken to quell the crisis. In some cases the delay in taking action and initial governmental mistakes in dealing with the crisis have cost the Nation dearly--as was true in the S&L crisis. The same can be said of the other crises of the preceding century where for example in the case of the Great Depression, steps taken by the Government after the problem arose--to withdraw liquidity from the market--actually made the problem markedly worse. Admittedly, identifying potential systemic problems is hard. It involves identifying financial ``bubbles,'' unsustainable periods of excess. However, though difficult, economists outside of Government have identified emerging bubbles, including the past one. Furthermore, there are steps that can be taken to mitigate such emerging problems, for example, increasing stock margin requirements or tightening lending standards or liquefying the markets early in the crisis. The Need To Create a New Governmental Mechanism. This Committee is wisely contemplating the creation of a Systemic Risk Council as a new mechanism to deal with questions of systemic risk. There is general agreement that some new mechanism is needed for identifying and mitigating systemic problems as none exists at the moment. Indeed, the current Treasury Department has also wisely highlighted the importance of considering systemic risk as one of the issues on which to focus as a central part of financial regulatory modernization. Former Treasury Secretary Paulson, too, who spearheaded Treasury's ``blueprint,'' focused on this important issue. There is now a reasonable consensus that there are times when financial issues go beyond the regulation and supervision of individual financial institutions. Why a Council in Particular Makes the Most Sense. There are a number of reasons why no current agency of Government is suited to be in charge of the systemic risk issue, and why a council with its own staff is the best approach for dealing with this problem. 1. Systemic Risk: A Product of Governmental Action or Inaction. It is essential to emphasize that historically, virtually all systemic crises are at their root caused by Government action or inaction. Though individual institutional weakness or failure may be the product of these troubled times and may add to the conflagration, the conditions and often even the triggering mechanisms for a systemic crisis are in the Government's control. i. For example, the decision to withdraw liquidity from the marketplace in the 1930s and the Smoot-Hawley tariffs were important causes of the Great Depression; ii. The decision to raise interest rates in the 1980s coupled with a weak regulatory mechanism and expansion of S&L powers led to the S&L failures of the 1980s; iii. The decision to produce an extended period of low interest rates, the unwillingness to rein in an over-levered consumer-- indeed quite the contrary--and high liquidity coupled with a de-emphasis of prudential regulation is at the root of the current crisis. 2. No Current Regulatory Agency Is Well Suited for the Task. Our existing regulators are not well suited, acting alone, to identify and/or mitigate systemic problems. There are a variety of reasons for this. a. Substantial Existing Duties. First, each of our existing institutions already has substantial responsibilities. b. Systemic Events Cross Existing Jurisdictional Lines. Second, systemic events often cross the jurisdictional lines of responsibilities of individual regulators, involving markets, sector concentrations, monetary policy considerations, housing policies, etc. c. Conflicts of Interest. Third, the responsibilities of individual regulators can create built-in conflicts of interest, biases that make it harder to identify and deal with a systemic event. d. Systemic Risk Not Fundamentally About Individual Private Sector Institution Supervision. Fourth, as noted above, it bears emphasis that the actions needed to deal with systemic issues (identification of an emerging systemic crisis, or the conditions for such a crisis, and then action to deal with the impending crisis) are largely not about supervising individual private-sector institutions. e. Systemic Events May Involve Any One Agency's Policies. Systemic crises may emanate from the polices of an individual financial agency. That has been true in the past. It is hard to have confidence that the same agency involved in making the policy decisions that may bring on a systemic crises will not be somewhat myopic when it comes to identifying the policy law or how to deal with it. f. Too Many Duties and Difficulties In Oversight. There is a legitimate concern that adding a systemic risk function to the already daunting functions of any of our existing financial agencies will simply create a situation where the agency will be unable to perform any one function as well as it would otherwise. Furthermore, Congressional oversight is made considerably more difficult where an agency has multiple responsibilities. g. Too Much Concentrated Power. Giving one agency systemic risk authority coupled with other regulatory authorities moves away from a situation of checks and balances to one of concentrated financial power. This is particularly true where systemic risk authority is incorporated in an agency with central banking powers. Any entity this powerful goes precisely against the wisdom of our founding fathers, who again and again opposed the centralization of economic power represented by the establishment of the First and Second Banks of the United States, and instead repeatedly insisted upon a system of checks and balances. They were wary, and I believe the current Congress should likewise be wary, of any one institution that does not have clear, simple functional responsibilities, or that is so large and sprawling in its mission and authority that the Congress cannot exercise adequate oversight. 3. Multiple Viewpoints With Focused Professional Staff. A Systemic Risk Council of the type contemplated by Committee has the virtue of combining the wisdom and differing viewpoints of all the current financial agencies. Each of these agencies sees the financial world from a different perspective. Each has its own expertise. Combined they will have a more fulsome appreciation of a larger more systemic problem. Of course, a council alone without a leader and staff will be less effective. To be a major factor in identifying and mitigating a systemic issue, the council will need a strong and thoughtful leader appointed by the President and confirmed by the Senate. That leader will need to have a staff of top economists and other professionals, though the staff can be modest in size and draw on the collective expertise of the staffs of the members of the council. Accordingly, I urge Congress to adopt a system whereby the Federal Reserve along with its fellow financial regulators and supervisors should form a council, the board of directors, if you will, of a new systemic risk agency. The agency should have a Chairman and CEO who is chosen by the President and confirmed by the Senate. The Chairman should have a staff: The function of the systemic risk council's staff should be to identify potential systemic events; take actions to avoid such events; and/or to take actions to mitigate systemic events in times of a crisis. Where the Chairman of the systemic council believes he or she needs to take steps to prevent or mitigate a systemic crisis, he or she may take such actions irrespective of the views of the agencies that make up the council, provided a majority of the council agrees.5. Taking additional steps to enhance the professionalization of America's financial services regulatory mechanism should be a top priority. America is blessed with an extremely strong group of dedicated regulators at our current financial services regulatory agencies. However, we must do much more to provide professional opportunities for our fine supervisory people: a. As I have said many times before, many colleges and universities in America today offer every conceivable degree except a degree in regulation, supervision, financial institution safety and soundness--let alone the most basic components of the same. Even individual courses in these disciplines are hard to come by. b. We should encourage chaired professors in these prudential disciplines. c. What I hope would be our new institutional regulatory agency should have the economic wherewithal to provide not just training but genuine, graduate school-level courses in these important disciplines. In sum, we need to further professionalize our regulatory, examination and supervision services, including by way of enhancing university and agency professional programs of study.6. Regulate all financial institutions, not just banks. All financial institutions engaged in the same activities at the same size levels should be similarly regulated. We cannot have a safe and sound financial services regulatory system that has to compete with un-regulated and under-regulated entities that are engaged in virtually identical activities: a. It simply does not work to have a large portion of our financial services system heavily regulated with specific capital charges and limits on product innovation, while we allow the remainder of the system to play by different rules. For America to have a safe and sound financial system, it needs to have a level regulatory playing field; otherwise the regulated sector will have a cost base that is different from the unregulated sector, which will drive the heavily regulated sector to go further out on the risk curve to earn the hurdle rates of return needed to attract much needed capital. b. In this regard, I want to emphasize that good regulation does not mean a lot of regulation. More is not better; bigger is not better; better is better. Sound regulation does not mean heaping burdens upon currently regulated or unregulated financial players--quite the contrary. I have come to learn after a lifetime of working with the regulatory services agencies that some regulations work well, others do not work and perhaps even more importantly many banks and other organizations are made markedly less safe where the regulator causes them to focus on the wrong item and/or piles on more and more regulation. Regulators too often forget that a financial services executive has only so many hours in a day. Targeting that time on key safety and soundness matters is critical to achieving a safer institution.7. Protecting consumer interests and making sure that we extend financial services fairly to all Americans must be a key element of any regulatory reform. We cannot have a safe and sound financial system without it. We cannot have a safe and sound financial regulatory system that does not protect the consumer, particularly the unsophisticated, nor can we have a safe and sound financial system that does not extend services fairly and appropriately to all Americans. The Administration has in this regard come out with a bold proposal to have an independent financial services consumer regulator. There is much to commend this proposal. However, this concept has been quite controversial not only among bankers but even among financial services regulators. Why? I think at the center of what gives serious heartburn to the detractors of this concept are three matters that deserve the attention of Congress: a. First, critics are concerned about the burdens that such a mechanism would create. These burdens are particularly pronounced without a single prudential regulator like the one I have proposed, because without such a change, we would again be adding to our alphabet soup of regulators. b. Second, I believe critics are justifiably concerned that the new agency would at the end of the day be all about examining and regulating banking organizations and bank-related organizations but not the un- and under-regulated financial services companies, many of which are heavily implicated as causes of the current crisis. c. Third, there is a concern that the new mechanism will not give rise to national standards but rather, by only setting a national standards floor, will give rise to 50 additional sets of consumer rules, making the operation of a retail banking organization a nightmare. For myself, I feel strongly that an independent consumer regulatory agency can only work if these three problems are solved. And I believe they can be solved in a way that improves upon the current situation for all stakeholders. My recommendations follow: Focus On Un- and Under-regulated Institutions. First, I would focus a new independent consumer financial regulatory agency primarily on the un- and under-regulated financial services companies. These companies have historically caused most of the problems for consumers. Many operate within well- known categories--check cashers, mortgage brokers, pay-day- lenders, loan sharks, pawn brokers--so they are not hard to find. It is here that we need to expend the lion's share of examination and supervisory efforts. Minimize Burden. Second, consistent with my comments on prudential supervision, I would work to have maximum effectiveness for the new agency with minimum burden. In this regard, it is hard to judge such burden unless and until we can see all the financial services regulatory modernization measures. Chairman Dodd and Ranking Committee Member Shelby, you along with many of your fellow Committee Members should be commended for waiting to act on any piece of financial services regulatory modernization until we can see the entire package-- for precisely these reasons. National Standards for Nationally Chartered Entities. Third, we need to establish uniform national standards for nationally chartered financial organizations. We are one Nation. One of our key competitive advantages as a Nation is our large market. We take a big step toward ruining that market for retail finance when we allow every State to set its own standards with its own enforcement mechanism or entities that have been nationally chartered and are nationally supervised. Do we really want to be a step behind the European Union and its common market? Do we really want to cut up our country so that we are less competitive vis-a-vis other large national marketplaces like China, Canada, and Australia? I hope not. I do not think many of the detractors of the current independent consumer agency proposal would continue to oppose the legislation--irrespective of how high the standards are--if the standards are uniform nationally and uniformly examined and enforced. Utilization of Existing Supervisory Teams. It is worth noting that one way to deal with the burden question that has been suggested by Ellen Seidman, former Deputy to the National Economic Council and former Director of the OTS, is to allow the new agency to set rules and allow the banking agencies to continue to be in charge of examination and enforcement. There is a great deal to say for this approach. However, I am reserving my own views until I see the entire package evolve, absolute musts being for me the three items just mentioned: strict burden reduction, true national standards, and a focus on the unregulated and under-regulated financial services entities.Conclusion In conclusion, Mr. Chairman, I again want to commend you, your colleagues, and the Committee staff for the serious way in which you have attacked this national problem. The financial crisis has laid bare the underbelly of our economic system and made clear that system's serious vulnerabilities. We are at a crossroads. Either we act boldly along the lines I have suggested or generations of Americans will, I believe, pay a very steep price and our international leadership in financial services will be shattered. Thank you. I would be pleased to answer any questions you may have. ______ FinancialCrisisInquiry--158 Why is the taxpayer taking a penny of a loss if in fact the losses are going to be a couple hundred billion a piece? I don’t understand. HENNESSY: A follow up… VICE CHAIRMAN THOMAS: Will the gentleman yield briefly to... HOLTZ-EAKIN: I want to follow up on exactly that point, with your permission. VICE CHAIRMAN THOMAS: Go ahead. HOLTZ-EAKIN: I’ll go fast. Is it fair to say that one of the reasons—and one of the reasons Fannie and Freddie are more interconnected than the others is the preferential regulations that allow banks to hold unlimited amounts of their debt in there? And so if we were to in fact force those losses out, their vast interconnectedness would have large implications for the system? BASS: Right, but the commission’s task is to clean up the system and prevent—from what I read—prevent future crises, right? So if you’re going to end up pumping those—those losses through the public shareholders, it’s equally divisible between banks in the United States, banks outside of the United States and foreign creditors. So they took those risks; they should assume them. And if, in fact, it forces U.S. banks into problems, well, the government’s paying for it anyway. Let’s go ahead and just pay a fraction of what we’re paying and let someone else shoulder some of the blame. So your answer’s yes. CHRG-111shrg53822--73 Mr. Rajan," Yes. The one comment I will make is it seems to me that the one concern is that a number of institutions, and the way they structure their activities, essentially make themselves ``too big to fail.'' And that is why I think you want to give them incentives not to become that way. Let me give an example. One of the reasons we worried about these large banks is the destruction of the payment and settlement system that happens when we fail these banks. Well, there are intricate ways in which the liability system of these banks is tied to the payment and settlement system. Right? One example is derivative contracts, which come due and have to be replaced if, in fact, the bank cannot make good on its debt. When you reduce the value of the debt, immediately, there is a consequence to the derivative contracts that the bank is involved in. These kinds of connections, interconnections, actually make the bank essentially too complicated, ``too big to fail.'' And my suggestion of forcing them to think about their own demise and proving to regulators that they could be closed in a relatively short time period--a weekend was just a number out of the box; but in a week, I think the rationale for that is you want to give these banks an incentive to think about not making themselves excessively complicated. And one way to do it is to put the onus on them to make their structures more simple, their liability structures, their organizational structures, so that when the regulator actually comes to unwind this bank, they have a less complicated entity to deal with. It is not going to be the answer by itself, and I think we need a lot of proposals on the table to do it, but it could be one piece of what we need. Senator Akaka. Thank you. This next question is for the panel, again, and has to do with about setting standards. A lot of commentators criticize our capital standards as being pro-cyclical, demanding that financial companies raise expensive capital at the worst possible times and too little capital in good times. What are your views on having regulators set standards that require banks and other financial companies to build capital when the economy is strong as a cushion to weather the downturns? Mr. Wallison? " CHRG-111shrg51290--60 STATEMENT OF STEVE BARTLETT President and Chief Executive Officer, Financial Services Roundtable March 3, 2009 Chairman Dodd, Ranking Member Shelby and Members of the Senate Banking Committee. I am Steve Bartlett, President and Chief Executive Officer of the Financial Services Roundtable. The Roundtable is a national trade association composed of the nation's largest banking, securities, and insurance companies. Our members provide a full range of financial products and services to consumers and businesses. Roundtable member companies provide fuel for America's economic engine, accounting directly for $85.5 trillion in managed assets, $965 billion in revenue, and 2.3 million jobs. On behalf of the members of the Roundtable, I wish to thank you for the opportunity to participate in this hearing on the role of consumer protection regulation in the on-going financial crisis. Many consumers have been harmed by this crisis, especially mortgage borrowers and investors. Yet, the scope and depth of this crisis is not simply a failure of consumer protection regulation. As I will explain in a moment, the root causes of this crisis are found in basic failures in many, but not all financial services firms, and the failure of our fragmented financial regulatory system. I also believe that this crisis illustrates the nexus between consumer protection regulation and safety and soundness regulation. Consumer protection and safety and soundness are intertwined. Prudential regulation and supervision of financial institutions is the first line of defense for protecting the interests of all consumers of financial products and services. For example, mortgage underwriting standards not only help to ensure that loans are made to qualified borrowers, but they also help to ensure that the lender gets repaid and can remain solvent. Given the nexus between the goals of consumer protection and safety and soundness, we do not support proposals to separate consumer protection regulation and safety and soundness regulation. Instead, we believe that the appropriate response to this crisis is the establishment of a better balance between these two goals within a reformed and more modern financial regulatory structure. Moreover, I would like to take this opportunity to express the Roundtable's concerns with the provision in the Omnibus Appropriations bill that would give State attorneys generals the authority to enforce compliance with the Truth-in-Lending Act (TILA) and would direct the Federal Trade Commission to write regulations related to mortgage lending. As I will explain further, we believe that one of the fundamental problems with our existing financial regulatory system is its fragmented structure. This provision goes in the opposite direction. It creates overlap and the potential for conflict between the Federal banking agencies, which already enforce compliance with TILA, and State AGs. It also creates overlap and the potential conflict between the Federal banking agencies, which are responsible for mortgage lending activities, and the Federal Trade Commission. While it may be argued that more ``cops on the beat'' can enhance compliance, more ``cops'' that are not required to act in any coordinated fashion will simply exacerbate the regulatory structural problems that contributed to the current crisis. My testimony is divided into three parts. First, I address ``What Went Wrong.'' Second, I address ``How to Fix the Problem.'' Finally, I take this opportunity to comment on the lending activities of TARP-assisted firms, and the Roundtable's continuing concerns over the impact of fair value accounting.What Went Wrong The proximate cause of the current financial crisis was the nation-wide collapse of housing values, and the impact of that collapse on individual homeowners and the holders of mortgage-backed securities. The crisis has since been exacerbated by a serious recession. The root causes of the crisis are twofold. The first was a clear breakdown in policies, practices, and processes at many, but not all, financial services firms. Poor loan underwriting standards and credit practices, excessive leverage, misaligned incentives, less than robust risk management and corporate governance are now well known and fully documented. Corrective actions are well underway in the private sector as underwriting standards are upgraded, credit practices reviewed and recalibrated, leverage is reduced as firms rebuild capital, incentives are being realigned, and some management teams have been replaced, while whole institutions have been intervened by supervisors or merged into other institutions. So needed corrective actions are being taken by the firms themselves. More immediately, we need to correct the failures that the crisis exposed in our complex and fragmented financial regulatory structure. Crises have a way of revealing structural flaws in regulation, supervision, and our regulatory architecture that have long-existed, but were little noticed until the crisis exposed the underlying weaknesses and fatal gaps in regulation and supervision. This one is no different. It has revealed significant gaps in the financial regulatory system. It also revealed that the system does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, high-risk activities, or vulnerable interconnections between firms and markets that can create systemic risk and result in panics like we saw last year and the crisis that lingers today. The regulation of mortgage finance illustrates these structural flaws in both regulation and supervision. Many of the firms and individuals involved in the origination of mortgage were not subject to supervision or regulation by any prudential regulator. No single regulator was held accountable for identifying and recommending corrective actions across the activity known as mortgage lending to consumers. Many mortgage brokers are organized under State law, and operated outside of the regulated banking industry. They had no contractual or fiduciary obligations to brokers who referred loans to them. Likewise, many brokers were not subject to any licensing qualifications and had no continuing obligations to individual borrowers. Most were not supervised in a prudential manner like depository institutions engaged in the same business line. The Federal banking regulators recognized many of these problems and took actions--belatedly--to address the institutions within their jurisdiction, but they lacked to power to reach all lenders. Eventually, the Federal Reserve Board's HOEPA regulations did extend some consumer protections to a broader range of lenders, but the Board does not have the authority to ensure that those lenders are engaged in safe and sound underwriting practices or risk management. The process of securitization suffered from a similar lack of systemic oversight and prudential regulation. No one was responsible for addressing the over-reliance investors placed upon the credit rating agencies to rate mortgage-backed securities, or the risks posed to the entire financial system by the development of instruments to transfer that risk worldwide.How to Fix the Problem How do we fix this problem? Like others in the financial services industry, the members of the Financial Services Roundtable have been engaged in a lively debate over how to better protect consumers by addressing the structural flaws in our current financial regulatory system. While our internal deliberations continue, we have developed a set of guiding principles and a ``Draft Financial Regulatory Architecture'' that is intended to close the gaps in our existing financial regulatory system. We are pleased that the set of regulatory reform principles that President Obama announced last week are broadly consistent and compatible with the Roundtable's principles for much needed reforms. Our first principle in our 2007 Blueprint for U.S. Financial Modernization was to ``treat consumers fairly.'' Our current principles for regulatory reform this year build on that guiding principle and call for: 1) a new regulatory architecture; 2) common prudential and consumer and investor protection standards; 3) balanced and effective regulation; 4) international cooperation and national treatment; 5) failure resolution; and 6) accounting standards. Our plan also seeks to encourage greater coordination and cooperation among financial regulators, and to identify systemic risks before they materialize. We also seek to rationalize and simplify the existing regulatory architecture in ways that make more sense in our modern, global economy. The key features of our proposed regulatory architecture are as follows. Financial Markets Coordinating Council To enhance coordination and cooperation among the many and various financial regulatory agencies, we propose to expand membership of the President's Working Group on Financial Markets (PWG) and rename it as the Financial Markets Coordinating Council (FMCC). We believe that this Council should be established by law, in contrast to the existing PWG, which has operated under a Presidential Executive Order since 1988. This would permit Congress to oversee the Council's activities on a regular and ongoing basis. We also believe that the Council should include representatives from all major Federal financial agencies, as well as individuals who can represent State banking, insurance, and securities regulation. This Council could serve as a forum for national and State financial regulators to meet and discuss regulatory and supervisory policies, share information, and develop early warning detections. In other words, it could help to better coordinate policies within our still fragmented regulatory system. We do not believe that the Council should have independent regulatory or supervisory powers. However, it might be appropriate for the Council to have some ability to review the goals and objectives of the regulations and policies of Federal and State financial agencies, and thereby ensure that they are consistent.Federal Reserve Board To address systemic risk, we believe the Federal Reserve Board (Board) should be authorized to act as a market stability regulator. As a market stability regulator, the Board should be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to our financial system. To perform this function, the Board should be empowered to collect information on financial markets and financial services firms, to participate in joint examinations with other regulators, and to recommend actions to other regulators that address practices that pose a significant risk to the stability and integrity of the U.S. financial services system. The Board's authority to collection information should apply not only to depository institutions, but also to all types of financial services firms, including broker/dealers, insurance companies, hedge funds, private equity firms, industrial loan companies, credit unions, and any other financial services firms that facilitate financial flows (e.g., transactions, savings, investments, credit, and financial protection) in our economy. Also, this authority should not be based upon the size of an institution. It is possible that a number of smaller institutions could be engaged in activities that collectively pose a systemic risk.National Financial Institutions Regulator To reduce gaps in regulation, we propose the consolidation of several existing Federal agencies into a single, National Financial Institutions Regulator (NFIR). This new agency would be a consolidated prudential and consumer protection agency for banking, securities and insurance. More specifically, it would charter, regulate and supervise (i) banks, thrifts, and credit unions, currently supervised by the Office of the Thrift Supervision, the Office of the Comptroller of the Currency, and the National Credit Union Administration; (ii) licensed broker/dealers, investment advisors, investment companies, futures commission merchants, commodity pool operators, and other similar intermediaries currently supervised by the Securities and Exchange Commission or the Commodities Futures Trading Commission; and (iii) insurance companies and insurance producers that select a Federal charter. The AIG case illustrates the need for the Federal Government to have the capacity to supervise insurance companies. Also, with the exception of holding companies for banks, the NFIR would be the regulator for all companies that control broker/dealers or national chartered insurance companies. The NFIR would reduce regulatory gaps by establishing comparable prudential standards for all of these of nationally chartered or licensed entities. For example, national banks, Federal thrifts and federally licensed brokers/dealers that are engaged in comparable activities should be subject to comparable capital and liquidity standards. Similarly, all federally chartered insurers would be subject to the same prudential and market conduct standards. In the area of mortgage origination, we believe that the NFIR's prudential and consumer protection standards should apply to both national and State lenders. Mortgage lenders, regardless of how they are organized, should be required to retain some of the risk for the loans they originate (keep some ``skin-in-the-game''). Likewise, mortgage borrowers, regardless of where they live or who their lender is, should be protected by the same safety and soundness and consumer standards. As noted above, we believe that is it important for this agency to combine both safety and soundness (prudential) regulation and consumer protection regulation. Both functions can be informed, and enhanced, by the other. Prudential regulation can identify practices that could harm consumers, and can ensure that a firm can continue to provide products and services to consumers. The key is not to separate the two, but to find an appropriate balance between the two.National Capital Markets Agency To focus greater attention on the stability and integrity of financial markets, we propose the creation of a National Capital Markets Agency through the merger of the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC), preserving the best features of each agency. The NCMA would regulate and supervise capital markets and exchanges. As noted above, the existing regulatory and supervisory authority of the SEC and CFTC over firms and individuals that serve as intermediaries between markets and customers, such as broker/dealers, investment companies, investment advisors, and futures commission merchants, and other intermediaries would be transferred to the NFIR. The NCMA also should be responsible for establishing standards for accounting, corporate finance, and corporate governance for all public companies.National Insurance Resolution Authority To protect depositors, policyholders, and investors, we propose that the Federal Deposit Insurance Corporation (FDIC) would be renamed the National Insurance and Resolution Authority (NIRA), and that this agency act not only as an insurer of bank deposits, but also as the guarantor of retail insurance policies written by nationally chartered insurance companies, and a financial backstop for investors who have claims against broker/dealers. These three insurance systems would be legally and functionally separated. Additionally, this agency should be authorized to act as the receiver for large non-bank financial services firms. The failure of Lehman Brothers illustrated the need for such a better system to address the failure of large non-banking firms.Federal Housing Finance Agency Finally, to supervise the Federal Home Loan Banks and to oversee the emergence and future restructuring of Fannie Mae and Freddie Mac from conservatorship we propose that the Federal Housing Finance Agency remain in place, pending a thorough review of the role and structure of the housing GSEs in our economy.TARP Lending and Fair Value Accounting Before I close I would like to address two other issues of importance to policymakers and our financial services industry: lending by institutions that have received TARP funds, and the impact of fair value accounting in illiquid markets. Lending by institutions that have received TARP funds has become a concern, especially given the recessionary pressures facing the economy. I have attached to this statement a series of tables that the Roundtable has compiled on this issue. Those tables show the continued commitment of the nation's largest financial services firms to lending. Fair value accounting also is a major concern for the members of the Roundtable. We continue to believe that the pro-cyclical effects of existing policies are unnecessarily exacerbating this crisis. We urge this Committee to direct financial regulators to adjust current accounting standards to reduce the pro-cyclical effects of fair value accounting in illiquid markets. We also urge the U.S. and international financial regulators coordinate and harmonize regulatory policies to development accounting standards that achieve the goals of transparency, understandability, and comparability.Conclusion Thank you again for the opportunity to appear today to address the connection between consumer protection regulation and this on-going financial crisis. The Roundtable believes that the reforms to our financial regulatory system we have developed would substantially improve the protection of consumers by reducing existing gaps in regulation, enhancing coordination and cooperation among regulators, and identifying systemic risks. We also call on Congress to address the continuing pro-cyclical effects of fair value accounting. Broader regulatory reform is important not only to ensure that financial institutions continue to meet the needs of all consumers but to restart economic growth and much needed job creation. Financial reform and ending the recession soon are inextricably linked--we need both. We need a financial system that provides market stability and integrity, yet encourages innovation and competition to serve consumers and meet the needs of a vibrant and growing economy. We need better, more effective regulation and a modern financial regulatory system that is unrivaled anywhere in the world. We deserve no less. At the Roundtable, we are poised and ready to work with you on these initiatives. As John F. Kennedy once cited French Marshall Lyautey, who asked his gardener to plant a tree. The gardener objected that the tree was slow growing and would not reach maturity for 100 years. The Marshall replied, ``In that case, there is no time to lose; plant it this afternoon!'' The same is true with regard to the future of the United States in global financial services--there is no time to lose; let's all start this afternoon. ______ CHRG-110hhrg46591--281 Mr. Neugebauer," Thank you, Mr. Chairman. On one of the things I agree with Mr. Yingling and with Mr. Washburn, and it is that we need to make sure that we do not overreach and impact those financial institutions that did not do that. I kind of liken that to little Johnny misbehaved in class, and the whole class had to stay after school. What we have in our banking system today are our community banks. Some of them are small. Some of them are medium-sized. Some of them are large community banks. Then we have these very large banking financial institutions. There is going to be a lot of discussion over the next few months and years, probably in this committee, on systemic risk and on the size of an institution and on how you manage that risk. With a broad range of financial institutions, how do we develop a new regulatory pattern or institution that can regulate such a broad range? Because one of the things we hear folks say is that we need one regulator for, for example, the banking industry or that we need two regulators. Can one regulator do that? What would that new structure look like, if we were to change that structure, that could regulate such a wide variety of institutions? " CHRG-111hhrg55814--169 The Chairman," But it could be, theoretically, a non-bank entity that's causing systemic risk or acting out of control in some way. That's true, right? " CHRG-109hhrg31539--168 Mr. Gillmor," Let me ask you, should we maintain--is it important for the health of the financial system to maintain that split between commerce and banking? " FOMC20080916meeting--27 25,MR. LACKER., Remind me again how big the European system of central banks' own outright holdings of dollar balances are. CHRG-111shrg54789--179 REGULATORS Current regulators may already have some of the powers that the new agency would be given, but they haven't used them. Conflicts of interest and a lack of will work against consumer enforcement. In this section, we detail numerous actions and inactions by the Federal banking regulators that have led to or encouraged unfair practices, higher prices for consumers, and less competition.A. The Federal Reserve Board ignored the growing mortgage crisis for years after receiving Congressional authority to enact antipredatory mortgage lending rules in 1994. The Federal Reserve Board was granted sweeping antipredatory mortgage regulatory authority by the 1994 Home Ownership and Equity Protection Act (HOEPA). Final regulations were issued on 30 July 2008 only after the world economy had collapsed due to the collapse of the U.S. housing market triggered by predatory lending. \47\--------------------------------------------------------------------------- \47\ 73 FR 147, p. 44522, Final HOEPA Rule, 30 July 2008.---------------------------------------------------------------------------B. At the same time, the Office of the Comptroller of the Currency engaged in an escalating pattern of preemption of State laws designed to protect consumers from a variety of unfair bank practices and to quell the growing predatory mortgage crisis, culminating in its 2004 rules preempting both State laws and State enforcement of laws over national banks and their subsidiaries. In interpretation letters, amicus briefs and other filings, the OCC preempted State laws and local ordinances requiring lifeline banking (NJ 1992, NY, 1994), prohibiting fees to cash ``on-us'' checks (par value requirements) (TX, 1995), banning ATM surcharges (San Francisco, Santa Monica and Ohio and Connecticut, 1998-2000), requiring credit card disclosures (CA, 2003) and opposing predatory lending and ordinances (numerous States and cities). \48\ Throughout, OCC ignored Congressional requirements accompanying the 1994 Riegle-Neal Act not to preempt without going through a detailed preemption notice and comment procedure, as the Congress had found many OCC actions ``inappropriately aggressive.'' \49\--------------------------------------------------------------------------- \48\ ``Role of the Office of Thrift Supervision and Office of the Comptroller of the Currency in the Preemption of State Law'', USGAO, prepared for Financial Services Committee Chairman James Leach, 7 February 2000, available at http://www.gao.gov/corresp/ggd-00-51r.pdf (last visited 21 June 2009). \49\ Statement of managers filed with the conference report on H.R. 3841, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, Congressional Record Page S10532, 3 August 1994.--------------------------------------------------------------------------- In 2000-2004, the OCC worked with increasing aggressiveness to prevent the States from enforcing State laws and stronger State consumer protection standards against national banks and their operating subsidiaries, from investigating or monitoring national banks and their operating subsidiaries, and from seeking relief for consumers from national banks and subsidiaries. These efforts began with interpretative letters stopping State enforcement and State standards in the period up to 2004, followed by OCC's wide-ranging preemption regulations in 2004 purporting to interpret the National Bank Act, plus briefs in court cases supporting national banks' efforts to block State consumer protections. We discuss these matters in greater detail below, in Section 5, rebutting industry arguments against the CFPA.C. The agencies took little action except to propose greater disclosures, as unfair credit card practices increased over the years, until Congress stepped in. Further, between 1995 and 2007, the Office of the Comptroller of Currency issued only one public enforcement action against a Top Ten credit card bank (and then only after the San Francisco District Attorney had brought an enforcement action). In that period, ``the OCC has not issued a public enforcement order against any of the eight largest national banks for violating consumer lending laws.'' \50\ The OCC's failure to act on rising credit card complaints at the largest national banks triggered Congress to investigate, resulting in passage of the 2009 Credit Card Accountability, Responsibility and Disclosure Act (CARD Act). \51\ While this Committee was considering that law, other Federal regulators finally used their authority under the Federal Trade Commission Act to propose and finalize a similar rule. \52\ By contrast, the OCC requested the addition of two significant loopholes to a key protection of the proposed rule.--------------------------------------------------------------------------- \50\ Testimony of Professor Arthur Wilmarth, 26 April 2007, before the Subcommittee on Financial Institutions and Consumer Credit, hearing on Credit Card Practices: Current Consumer and Regulatory Issues at http://www.house.gov/financialservices/hearing110/htwilmarth042607.pdf. \51\ H.R. 627 was signed into law by President Obama as Pub. L. No. 111-24 on 22 May 2009. \52\ The final rule was published in the Federal Register a month later. 74 FR 18, page 5498 Thursday, January 29, 2009.--------------------------------------------------------------------------- Meanwhile, this Committee and its Subcommittee on Financial Institutions and Consumer Credit had conducted numerous hearings on the impact of current credit card issuer practices on consumers. The Committee heard testimony from academics and consumer representatives regarding abusive lending practices that are widespread in the credit card industry, including: The unfair application of penalty and ``default'' interest rates that can rise above 30 percent; Applying these interest rate hikes retroactively on existing credit card debt, which can lead to sharp increases in monthly payments and force consumers on tight budgets into credit counseling and bankruptcy; High and increasing ``penalty'' fees for paying late or exceeding the credit limit. Sometimes issuers use tricks or traps to illegitimately bring in fee income, such as requiring that payments be received in the late morning of the due date or approving purchases above the credit limit; Aggressive credit card marketing directed at college students and other young people; Requiring consumers to waive their right to pursue legal violations in the court system and forcing them to participate in arbitration proceedings if there is a dispute, often before an arbitrator with a conflict of interest; and Sharply raising consumers' interest rates because of a supposed problem a consumer is having paying another creditor. Even though few credit card issuers now admit to the discredited practice of ``universal default,'' eight of the ten largest credit card issuers continue to permit this practice under sections in cardholder agreements that allow issuers to change contract terms at ``any time for any reason.'' \53\--------------------------------------------------------------------------- \53\ Testimony of Linda Sherry of Consumer Action, House Subcommittee on Financial Institutions and Consumer Credit, April 26, 2007. In contrast to this absence of public enforcement action by the OCC against major national banks, State officials and other Federal agencies have issued numerous enforcement orders against leading national banks or their affiliates, including Bank of America, Bank One, Citigroup, Fleet, JPMorgan Chase, and USBancorp--for a wide variety of abusive practices over the past decade. \54\--------------------------------------------------------------------------- \54\ Testimony of Arthur E. Wilmarth, Jr., Professor of Law, George Washington University Law School, April 26, 2007.--------------------------------------------------------------------------- The OCC and PRB were largely silent while credit card issuers expanded efforts to market and extend credit at a much faster speed than the rate at which Americans have taken on credit card debt. This credit expansion had a disproportionately negative effect on the least sophisticated, highest risk and lowest income households. It has also resulted in both relatively high losses for the industry and record profits. That is because, as mentioned above, the industry has been very aggressive in implementing a number of new--and extremely costly--fees and interest rates. \55\ Although the agencies did issue significant guidance in 2003 to require issuers to increase the size of minimum monthly payments that issuers require consumers to pay, \56\ neither agency has proposed any actions (or asked for the legal authority to do so) to rein in aggressive lending or unjustifiable fees and interest rates.--------------------------------------------------------------------------- \55\ Testimony of Travis B. Plunkett of the Consumer Federation of America, Senate Banking Committee, January 25, 2007. \56\ Joint press release of Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency and Office of Thrift Supervision, ``FFIEC Agencies Issue Guidance on Credit Card Account Management and Loss Allowance Practices,'' January 8, 2003, see attached ``Account Management and Loss Allowance Guidance'' at 3.--------------------------------------------------------------------------- In addition, in 1995 the OCC amended a rule, with its action later upheld by the Supreme Court, \57\ that allowed credit card banks to export fees nationwide, as if they were interest, resulting in massive increases in the size of penalty late and overdraft fees.--------------------------------------------------------------------------- \57\ The rule is at 12 C.F.R. 7.4001(a). The case is Smiley v. Citibank, 517 U.S. 735.---------------------------------------------------------------------------D. The Federal Reserve has allowed debit card cash advances (overdraft loans) without consent, contract, cost disclosure, or fair repayment terms. The FRB has refused to require banks to comply with the Truth in Lending Act (TILA) when they loan money to customers who are permitted to overdraw their accounts. While the FRB issued a staff commentary clarifying that TILA applied to payday loans, the Board has refused in several proceedings to apply the same rules to banks that make nearly identical loans. \58\ As a result, American consumers spend at least $17.5 billion per year on cash advances from their banks without signing up for the credit and without getting cost-of-credit disclosures or a contract stating that the bank would in fact pay overdrafts. Consumers are induced to withdraw more cash at ATMs than they have in their account and spend more than they have with debit card purchases at point of sale. In both cases, the bank could simply deny the transaction, saving consumers average fees of $35 each time.--------------------------------------------------------------------------- \58\ National Consumer Law Center and Consumer Federation of America, Comments to the Federal Reserve Board, Docket No. R-1136, January 27, 2003. Appendix ``Bounce Protection: How Banks Turn Rubber Into Gold by Enticing Consumers To Write Bad Checks.'' Also, CFA, Consumers Union, and U.S. Public Interest Research Group, Supplemental Comments relating to Docket R-1136, May 2, 2003. CFA, et al. Comments to the Federal Reserve System, 12 CFR Part 230, Docket No. R-1197, Proposed Amendments to Regulation DD, August 6, 2004. Letter from CFA and national groups to the Chairman of the Federal Reserve Board and Federal Bank Regulators, urging Truth in Lending for overdraft loans, June 8, 2005. CFA, et al., Comments, Federal Reserve System, OTS, and NCUA, FRB Docket No. R-1314, OTS-2008-0004, NCUA RIN 3133-AD47, August 4, 2008. CFA Comments, Federal Reserve System, FRB Docket No. R-1343, March 30, 2009.--------------------------------------------------------------------------- The FRB has permitted banks to avoid TILA requirements because bankers claim that systematically charging unsuspecting consumers very high fees for overdraft loans they did not request is the equivalent to occasionally covering a paper check that would otherwise bounce. Instead of treating short term bank loans in the same manner as all other loans covered under TILA, as consumer organizations recommended, the FRB issued and updated regulations under the Truth in Savings Act, pretending that finance charges for these loans were bank ``service fees.'' In several dockets, national consumer organizations provided well-researched comments, urging the Federal Reserve to place consumer protection ahead of bank profits, to no avail. As a result, consumers unknowingly borrow billions of dollars at astronomical interest rates. A $100 overdraft loan with a $35 fee that is repaid in 2 weeks costs 910 percent APR. The use of debit cards for small purchases often results in consumers paying more in overdraft fees than the amount of credit extended. The FDIC found last year that the average debit card point of purchase overdraft is just $20, while the sample of State banks surveyed by the FDIC charged a $27 fee. If that $20 overdraft loan were repaid in two weeks, the FDIC noted that the APR came to 3,520 percent. \59\--------------------------------------------------------------------------- \59\ FDIC Study of Bank Overdraft Programs, Federal Deposit Insurance Corporation, November 2008 at v.--------------------------------------------------------------------------- As the Federal Reserve has failed to protect bank account customers from unauthorized overdraft loans, banks are raising fees and adding new ones. In the CFA survey of the 16 largest banks updated in July 2009, we found that 14 of the 16 largest banks charge $35 or more for initial or repeat overdrafts and nine of the largest banks use a tiered fee structure to escalate fees over the year. For example, USBank charges $19 for the first overdraft in a year, $35 for the second to fourth overdraft, and $37.50 thereafter. Ten of the largest banks charge a sustained overdraft fee, imposing additional fees if the overdraft and fees are not repaid within days. Bank of America began in June to impose a second $35 fee if an overdraft is not repaid within 5 days. As a result, a Bank of America customer who is permitted by her bank to overdraw by $20 with a debit card purchase can easily be charged $70 for a 5 day extension of credit. \60\ (For more detail, please see CFA Survey: Sixteen Largest Bank Overdraft Fees and Terms, Appendix 5.)--------------------------------------------------------------------------- \60\ Bank of America, ``Important Information Regarding Changes to Your Account'' p. 2. Accessed online June 15, 2009. ``Extended Overdrawn Balance Charge, June 5, 2009: For each time we determine your account is overdrawn by any amount and continues to be overdrawn for 5 or more consecutive business days, we will charge one fee of $35. This fee is in addition to applicable Overdraft Item Fees and NSF Returned Item Fees.''--------------------------------------------------------------------------- Cash advances on debit cards are not protected by the Truth in Lending Act prohibition on banks using set off rights to collect payment out of deposits into their customers' accounts. If the purchase involved a credit card, on the other hand, it would violate Federal law for a bank to pay the balance owed from a checking account at the same bank. Banks routinely pay back debit card cash advances to themselves by taking payment directly out of consumers' checking accounts, even if those accounts contain entirely exempt funds such as Social Security. The Federal Reserve is considering comments filed in yet another overdraft loan docket, this time considering whether to require banks to permit consumers to opt-out of fee-based overdraft programs, or, alternatively, to require banks to get consumers to opt in for overdrafts. This proposal would change Reg E which implements the Electronic Fund Transfer Act and would only apply to overdrafts created by point of sale debit card transactions and to ATM withdrawals, leaving all other types of transactions that are permitted to overdraw for a fee unaddressed. Consumer organizations urged the Federal Reserve to require banks to get their customers' affirmative consent, the same policy included in the recently enacted credit card bill which requires affirmative selection for creditors to permit over-the-limit transactions for a fee. \61\--------------------------------------------------------------------------- \61\ Federal Reserve Board, Docket No. R-1343, comments were due March 30, 2009.---------------------------------------------------------------------------E. The Fed is allowing a shadow banking system (prepaid cards) outside of consumer protection laws to develop and target the unbanked and immigrants; The OTS is allowing bank payday loans (which preempt State laws) on prepaid cards. The Electronic Funds Transfer Act requires key disclosures of fees and other practices, protects consumer bank accounts from unauthorized transfers, requires resolution of billing errors, gives consumers the right to stop electronic payments, and requires Statements showing transaction information, among other protections. The EFTA is also the statute that will hold the new protections against overdraft fee practices that the Fed is writing. Yet the Fed has failed to include most prepaid cards in the EFTA's protections, even while the prepaid industry is growing and is developing into a shadow banking system. In 2006, the Fed issued rules including payroll cards--prepaid cards that are used to pay wages instead of a paper check for those who do not have direct deposit to a bank account--within the definition of the ``accounts'' subject to the EFTA. But the Fed permitted payroll card accounts to avoid the Statement requirements for bank accounts, relying instead on the availability of account information on the Internet. Forcing consumers to monitor their accounts online to check for unauthorized transfers and fees and charges is particularly inappropriate for the population targeted for these cards: consumers without bank accounts, who likely do not have or use regular Internet access. Even worse, the Fed refused to adopt the recommendations of consumer groups that self-selected payroll cards--prepaid cards that consumers shop for and choose on their own as the destination for direct deposit of their wages--should receive the same EFTA protections that employer designated payroll cards receive. The Fed continues to take the position that general prepaid cards are not protected by the EFTA. This development has become all the more glaring as Federal and State government agencies have moved to prepaid cards to pay many Government benefits, from Social Security and Indian Trust Funds to unemployment insurance and State-collected child support. Some agencies, such as the Treasury Department when it created the Social Security Direct Express Card, have included in their contract requirements that the issuer must comply with the EFTA. But not all have, and compliance is uneven, despite the fact that the EFTA itself clearly references and anticipates coverage of electronic systems for paying unemployment insurance and other non-needs-tested Government benefits. The Fed's failure to protect this shadow banking system is also disturbing as prepaid cards are becoming a popular product offered by many predatory lenders, like payday lenders. Indeed, the Fed is not the only one that has recently dropped the ball on consumer protection on prepaid cards. One positive effort by the banking agencies in the past decade was the successful effort to end rent-a-bank partnerships that allowed payday lenders to partner with depositories to use their preemptive powers to preempt State payday loan laws. \62\ But more recently, one prepaid card issuer, Meta Bank, has developed a predatory, payday loan feature--iAdvance--on its prepaid cards that receive direct deposit of wages and Government benefits. At a recent conference, an iAdvance official boasted that Meta Bank's regulator--the OTS--has been very ``flexible'' with them and ``understands'' this product.--------------------------------------------------------------------------- \62\ Payday lending is so egregious that even the Office of the Comptroller of the Currency refused to let storefront lenders hide behind their partner banks' charters to export usury.---------------------------------------------------------------------------F. Despite advances in technology, the Federal Reserve has refused to speed up availability of deposits to consumers. Despite rapid technological changes in the movement of money electronically, the adoption of the Check 21 law to speed check processing, and electronic check conversion at the cash register, the Federal Reserve has failed to shorten the amount of time that banks are allowed to hold deposits before they are cleared. Money flies out of bank accounts at warp speed. Deposits crawl in. Even cash that is deposited over the counter to a bank teller can be held for 24 hours before becoming available to cover a transaction. The second business day rule for local checks means that a low-income worker who deposits a pay check on Friday afternoon will not get access to funds until the following Tuesday. If the paycheck is not local, it can be held for five business days. This long time period applies even when the check is written on the same bank where it is deposited. Consumers who deposit more than $5,000 in one day face an added wait of about 5 to 6 more business days. Banks refuse to cash checks for consumers who do not have equivalent funds already on deposit. The combination of unjustifiably long deposit holds and banks' refusal to cash account holders' checks pushes low income consumers towards check cashing outlets, where they must pay 2 to 4 percent of the value of the check to get immediate access to cash. Consumer groups have called on the Federal Reserve to speed up deposit availability and to prohibit banks from imposing overdraft or insufficient fund (NSF) fees on transactions that would not have overdrawn if deposits had been available. The Federal Reserve vigorously supported Check 21, which has speeded up withdrawals but has refused to reduce the time period for local and nonlocal check hold periods for consumers.G. The Federal Reserve has supported the position of payday lenders and telemarketing fraud artists by permitting remotely created checks (demand drafts) to subvert consumer rights under the electronic funds transfer act. In 2005, the National Association of Attorneys General, the National Consumer Law Center, Consumer Federation of America, Consumers Union, the National Association of Consumer Advocates, and U.S. Public Interest Research Group filed comments with the Federal Reserve in Docket No. R-1226, regarding proposed changes to Regulation CC with respect to demand drafts. Demand drafts are unsigned checks created by a third party to withdraw money from consumer bank accounts. State officials told the FRB that demand drafts are frequently used to perpetrate fraud on consumers and that the drafts should be eliminated in favor of electronic funds transfers that serve the same purpose and are covered by protections in the Electronic Funds Transfer Act. Since automated clearinghouse transactions are easily traced, fraud artists prefer to use demand drafts. Fraudulent telemarketers increasingly rely on bank debits to get money from their victims. The Federal Trade Commission earlier this year settled a series of cases against telemarketers who used demand drafts to fraudulently deplete consumers' bank accounts. Fourteen defendants agreed to pay a total of more than $16 million to settle FTC charges while Wachovia Bank paid $33 million in a settlement with the Comptroller of the Currency. \63\--------------------------------------------------------------------------- \63\ Press Release, ``Massive Telemarketing Scheme Affected Nearly One Million Consumers Nationwide; Wachovia Bank To Provide an Additional $33 Million to Suntasia Victims,'' Federal Trade Commission, January 13, 2009, viewed at http://www.ftc.gov/opa/2009/01/suntasia.shtm.--------------------------------------------------------------------------- Remotely created checks are also used by high cost lenders to remove funds from checking accounts even when consumers exercise their right to revoke authorization to collect payment through electronic funds transfer. CFA first issued a report on Internet payday lending in 2004 and documented that some high-cost lenders converted debts to demand drafts when consumers exercised their EFTA right to revoke authorization to electronically withdraw money from their bank accounts. CFA brought this to the attention of the Federal Reserve in 2005, 2006, and 2007. No action has been taken to safeguard consumers' bank accounts from unauthorized unsigned checks used by telemarketers or conversion of a loan payment from an electronic funds transfer to a demand draft to thwart EFTA protections or exploit a loophole in EFTA coverage. The structure of online payday loans facilitates the use of demand drafts. Every application for a payday loan requires consumers to provide their bank account routing number and other information necessary to create a demand draft as well as boiler plate contract language to authorize the device. The account information is initially used by online lenders to deliver the proceeds of the loan into the borrower's bank account using the ACH system. Once the lender has the checking account information, however, it can use it to collect loan payments via remotely created checks per boilerplate contract language even after the consumer revokes authorization for the lender to electronically withdraw payments. The use of remotely created checks is common in online payday loan contracts. ZipCash LLC ``Promise to Pay'' section of a contract included the disclosure that the borrower may revoke authorization to electronically access the bank account as provided by the Electronic Fund Transfer Act. However, revoking that authorization will not stop the lender from unilaterally withdrawing funds from the borrower's bank account. The contract authorizes creation of a demand draft which cannot be terminated. ``While you may revoke the authorization to effect ACH debit entries at any time up to 3 business days prior to the due date, you may not revoke the authorization to prepare and submit checks on your behalf until such time as the loan is paid in full.'' (Emphasis added.) \64\--------------------------------------------------------------------------- \64\ Loan Supplement (ZipCash LLC) Form #2B, on file with CFA.---------------------------------------------------------------------------H. The Federal Reserve has taken no action to safeguard bank accounts from Internet payday lenders. In 2006, consumer groups met with Federal Reserve staff to urge them to take regulatory action to protect consumers whose accounts were being electronically accessed by Internet payday lenders. We joined with other groups in a follow up letter in 2007, urging the Federal Reserve to make the following changes to Regulation E: Clarify that remotely created checks are covered by the Electronic Funds Transfer Act. Ensure that the debiting of consumers' accounts by Internet payday lenders is subject to all the restrictions applicable to preauthorized electronic funds transfers. Prohibit multiple attempts to ``present'' an electronic debit. Prohibit the practice of charging consumers a fee to revoke authorization for preauthorized electronic funds transfers. Amend the Official Staff Interpretations to clarify that consumers need not be required to inform the payee in order to stop payment on preauthorized electronic transfers. While FRB staff was willing to discuss these issues, the FRB took no action to safeguard consumers when Internet payday lenders and other questionable creditors evade consumer protections or exploit gaps in the Electronic Fund Transfer Act to mount electronic assaults on consumers' bank accounts. As a result of inaction by the Federal Reserve, payday loans secured by repeat debit transactions undermine the protections of the Electronic Fund Transfer Act, which prohibits basing the extension of credit with periodic payments on a requirement to repay the loan electronically. \65\ Payday loans secured by debit access to the borrower's bank account which cannot be cancelled also functions as the modern banking equivalent of a wage assignment--a practice which is prohibited when done directly. The payday lender has first claim on the direct deposit of the borrower's next paycheck or exempt Federal funds, such as Social Security, SSI, or Veterans Benefit payments. Consumers need control of their accounts to decide which bills get paid first and to manage scarce family resources. Instead of using its authority to safeguard electronic access to consumers' bank accounts, the Federal Reserve has stood idly by as the online payday loan industry has expanded.--------------------------------------------------------------------------- \65\ Reg E, 12 C.F.R. 205.10(e). 15 U.S.C. 1693k states that ``no person'' may condition extension of credit to a consumer on the consumer's repayment by means of a preauthorized electronic fund transfer.---------------------------------------------------------------------------I. The banking agencies have failed to stop banks from imposing unlawful freezes on accounts containing social security and other funds exempt from garnishment. Federal benefits including Social Security and Veteran's benefits (as well as State equivalents) are taxpayer dollars targeted to relieve poverty and ensure minimum subsistence income to the Nation's workers. Despite the purposes of these benefits, banks routinely freeze bank accounts containing these benefits pursuant to garnishment or attachment orders, and assess expensive fees--especially insufficient fund (NSF) fees--against these accounts. The number of people who are being harmed by these practices has escalated in recent years, largely due to the increase in the number of recipients whose benefits are electronically deposited into bank accounts. This is the result of the strong Federal policy to encourage this in the Electronic Funds Transfer Act. And yet, the banking agencies have failed to issue appropriate guidance to ensure that the millions of Federal benefit recipients receive the protections they are entitled to under Federal law.J. The Comptroller of the Currency permits banks to manipulate payment order to extract maximum bounced check and overdraft fees, even when overdrafts are permitted. The Comptroller of the Currency permits national banks to rig the order in which debits are processed. This practice increases the number of transactions that trigger an overdrawn account, resulting in higher fee income for banks. When banks began to face challenges in court to the practice of clearing debits according to the size of the debit--from the largest to the smallest--rather than when the debit occurred or from smallest to largest check, the OCC issued guidelines that allow banks to use this dubious practice. The OCC issued an Interpretive Letter allowing high-to-low check clearing when banks follow the OCC's considerations in adopting this policy. Those considerations include: the cost incurred by the bank in providing the service; the deterrence of misuse by customers of banking services; the enhancement of the competitive position of the bank in accordance with the bank's business plan and marketing strategy; and the maintenance of the safety and soundness of the institution. \66\ None of the OCC's considerations relate to consumer protection.--------------------------------------------------------------------------- \66\ 12 C.F.R. 7.4002(b).--------------------------------------------------------------------------- The Office of Thrift Supervision (OTS) addressed manipulation of transaction-clearing rules in the Final Guidance on Thrift Overdraft Programs issued in 2005. The OTS, by contrast, advised thrifts that transaction-clearing rules (including check-clearing and batch debit processing) should not be administered unfairly or manipulated to inflate fees. \67\ The Guidelines issued by the other Federal regulatory agencies merely urged banks and credit unions to explain the impact of their transaction clearing policies. The Interagency ``Best Practices'' State: ``Clearly explain to consumers that transactions may not be processed in the order in which they occurred, and that the order in which transactions are received by the institution and processed can affect the total amount of overdraft fees incurred by the consumers.'' \68\--------------------------------------------------------------------------- \67\ Office of Thrift Supervision, Guidance on Overdraft Protection Programs, February 14, 2005, p. 15. \68\ Department of Treasury, Joint Guidance on Overdraft Protection Programs, February 15, 2005, p. 13.--------------------------------------------------------------------------- CFA and other national consumer groups wrote to the Comptroller and other Federal bank regulators in 2005 regarding the unfair trade practice of banks ordering withdrawals from high-to-low, while at the same time unilaterally permitting overdrafts for a fee. One of the OCC's ``considerations'' is that the overdraft policy should ``deter misuse of bank services.'' Since banks deliberately program their computers to process withdrawals high-to-low and to permit customers to overdraw at the ATM and Point of Sale, there is no ``misuse'' to be deterred. No Federal bank regulator took steps to direct banks to change withdrawal order to benefit low-balance consumers or to stop the unfair practice of deliberately causing more transactions to bounce in order to charge high fees. CFA's survey of the 16 largest banks earlier this year found that all of them either clear transactions largest first or reserve the right to do so. \69\ Since ordering withdrawals largest first is likely to deplete scarce resources and trigger more overdraft and insufficient funds fees for many Americans, banks have no incentive to change this practice absent strong oversight by bank regulators.--------------------------------------------------------------------------- \69\ Consumer Federation of America, Comments to Federal Reserve Board, Docket No. R-1343, Reg. E, submitted March 30, 2009.---------------------------------------------------------------------------K. The regulators have failed to enforce the Truth In Savings Act requirement that banks provide account disclosures to prospective customers. According to a 2008 GAO report \70\ to Rep. Carolyn Maloney, then-chair of the Financial Institutions and Consumer Credit Subcommittee, based on a secret shopper investigation, banks don't give consumers access to the detailed schedule of account fee disclosures as required by the 1991 Truth In Savings Act. From GAO:--------------------------------------------------------------------------- \70\ ``Federal Banking Regulators Could Better Ensure That Consumers Have Required Disclosure Documents Prior to Opening Checking or Savings Accounts'', GAO-08-28I, January 2008, available at http://www.gao.gov/new.items/d08281.pdf (last visited 21 June 2009). Regulation DD, which implements the Truth in Savings Act (TISA), requires depository institutions to disclose (among other things) the amount of any fee that may be imposed in connection with an account and the conditions under which such fees are imposed. [ . . . ] GAO employees posed as consumers shopping for checking and savings accounts [ . . . ] Our visits to 185 branches of depository institutions nationwide suggest that consumers shopping for accounts may find it difficult to obtain account terms and conditions and disclosures of fees upon request prior to opening an account. Similarly, our review of the Web sites of the banks, thrifts, and credit unions we visited suggests that this information may also not be readily available on the Internet We were unable to obtain, upon request, a comprehensive list of all checking and savings account foes at 40 of the branches (22 percent) that we visited. [ . . . ] The results are consistent with those reported by a consumer group [U.S. PIRG] that conducted a --------------------------------------------------------------------------- similar exercise in 2001. This, of course, keeps consumers from being able to shop around and compare prices. As cited by GAO, U.S. PIRG then complained of these concerns in a 2001 letter to then Federal Reserve Board Chairman Alan Greenspan. \71\ No action was taken. The problem is exacerbated by a 2001 Congressional decision to eliminate consumers' private rights olfaction for Truth In Savings violations.--------------------------------------------------------------------------- \71\ The 1 November 2001 letter from Edmund Mierzwinski, U.S. PIRG, to Greenspan is available at http://static.uspirg.org/reports/bigbanks2001/greenspanltr.pdf (last visited 21 June 2009). In that letter, we also urged the regulators to extend Truth In Savings disclosure requirements to the Internet. No action was taken.---------------------------------------------------------------------------L. The Federal Reserve actively campaigned to eliminate a Congressional requirement that it publish an annual survey of bank account fees. One of the consumer protections included in the 1989 savings and loan bailout law known as the Financial Institutions Reform, Recovery and Enforcement Act was Section 1002, which required the Federal Reserve to publish an annual report to Congress on fees and services of depository institutions. The Fed actively campaigned in opposition to the requirement and succeeded in convincing Congress to sunset the survey in 2003. \72\ Most likely, the Fed was unhappy with the report's continued findings that each year bank fees increased, and that each year, bigger banks imposed the biggest fees.--------------------------------------------------------------------------- \72\ The final 2003 report to Congress is available here http://www.federalreserve.gov/boarddocs/rptcongress/2003fees.pdf (last visited 21 June 2009). The 1997-2003 reports can all be accessed from this page, http://www.federalreserve.gov/pubs/reports_other.htm (last visited 21 June 2009).---------------------------------------------------------------------------SECTION 4. STRUCTURE AND JURISDICTION OF A CONSUMER FINANCIAL FinancialCrisisInquiry--697 ZANDI: OK. Two trillion dollars in private bond issuance at the height of the issuance is clearly overdone. It’s— it’s unhealthy. That’s how we got all these bad loans being made. But in 2009, we had $150 billion in issuance, all of it TALF-supported. That is clearly unhealthy, and the banking system won’t work with that, either. We need something in January 13, 2010 between so that the system can work properly and credit will start to flow. Until that happens, the system is going to remain quite troubled. HOLTZ-EAKIN: And I guess this goes to my last question for Mr. Cloutier. And you may want to weigh in. What I hear again and again is there is on the ground demand for credit. That suggests that there’s a business that could be made in supplying that credit, makes profits. Why is it that we don’t see the entry of new community banks to meet this observed need? And at the back end of that, if you’ve got new banks with pristine balance sheets there should be very little difficulty in securitizing their loans, why is this not happening? CHRG-111hhrg55814--26 Secretary Geithner," Thank you, Mr. Chairman. It's a pleasure to be here again. I want to begin with a few comments on the economy. Today, we learned that our economy is growing again. In the third quarter of this year, the economy grew at an annual rate of 3.5 percent, the first time we have seen positive growth in a year, and the strongest growth in 2 years. Business and consumer confidence has improved substantially since the end of last year. House prices are rising. The value of American savings has increased substantially. Americans are now saving more and we are borrowing much less from the rest of the world. Consumers are just starting to spend again. Businesses are starting to see orders increase. Exports are expanding. And these improvements are the direct result of the tax cuts and investments that were part of the Recovery Act and the actions we have taken to stabilize the financial system and unfreeze credit markets. But, this is just the beginning. Unemployment remains unacceptably high. For every person out of work, for every family facing foreclosure, for every small business facing a credit crunch, the recession remains alive and acute. Growth will bring jobs, but we need to continue working together to strengthen the recovery and create the conditions where businesses will invest again and all Americans will have the confidence that they can provide for their families, send their kids to college, feel secure in retirement. And we have a responsibility as part of that to create a financial system that is more fair and more stable, one that provides protections for consumers and investors, and gives businesses access to the capital they need to grow. That brings me to the topic at hand. This committee has made enormous progress in the past several weeks. In the face of a substantial opposition, you have acted swiftly to lay the foundation for far-reaching reforms that would better protect consumers and investors from unfair, fraudulent investment lending practices to regulate the derivatives market, to improve investor protection, to reform credit rating agencies, to improve the securitization markets, and to bring basic oversight to hedge funds and other unregulated activities. Today, you carry this momentum forward. One of the most searing lessons of last fall is that no financial system can work if institutions and investors assume that the government will protect them from the consequences of failure. Never again should taxpayers be put in the position of having to pay for the losses of private institutions. We need to build a system in which individual firms, no matter how large or important, can fail without risking catastrophic damage to the economy. Last June, we outlined a comprehensive set of proposals to achieve this goal. There has been a lot of work by this committee and many others since then. The chairman has introduced new legislation to accomplish that. We believe any effective set of reforms has to have five key elements. I am going to outline those very, very quickly, but I want to say that the legislation, in our judgment, meets that test. The first test is the government has to have the ability to resolve failing major financial institutions in an orderly manner with losses absorbed not by taxpayers, but by equity holders and by unsecured creditors. In all but the rarest cases, bankruptcy will remain the dominant tool for handling financial failure, but as the collapse of Lehman Brothers demonstrates, the Bankruptcy Code is not an effective tool for resolving the failure of complicated global financial institutions in times of severe stress. Under the proposals we provided, which are very similar to what already exists for banks and thrifts, a failing firm will be placed into an FDIC-managed receivership so they can be unwound, dismantled, sold or liquidated in an orderly way. Stakeholders of the firm would absorb losses. Managers responsible for failure would be replaced. A second key element of reform: any individual firm that puts itself in the position where it cannot survive without special assistance from the government must face the consequences of that failure. That's why this proposed resolution authority would be limited to facilitating the orderly demise of the failing firm, not ensuring its survival. It's not about redemption for the firm that makes mistakes. It's about unwinding them in a way that doesn't cause catastrophic damage to the economy. Third key point: Taxpayers must not be on the hook for losses resulting from failure and subsequent resolution of a large financial firm. The government should have the authority, as it now does, when we resolve small banks and thrifts. The government should have the authority to recoup any losses by assessing a fee on other financial institutions. These assessments should be stretched out over time as necessary to avoid amplifying adding to the pressures you face in crisis. Fourth key point, and I want to emphasize this: The emergency authorities now granted to the Federal Reserve and the FDIC, should be limited so that they are subject to appropriate checks and balances and can be only used to protect the system as a whole. Final element: The government has to have stronger supervisory and regulatory authority over these major firms. They need to be empowered with explicit authority to force major institutions to reduce their size or restrict the scope of their activities, where that is necessary to reduce risks to the system. And this is a critically important tool we do not have at present. Regulators must be able to impose tougher requirements, most critically, stronger capital rules, more stringent liquidity requirements that would reduce the probability that major financial institutions in the future would take on a scale of size and leverage that could threaten the stability of the financial system. This would provide strong incentives for firms to shrink simply to reduce leverage. We have to close loopholes, reduce the possibilities for gaming the system, for avoiding these strong standards. So monitoring threats to stability will fall to the responsibility of this new financial services oversight council. The council would have the obligation and the authority to identify any firm whose size and leverage and complexity creates a risk to the system as a whole and needs to be subject to heightened, stronger standards, stronger constraints on leverage. The Federal Reserve under this model would oversee individual financial firms so that there's a clear, inescapable, single point of accountability. The Fed already provides this role for major banks, bank holding companies, but it needs to provide the role for any firm that creates that potential risk to the system as a whole. The rules in place today are inadequate and they are outdated. We have all seen what happens, when in a crisis the government is left with inadequate tools to respond to data damage. That is a searing lesson of last fall. In today's markets, capital moves at unimaginable speeds. When the system was created more than 90 years ago, and today's economy given these risks requires we bring that framework into the 21st Century. The bill before the committee does that. It's the comprehensive, coordinated answer to the moral hazard problem we are also concerned about. What it does not do is provide a government guarantee for troubled financial firms. It does not create a fixed list of systemically important firms. It does not create permanent TARP authority; and, it does not give the government broad discretion to step in and rescue insolvent firms. We are looking forward. We are looking to make sure we provide future Administrations and future Congresses with better options than existed last year. This is still an extremely sensitive moment in the financial system. Investors across the country and around the world are watching very carefully your deliberations, our debate, our discussions; and, I want to make sure they understand that these reforms we're proposing are about preventing the crises of the future, while we work to repair the damage still caused by the current crisis. The American people are counting on us to get this right and to get this done. I want to compliment you again for the enormous progress you made already and I look forward to continuing to work with you to produce a strong package of reforms. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner can be found on page 150 of the appendix.] " CHRG-110shrg46629--46 Chairman Bernanke," Recently, I think they perhaps tightened a bit, actually, because of some concerns that were initially prompted by the subprime mortgage lending issues. Again from the Federal Reserve's perspectives, our principal concern is the safety and soundness of the banking system. What we have done recently is work with other regulators such as the SEC and the OCC and, in some cases also with foreign regulators, the FSA in the United Kingdom for example and German and Swiss regulators, to do what we call horizontal reviews which is that collectively we look at the practices of a large set of institutions, both commercial banks and investment banks, to see how they are managing certain types of activities. For example, the financing of leveraged buyouts, abridged equity and the like. And trying to make an evaluation of what are best practices, trying to give back information back to the companies and trying to use those reviews to inform our own supervision. And so we are very aware of these issues from the perspective of the risk-taking by large financial institutions and we are studying them, trying to provide information to the institutions themselves, and using them in our own supervisory guidance. Senator Reed. Are you confident that you can identify and monitor these risks posed by CLOs? And in a related point, do you anticipate seeing the same phenomena in the CLO market that we have seen in the CDO market, a bump? " CHRG-111shrg56376--171 Mr. Ludwig," But in terms of bank lending, you would have a highly professionalized institutional regulator, and to Senator Corker's concerns about procyclicality and also--I do not think it would be a super OCC. One of the problems with the current alphabet soup is nobody is large enough, professional enough that there is really the kind of study, focus, or stature for these supervisors to be able to go head to head adequately on things like derivatives, emerging new capital structures, et cetera. So I think that you would have two that would be at the Federal level close to supervision, but the Federal Reserve by nature, with its information gathering, study, and concern would be actively involved in thinking about these issues and prescribing solutions. And the new systemic council or systemic enterprise would also be very much a backstop to the banking supervision, as it would be a backstop to other regulatory issues throughout the Federal and State systems. Senator Reed. Well, let me just take a step further and focus on the point that Professor Baily made about the top-to-bottom bank holding company regulation. Would that be the Federal Reserve, or would that be the new---- " CHRG-111shrg55117--7 Mr. Bernanke," Thank you. Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy. Even so, the financial shocks that hit the global economy in September and October were the worst since the 1930s, and they helped push the global economy into the deepest recession since World War II. The U.S. economy contracted sharply in the fourth quarter of last year and the first quarter of this year. More recently, the pace of decline appears to have slowed significantly, and final demand and production have shown tentative signs of stabilization. The labor market, however, has continued to weaken. Consumer price inflation, which fell to low levels late last year, remained subdued in the first 6 months of 2009. To promote economic recovery and foster price stability, the Federal Open Market Committee last year brought its target for the Federal funds rate to a historically low range of 0 to \1/4\ percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant maintaining the Federal funds rate at exceptionally low levels for an extended period. At the time of our February report, financial markets at home and abroad were under intense strains, with equity prices at multiyear lows, risk spreads for private borrowers at very elevated levels, and some important financial markets essentially shut. Today, financial conditions remain stressed, and many households and businesses are finding credit difficult to obtain. Nevertheless, on net, the past few months have seen some notable improvements. For example, interest rate spreads in short-term money markets, such as the interbank market and the commercial paper market, have continued to narrow. The extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets. Reflecting this greater investor receptivity, corporate bond issuance has been strong. Many markets are functioning more normally, with increased liquidity and lower bid-asked spreads. Equity prices, which hit a low point in March, have recovered to roughly their levels at the end of last year, and banks have raised a significant amount of new capital. Many of the improvements in financial conditions can be traced, in part, to policy actions taken by the Federal Reserve to encourage the flow of credit. For example, the decline in interbank lending rates and spreads was facilitated by the actions of the Federal Reserve and other central banks to ensure that financial institutions have access to adequate amounts of short-term liquidity, which in turn has increased the stability of the banking system and the ability of banks to lend. Interest rates and spreads on commercial paper dropped significantly as a result of the backstop liquidity facilities that the Federal Reserve introduced last fall for that market. Our purchases of agency mortgage-backed securities and other longer-term assets have helped lower conforming fixed mortgage rates. And the Term Asset-Backed Securities Loan Facility, or TALF, which was implemented this year, has helped to restart the securitization markets for various classes of consumer and small business credit. Earlier this year, the Federal Reserve and other Federal banking regulatory agencies undertook the Supervisory Capital Assessment Program, popularly known as the ``stress test,'' to determine the capital needs of the largest financial institutions. The results of the SCAP were reported in May, and they appeared to increase investor confidence in the U.S. banking system. Subsequently, the great majority of institutions that underwent the assessment have raised equity in public markets. And, on June 17, 10 of the largest U.S. bank holding companies--all but one of which participated in the SCAP--repaid a total of nearly $70 billion to the Treasury. Better conditions in financial markets have been accompanied by some improvement in economic prospects. Consumer spending has been relatively stable so far this year, and the decline in housing activity appears to have moderated. Businesses have continued to cut capital spending and liquidate inventories, but the likely slowdown in the pace of inventory liquidation in coming quarters represents another factor that may support a turnaround in activity. Although the recession in the rest of the world led to a steep drop in the demand for U.S. exports, this drag on our economy also appears to be waning, as many of our trading partners are also seeing signs of stabilization. Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2009 through 2011. FOMC participants generally expect that, after declining in the first half of this year, output will increase slightly over the remainder of 2009. The recovery is expected to be gradual in 2010, with some acceleration in activity in 2011. Although the unemployment rate is projected to peak at the end of this year, the projected declines in 2010 and 2011 would still leave unemployment well above FOMC participants' views of the longer-run sustainable rate. All participants expect that inflation will be somewhat lower this year than in recent years, and most expect it to remain subdued over the next 2 years. In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery. Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period. However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. The FOMC has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate. To some extent, our policy measures will unwind automatically as the economy recovers and financial strains ease, because most of our extraordinary liquidity facilities are priced at a premium over normal interest rate spreads. Indeed, total Federal Reserve credit extended to banks and other market participants has declined from roughly $1.5 trillion at the end of 2008 to less than $600 billion, reflecting the improvement in financial conditions that has already occurred. In addition, bank reserves held at the Fed will decline as the longer-term assets that we own are maturing or are prepaid. Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed. Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the Federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve. Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits. But interest on reserves is by no means the only tool we have to influence market interest rates. For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at a later date. Reverse repurchase agreements, which can be executed with primary dealers, Government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer-term securities. Not only would such sales drain reserves and raise short-term interest rates, but they also could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets. In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability. Our economy and financial markets have faced extraordinary near-term challenges, and strong and timely actions to respond to those challenges have been necessary and appropriate. I have discussed some of the measures taken by the Federal Reserve to promote economic growth and financial stability. The Congress also has taken substantial actions, including the passage of a fiscal stimulus package. Nevertheless, even as important steps have been taken to address the recession and the intense threats to financial stability, maintaining the confidence of the public and financial markets requires that policy makers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and the continued increases in the costs of Medicare and Medicaid. Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult. Moreover, agreeing on a sustainable long-run fiscal path now could yield considerable near-term economic benefits in the form of lower long-term interest rates and increased consumer and business confidence. Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth. A clear lesson of the recent financial turmoil is that we must make our system of financial supervision and regulation more effective, both in the United States and abroad. In my view, comprehensive reform should include at least the following key elements: A prudential approach that focuses on the stability of the financial system as a whole, not just the safety and soundness of individual institutions, and that includes formal mechanisms for identifying and dealing with emerging systemic risks; Stronger capital and liquidity standards for financial firms, with more stringent standards for large, complex, and financially interconnected firms; The extension and enhancement of supervisory oversight, including effective consolidated supervision, to all financial organizations that could pose a significant risk to the overall financial system; An enhanced bankruptcy or resolution regime, modeled on the current system for depository institutions, that would allow financially troubled, systemically important nonbank financial institutions to be wound down without broad disruption to the financial system and the economy; Enhanced protections for consumers and investors in their financial dealings; Measures to ensure that critical payment, clearing, and settlement arrangements are resilient to financial shocks, and that practices related to the trading and clearing of derivatives and other financial instruments do not pose risks to the financial system as a whole; And, finally, improved coordination across countries in the development of regulations and in the supervision of internationally active firms. The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight. For example, we are expanding our use of horizontal reviews of financial firms to provide a more comprehensive understanding of practices and risks in the financial system. The Federal Reserve also remains strongly committed to effectively carrying out our responsibilities for consumer protection. Over the past 3 years, the Federal Reserve has written rules providing strong protections for mortgage borrowers and credit card users, among many other substantive actions. Later this week, the Board will issue a proposal using our authority under the Truth in Lending Act, which will include new, consumer-tested disclosures as well as rule changes applying to mortgages and home equity lines of credit; in addition, the proposal includes new rules governing the compensation of mortgage originators. We are expanding our supervisory activities to include risk-focused reviews of consumer compliance in nonbank subsidiaries of holding companies. Our community affairs and research areas have provided support and assistance for organizations specializing in foreclosure mitigation, and we have worked with nonprofit groups on strategies for neighborhood stabilization. The Federal Reserve's combination of expertise in financial markets, payment systems, and supervision positions us well to protect the interests of consumers in their financial transactions. We look forward to discussing with the Congress ways to further formalize our institution's strong commitment to consumer protection. Finally, the Congress and the American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayers' resources. The Federal Reserve is committed to transparency and accountability in its operations. We report on our activities in a variety of ways, including reports like the one I am presenting to the Congress today, other testimonies, and speeches. The FOMC releases a statement immediately after each regularly scheduled meeting and detailed minutes of each meeting on a timely basis. We have increased the frequency and scope of the published economic forecasts of FOMC participants. We provide the public with detailed annual reports on the financial activities of the Federal Reserve System that are audited by an independent public accounting firm, and we publish a complete balance sheet each week. We have recently taken additional steps to better inform the public about the programs we have instituted to combat the financial crisis. We expanded our Web site this year to bring together already available information as well as considerable new information on our policy programs and financial activities. In June, we initiated a monthly report to the Congress that provides even more information on Federal Reserve liquidity programs, including breakdowns of our lending, the associated collateral, and other facets of programs established to address the financial crisis. These steps should help the public understand the efforts that we have taken to protect the taxpayer as we supply liquidity to the financial system and support the functioning of key credit markets. The Congress has recently discussed proposals to expand the audit authority of the GAO over the Federal Reserve. As you know, the Federal Reserve is already subject to frequent reviews by the GAO. The GAO has broad authority to audit our operations and functions. The Congress recently granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to ``single and specific'' companies under the authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities provided to, or created for, AIG and Bear Stearns. The GAO and the Special Inspector General have the right to audit our TALF program, which uses funds from the Troubled Assets Relief Program. The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in making and executing monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of Members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence. Thank you, Mr. Chairman. " CHRG-111shrg57709--124 Mr. Volcker," Let me try that one. Commercial banking, as I said, is a risky business. Now the question is whether you want to, in effect, provide a subsidy or provide protection when they are lending to small business, when they are lending to medium-size business, when they are lending to homeowners, when they are transferring money around the Country. Those are important continuing functions of a commercial bank, in my view, and I do think it is deserving of some public support. I do not think speculative activity falls in that range. They are not lending to your constituents. They are out making money for themselves and making money with big bonuses. And why do we want to protect that activity? I want to encourage them to go into commercial lending activity. Senator Johanns. But, see, you are assuming something about what I am doing. I do not like the bailouts. I voted against TARP, the second tranche of TARP. Quite honestly, I do not think we should put the taxpayer in that position. But I also likewise think that if your goal is to try to wrestle risk out of the system, you get to a point where quite honestly you do not have a workable system anymore, and that is what worries me about where you are going here--is because you are using this opportunity to put into place something that has some pretty profound consequences, and I am not sure these circumstances justify that step. That is why I ask these questions. " fcic_final_report_full--36 Even those who had profited from the growth of nontraditional lending practices said they became disturbed by what was happening. Herb Sandler, the co-founder of the mortgage lender Golden West Financial Corporation, which was heavily loaded with option ARM loans, wrote a letter to officials at the Federal Reserve, the FDIC, the OTS, and the OCC warning that regulators were “too dependent” on ratings agencies and “there is a high potential for gaming when virtually any asset can be churned through securitization and transformed into a AAA-rated asset, and when a multi-billion dollar industry is all too eager to facilitate this alchemy.”  Similarly, Lewis Ranieri, a mortgage finance veteran who helped engineer the Wall Street mortgage securitization machine in the s, said he didn’t like what he called “the madness” that had descended on the real estate market. Ranieri told the Commis- sion, “I was not the only guy. I’m not telling you I was John the Baptist. There were enough of us, analysts and others, wandering around going ‘look at this stuff,’ that it would be hard to miss it.”  Ranieri’s own Houston-based Franklin Bank Corporation would itself collapse under the weight of the financial crisis in November . Other industry veterans inside the business also acknowledged that the rules of the game were being changed. “Poison” was the word famously used by Country- wide’s Mozilo to describe one of the loan products his firm was originating.  “In all my years in the business I have never seen a more toxic [product],” he wrote in an in- ternal email.  Others at the bank argued in response that they were offering prod- ucts “pervasively offered in the marketplace by virtually every relevant competitor of ours.”  Still, Mozilo was nervous. “There was a time when savings and loans were doing things because their competitors were doing it,” he told the other executives. “They all went broke.”  In late , regulators decided to take a look at the changing mortgage market. Sabeth Siddique, the assistant director for credit risk in the Division of Banking Su- pervision and Regulation at the Federal Reserve Board, was charged with investigat- ing how broadly loan patterns were changing. He took the questions directly to large banks in  and asked them how many of which kinds of loans they were making. Siddique found the information he received “very alarming,” he told the Commis- sion.  In fact, nontraditional loans made up  percent of originations at Coun- trywide,  percent at Wells Fargo,  at National City,  at Washington Mutual, . at CitiFinancial, and . at Bank of America. Moreover, the banks expected that their originations of nontraditional loans would rise by  in , to . billion. The review also noted the “slowly deteriorating quality of loans due to loosening underwriting standards.” In addition, it found that two-thirds of the non- traditional loans made by the banks in  had been of the stated-income, minimal documentation variety known as liar loans, which had a particularly great likelihood of going sour.  The reaction to Siddique’s briefing was mixed. Federal Reserve Governor Bies re- called the response by the Fed governors and regional board directors as divided from the beginning. “Some people on the board and regional presidents . . . just wanted to come to a different answer. So they did ignore it, or the full thrust of it,” she told the Commission.  FOMC20080625meeting--308 306,MR. MISHKIN.," Thank you, Mr. Chairman. I also strongly support the short-term strategy that was laid out by the Chairman. I don't see that we really have an alternative in that context. There are a lot of issues here. The reality is that this is super complex, and we have a lot of work over the next year to be ready for the next Administration, when all these issues are going to become extremely relevant. In general terms, regarding the long-term issues, although we got here under exigent circumstances, in a financial disruption, we might have gotten here anyway. The reality is that there was a fundamental change in the way the financial system works. When banks are not so dominant, the distinction between investment banks and commercial banks in terms of the way the financial system works is really much less. It would be nice to think that we could limit the kinds of lending facilities that we have so that we didn't have to worry about regulating or supervising other institutions, but I don't think that is realistic. The nature of the changes in the financial system means that we extended the government safety net but it probably would have been extended anyway. It was just unfortunate that it had to happen in such a crisis atmosphere. So I think we have to think very hard about the issue of limiting moral hazard in terms of a much wider range of institutions. I am very sympathetic to the issues that President Stern raised, which is that we have to think about the kind of things that we have thought about more in terms of the banking industry: How do we actually set things up so that it is easier for firms to fail and not be systemic? There are a smaller number of firms that we actually have to supervise and regulate, and the reality is that we have to think very hard about how we're going to extend regulation and supervision to a wider range of firms. We just can't escape that. It would be nice to say that we could limit it, but we are not going to be able to limit it except to the extent that we can think about some of these issues. But it is going to be a huge issue going forward, and we really have to be ready to deal with the political process. The way we are proceeding makes a lot of sense. It is not committing us in a way that creates a problem, but we have to be ready when this issue is dealt with. It will be one of the hottest issues that the next Administration and the next Congress will have to deal with. We have to be really on point and to have positions very carefully thought out, not just by the Board but by the entire FOMC and the entire System, so that we can have a unified position to make sure that crazy stuff doesn't happen and that sensible stuff does. Thank you. " CHRG-111hhrg54868--21 Mr. Smith," Chief nuisance, right. Good afternoon, Chairman Frank, Ranking Member Bachus, and distinguished members of the committee. I appreciate the opportunity to continue our discussion of financial services regulatory reform. First and foremost, the decisions that you make will determine the industry's structure and its impact on communities, small businesses, and consumers across the country. My colleagues and I are very concerned that we could end up with a highly concentrated and consolidated industry that holds too much sway over the Federal Government and is unmoved by the needs of consumers and communities. The States have made the industry--that is, the financial services industry--more diverse and accountable. You see this in the fact that the States have chartered over two-thirds of the Nation's 8,000 banks, and you see this in the fact that the States serve as incubators and models for consumer protection. We hope that we can agree that the outcome of reform cannot be less diversity and less accountability, and yet we are hearing proposals that will undermine both diversity and accountability, proposals that will drive us towards greater centralization and consolidation. In our view, a consolidated banking system and industry would be in conflict with the health of our State and local economies and would further erode public confidence. I would like to make a few brief points on some specific issues and proposals. First, it is important to preserve the role of State law and the role of the States to set and enforce tougher consumer protection standards. Nationally chartered banks must not be able to hide behind preemptive regulatory declarations, declarations that are directly contrary to long-standing congressional intent. We oppose any effort to undermine the provisions in H.R. 3126, preserving the ability of the States to set and enforce tougher consumer protection standards. Second, creating a single monolithic regulator as a means of improving financial regulation relies on the faulty assumption that regulator consolidation leads to a safer and stronger banking system. Such a structure would diminish regulatory accountability and discipline. It would lead to further industry consolidation and facilitate regulatory capture by the Nation's largest financial institutions. A single Federal regulator, a regulator that both charters and examines national banks and examines State-chartered institutions, would irreparably harm the dual banking system and the diversity that is the hallmark of that system. Finally, regulatory reform must directly address and end ``too-big-to-fail.'' This means regulatory safeguards to prevent growth driven by excessive risk-taking and leverage, a clear path for resolving large interconnected institutions, and no discretionary safety net. Only in this manner will we be able to preserve the financial system's stability and protect taxpayers from potential unlimited liability from failed firms. As always, sir, it is an honor to appear before you. Thank you very much. I look forward to answering your questions. [The prepared statement of Mr. Smith can be found on page 132 of the appendix.] " CHRG-111hhrg55809--62 Mr. Bernanke," Well, my view at this point is that I would not think that any hedge fund or private equity fund would become a systemically critical firm individually. However, it would be important for the systemic risk council to pay attention to the industry as a whole and make sure that it understood what was going on so there wouldn't be kind of a broad-based problem that might cut across a lot of firms. Ms. Velazquez. As we continue to see fallout from this recession, one result has been even greater consolidation in the banking and financial sector. Our largest banks are now bigger than ever, and events from the past year have demonstrated that some financial institutions are indeed ``too-big-to-fail.'' What steps could a systemic regulator take to mitigate the continued concentration of risk in a few very large institutions? " CHRG-111hhrg48874--95 Mr. Castle," Any other comments? Ms. Duke. I think we have talked a lot about systemic risk regulation and, again, I feel like it is important that there is a broad policy agenda. There should be oversight of the system as a whole, not just oversight of the individual components or individual firms. Some parts of it that we think are important are functional supervision and onsolidated supervision, such as we have for bank holding companies, and for companies that may not necessarily be bank holding companies, in addition to systemic risk regulation. There does need to be a resolution regime for systemically important financial institutions, but I don't know if that necessarily has to be held by the same entity that has responsibility for systemic risk supervision. We think it is important that systemically important payment systems, as well as firms, be supervised, that there be attention paid to consumer and investor protection, and that some authority have the express responsibility to monitor and address systemic risk wherever it happens. Places where this might have come to light would be places where individual exposures in firms were identical to individual exposures at other firms, so those two--if the risk of an event happened in one firm, it wouldn't necessarily spill over to all firms. It might also involve looking at particular products, and obviously the mortgage-backed securities and the more complex securities would be an example of that. A third example of a place where this might have come into play would be in credit default swaps. " FOMC20080130meeting--3 1,MR. POOLE.," Thanks, Mr. Chairman. I came here 10 years ago with a boom. I'm going out with a pause. [Laughter] " CHRG-111shrg57319--595 Mr. Killinger," I believe we were talking about back in the housing boom period? Senator Levin. Yes. And you were talking about your high-risk products? " CHRG-111hhrg53244--13 Mr. Bernanke," Thank you, Mr. Chairman. Chairman Frank, Ranking Member Bachus, and other members of the committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy. Even so, the financial shocks that hit the global economy in September and October were the worst since the 1930's; and they helped push the global economy into the deepest recession since World War II. The U.S. economy contracted sharply in the fourth quarter of last year and the first quarter of this year. More recently, the pace of decline appears to have slowed significantly; and final demand and production have shown tentative signs of stabilization. The labor market, however, has continued to weaken. Consumer price inflation, which fell to low levels late last year, remain subdued in the first 6 months of 2009. To promote economic recovery and foster price stability, the Federal Open Market Committee last year brought its target for the Federal funds rate to a historically low range of zero to one-quarter percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant maintaining the Federal funds rate at exceptionally low levels for an extended period. At the time of our February report, financial markets at home and abroad were under intense strains, with equity prices at multiyear lows, risk spreads for private borrowers at very elevated levels, and some important financial markets essentially shut. Today, financial conditions remain stressed, and many households and businesses are finding credit difficult to obtain. Nonetheless, on net, the past few months have seen some notable improvements. For example, interest rate spreads and short-term money markets, such as the interbank market and the commercial paper market, have continued to narrow. The extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets. Reflecting this greater investor receptivity, corporate bond issuance has been strong. Many markets are functioning more normally, with increased liquidity and lower bid-asked spreads. Equity prices, which hit a low point in March, have recovered to roughly their levels at the end of last year; and banks have raised significant amounts of new capital. Many of the improvements in financial conditions can be traced in part to policy actions taken by the Federal Reserve to encourage the flow of credit. For example, the decline in interbank lending rates and spreads was facilitated by the actions of the Federal Reserve and other central banks to ensure that financial institutions have adequate access to short-term liquidity, which in turn has increased the stability of the banking system and the ability of banks to lend. Interest rates and spreads on commercial paper dropped significantly as a result of the backstop liquidity facilities that the Federal Reserve introduced last fall for that market. Our purchases of agency mortgage-backed securities and other longer-term assets have helped to lower conforming fixed mortgage rates. And the Term Asset-Backed Securities Loan Facility, or TALF, which was implemented this year, has helped to restart the securitization markets for various classes of consumer and small business credit. Earlier this year, the Federal Reserve and other Federal banking regulatory agencies undertook the Supervisory Capital Assessment Program (SCARP), popularly known as the stress test, to determine the capital needs of our largest financial institutions. The results of the SCAP were reported in May, and they appear to increase investor confidence in the U.S. banking system. Subsequently, the great majority of institutions that underwent the assessment have raised equity in public markets; and, on June 17th, 10 of the largest U.S. bank holding companies, all but one of which participated in the SCAP, repaid a total of nearly $70 billion to the Treasury. Better conditions in financial markets have been accompanied by some improvements in economic prospects. Consumer spending has been relatively stable so far this year, and the decline in housing activity appears to have moderated. Businesses have continued to cut capital spending and liquidate inventories, but the likely slowdown in the pace of inventory liquidation in coming quarters represents another factor that may support a turnaround in activity. Although the recession in the rest of the world led to a steep drop in the demand for U.S. exports, this drag on our economy also appears to be waning as many of our trading partners are also seeing signs of stabilization. Despite these positive signs, the rate of job loss remains high, and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2009 through 2011. FOMC participants generally expect that, after declining in the first half of this year, output will increase slightly over the remainder of 2009. The recovery is expected to be gradual in 2010, with some acceleration in activity in 2011. Although the unemployment rate is projected to peak at the end of this year, the projected declines in 2010 and 2011 would still leave unemployment well above FOMC participants' views of the longer-run sustainable rate. All participants expect that inflation will be somewhat lower than recent years, and most expect it to remain subdued over the next 2 years. In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery. Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period. However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. The FOMC has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate. To some extent, our policy measures will unwind automatically as the economy recovers and financial strains ease, because most of our extraordinary liquidity facilities are priced at a premium over normal interest rate spreads. Indeed, total Federal Reserve credit extended to banks and other market participants has declined from roughly $1.5 trillion at the end of 2008 to less than $600 billion, reflecting the improvement in financial conditions that has already occurred. In addition, bank reserves held at the Fed will decline as the longer-term assets that we own mature or are prepaid. Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed. Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the Federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk-free by holding balances at the Federal Reserve. Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attraction of this to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits. But interest on reserves is by no means the only tool we have to influence market rates. For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at later dates. Reverse repurchase agreements, which can be executed with primary dealers, Government-Sponsored Enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer term securities. Not only would such sales drain reserves and raise short-term interest rates, but they could also put upward pressure on longer-term rates by expanding the supply of longer-term assets. In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability. Our economy and financial markets have faced extraordinary near-term challenges, and strong and timely actions to respond to those challenges have been necessary and appropriate. I have discussed some of the measures taken by the Federal Reserve to promote economic growth and financial stability. The Congress also has taken substantial actions, including the passage of a fiscal stimulus package. Nevertheless, even as important steps have been taken to address the recession and the intense threats to financial stability, maintaining the confidence of the public and financial markets requires that policymakers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby boom generation and the continued increases in the costs of Medicare and Medicaid. Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult. Moreover, agreeing on a sustainable long-run fiscal path now could yield considerable near-term economic benefits in the form of lower long-term interest rates and increased consumer and business confidence. Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth. A clear lesson of the recent financial turmoil is that we must make our system of financial supervision and regulation more effective, both in the United States and abroad. In my view, comprehensive reform should include at least the following key elements: a prudential approach that focuses on the stability of the financial system as a whole and not just the safety and soundness of individual institutions, and that includes formal mechanisms for identifying and dealing with emerging systemic risks; stronger capital and liquidity standards for financial firms, with more stringent standards for large, complex, and financially interconnected firms; the extension and enhancement of supervisory oversight, including effective consolidated supervision to all financial organizations that could pose a significant risk to the overall financial system; an enhanced bankruptcy or resolution regime, modeled on the current system for depository institutions, that would allow financially troubled, systemically important nonbank financial institutions to be wound down without broad disruption to the financial institution's system and to the economy; enhanced protections for consumers and investors in their financial dealings; measures to ensure that critical payment, clearing, and settlement arrangements are resilient to financial shocks, and that practices related to the trading and clearing of derivatives and other financial instruments do not pose risk to the financial system as a whole; and, finally, improved coordination across countries in the development of regulations and in the supervision of internationally active firms. The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight. For example, we are expanding our use of horizontal reviews of financial firms to provide more comprehensive understanding of practices and risks in the financial system. The Federal Reserve also remains strongly committed to effectively carrying out our responsibilities for consumer protection. Over the past 3 years, the Federal Reserve has written rules providing strong protections for mortgage borrowers and credit card users, among many other substantive actions. Later this week, the Board will issue a proposal using our authority under the Truth in Lending Act, which will include new, consumer-tested disclosures as well as rule changes applying to mortgages and home equity lines of credit. In addition, the proposal includes new rules governing the compensation of mortgage originators. We are expanding our supervisory activities to include risk-focused reviews of consumer compliance in nonbank subsidiaries of holding companies. Our community affairs and research areas have provided support and assistance for organizations specializing in foreclosure mitigation, and we have worked with nonprofit groups on strategies for neighborhood stabilization. The Federal Reserve's combination of expertise in financial markets, payment systems, and supervision positions us well to protect the interests of consumers and their financial transactions. We look forward to discussing with the Congress ways to formalize our institution's strong commitment to consumer protection. The Congress and the American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayer resources. The Federal Reserve is committed to transparency and accountability in its operations. We report on our activities in a variety of ways, including reports like the one I am presenting to Congress today, other testimonies, and speeches. The FOMC releases a statement immediately after each regularly scheduled meeting and detailed minutes of each meeting on a timely basis. We have increased the frequency and scope of the published economic forecast of FOMC participants. We provide the public with detailed annual reports on the financial activities of the Federal Reserve System that are audited by an independent public accounting firm. We also publish a complete balance sheet each week. We have recently taken additional steps to better inform the public about the programs we have instituted to combat the financial crisis. We expanded our Web site this year to bring together already available information as well as considerable new information on our policy programs and financial activities. In June, we initiated a monthly report to the Congress that provides even more information on Federal Reserve liquidity programs, including breakdowns of our lending, the associated collateral, and other facets of programs established to address the financial crisis. These steps should help the public understand the efforts that we have taken to protect the taxpayer as we supply liquidity to the financial system and support the functioning of key credit markets. The Congress has recently discussed proposals to expand the audit authority of the GAO over the Federal Reserve. As you know, the Federal Reserve is already subject to frequent reviews by the GAO. The GAO has broad authority to audit our operations and functions. The Congress recently granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to ``single and specific'' companies under the authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities provided to, or created for, AIG or Bear Stearns. The GAO and the Special Inspector General have the right to audit our TALF program, which uses funds from the Troubled Asset Relief Program. The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in the making and execution of monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of Members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation and lead to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 68 of the appendix.] " CHRG-111hhrg54868--96 Mrs. Biggert," Have you explored the idea of a shared equity loss program and where the FDIC would match private equity and increase capital? In other words, instead of having them go under and then bring in somebody with the 90 percent, would that be a way of-- Ms. Bair. Well, we have a statutory prohibition against providing open bank assistance unless there is a systemic risk determination, which is hard to do with the smaller institutions. We have made a systemic risk determination with the Treasury and the Federal Reserve Board to undertake a troubled asset relief program--the PPIF or legacy loan program. We just did a test sale of a legacy loan mechanism with our receivership assets. And we are now looking at how we might use that for open institutions. I think it is a matter of evaluating what the criteria should be for institutions that are viable and have franchise value or would be viable with this additional help and can raise private capital. I think there is a good case to use such a mechanism if they can meet that criteria. However, we do have strong statutory restrictions against providing open bank assistance. And we do not have authority to make a direct capital investment in an open bank. " CHRG-111shrg55278--105 PREPARED STATEMENT OF MARY L. SCHAPIRO Chairman, Securities and Exchange Commission July 23, 2009Introduction Chairman Dodd, Ranking Member Shelby, and Members of the Committee: I am pleased to have the opportunity to testify concerning the regulation of systemic risk in the U.S. financial industry. \1\--------------------------------------------------------------------------- \1\ My testimony is on my own behalf, as Chairman of the SEC. The commission has not voted on this testimony.--------------------------------------------------------------------------- We have learned many lessons from the recent financial crisis and events of last fall, central among them being the need to identify, monitor, and reduce the possibility that a sudden shock will lead to a market seizure or cascade of failures that puts the entire financial system at risk. In turning those lessons into reforms, the following should guide us: First, there are two different kinds of ``systemic risk'': (1) the risk of sudden, near-term systemic seizures or cascading failures, and (2) the longer-term risk that our system will unintentionally favor large systemically important institutions over smaller, more nimble competitors, reducing the system's ability to innovate and adapt to change. We must be very careful that our efforts to protect the system from near-term systemic seizures do not inadvertently result in a long-term systemic imbalance. Second, there are two different kinds of ``systemic risk regulation'': (1) the traditional oversight, regulation, market transparency and enforcement provided by primary regulators that helps keep systemic risk from developing in the first place, and (2) the new ``macroprudential'' regulation designed to identify and minimize systemic risk if it does. Third, we must be cognizant of both kinds of regulation if we are to minimize both kinds of ``systemic risk.'' I believe the best way to achieve this balance is to: Address structural imbalances that facilitate the development of systemic risk by closing gaps in regulation, improving transparency and strengthening enforcement; and Establish a workable, macroprudential regulatory framework consisting of a single systemic risk regulator (SRR) with clear authority and accountability and a Financial Stability Oversight Council (Council) that can identify risks across the system, write rules to minimize systemic risk and help ensure that future regulatory gaps--and arbitrage opportunities--are minimized or avoided. Throughout this process, however, we must remain vigilant that our efforts to minimize ``sudden systemic risk'' do not inadvertently create new structural imbalances that undermine the long-term vibrancy of our capital markets.Addressing Structural Imbalances Through Traditional Oversight Much of the debate surrounding ``systemic risk'' and financial regulatory reform has focused on new ``macroprudential'' oversight and regulation. This debate has focused on whether we need a systemic risk regulator to identify and minimize systemic risk and how to resolve large interconnected institutions whose failure might affect the health of others or the system. The debate also has focused on whether it is possible to declare our readiness to ``resolve'' systemically important institutions without unintentionally facilitating their growth and systemic importance. Before turning to those issues, it is important that we not forget the role that traditional oversight, regulation and market transparency play in reducing systemic risk. This is the traditional ``block and tackle'' oversight and regulation, that is vital to ensuring that systemic risks do not develop in the first place.Filling Regulatory Gaps One central mechanism for reducing systemic risk is to ensure the same rules apply to the same or similar products and participants. Our global capital markets are incredibly fast and competitive: financial participants are competing with each other not just for ideas and talent but also with respect to ``microseconds'' and basis points. In such an environment, if financial participants realize they can achieve the same economic ends with fewer costs by flocking to a regulatory gap, they will do so quickly, often with size and leverage. We have seen this time and again, most recently with over-the-counter derivatives, instruments through which major institutions engage in enormous, virtually unregulated trading in synthetic versions of other, often regulated financial products. We can do much to reduce systemic risk if we close these gaps and ensure that similar products are regulated similarly.Improving Market Transparency In conjunction with filling regulatory gaps, market transparency can help to decrease systemic risk. We have seen tremendous growth in financial products and vehicles that work exactly like other products and vehicles, but with little or no transparency. For example, there are ``dark pools'' in which securities are traded that work like traditional markets without the oversight or information flow. Also, enormous risk resides in ``off-balance-sheet'' vehicles hidden from investors and other market participants who likely would have allocated capital more efficiently--and away from these risks--had the risks been fully disclosed. Transparency reduces systemic risk in several ways. It gives regulators and investors better information about markets, products and participants. It also helps regulators leverage market behavior to minimize the need for larger interventions. Where market participants are given sufficient information about assets, liabilities and risks, they, following their risk-reward analyses, could themselves allocate capital away from risk or demand higher returns for it. This in turn would help to reduce systemic risk before it develops. In this sense, the new ``macroprudential'' systemic risk regulation (set forth later in this testimony) can be seen as an important tool for identifying and reducing systemic risk, but not a first or only line of defense. I support the Administration's efforts to fill regulatory gaps and improve market transparency, particularly with respect to over-the-counter derivatives and hedge funds, and I believe they will go a long way toward reducing systemic risk.Active Enforcement It is important to note the role active regulation and enforcement plays in changing behavior and reducing systemic risks. Though we need vibrant capital markets and financial innovation to meet our country's changing needs, we have learned there are two sides to financial innovation. At their best, our markets are incredible machines capable of taking ``ordinary'' investments and savings and transforming them into new, highly useful products--turning today's thrift into tomorrow's stable wealth. At their worst, the self-interests of financial engineers seeking short-term profit can lead to ever more complex and costly products designed less to serve investors' needs than to generate fees. Throughout this crisis we have seen how traditional processes evolved into questionable business practices, that, when combined with leverage and global markets, created extensive systemic risk. A counterbalance to this is active enforcement that serves as a ready reminder of (1) what the rules are and (2) why we need them to protect consumers, investors, and taxpayers--and indeed the system itself.Macroprudential Oversight: The Need for a Systemic Risk Regulator and Financial Stability Oversight Council Although I believe in the critical role that traditional oversight, regulation, enforcement, and market transparency must play in reducing systemic risk, they alone are not sufficient. Functional regulation alone has shown several key shortcomings. First, information--and thinking--can remain ``siloed.'' Functional regulators typically look at particular financial participants or vehicles even as individual financial products flow through them all, often resulting in their seeing only small pieces of the broader financial landscape. Second, because financial actors can use different vehicles or jurisdictions from which to engage in the same activity, actors can sometimes ``choose'' their regulatory framework. This choice can sometimes result in regulatory competition--and a race to the bottom among competing regulators and jurisdictions, lowering standards and increasing systemic risk. Third, functional regulators have a set of statutory powers and a legal framework designed for their particular types of financial products or entities. Even if a regulator could extend its existing powers over other entities not typically within its jurisdiction, these legal frameworks are not easily transferrable either to other entities or other types of risk. Given these shortcomings, I agree with the Administration on the need to establish a regulatory framework for macroprudential oversight. Within that framework, I believe a hybrid approach consisting of a single systemic risk regulator and a powerful council is most appropriate. Such an approach would provide the best structure to ensure clear accountability for systemic risk, enable a strong, nimble response should circumstances arise and maintain the broad and differing perspectives needed to best identify developing risks and minimize unintended consequences.A Systemic Risk Regulator Given the (1) speed, size, and complexity of our global capital markets; (2) large role a relatively small number of major financial intermediaries play in that system; and (3) extent of Government interventions needed to address the recent turmoil, I agree there needs to be a Government entity responsible for monitoring our entire financial system for systemwide risks, with the tools to forestall emergencies. I believe this role could be performed by the Federal Reserve or a new entity specifically designed for this task. This ``systemic risk regulator'' should have access to information across the financial markets and, in addition to the individual functional regulators, serve as a second set of eyes upon those institutions whose failure might put the system at risk. It should have ready access to information about institutions that might pose a risk to the system, including holding company liquidity and risk exposures; monitor whether institutions are maintaining capital levels required by the Council; and have clear delegated authority to respond quickly in extraordinary circumstances. In addition, an SRR should be required to report to the Council on its supervisory programs and the risks and trends it identifies at the institutions it supervises.Financial Stability Oversight Council Further, I agree with the Administration and FDIC Chairman Bair that this SRR must be combined with a newly created Council. I believe, however, that any Council must be strengthened beyond the framework set forth in the Administration's ``white paper.'' This Council should have the tools needed to identify emerging risks, be able to establish rules for leverage and risk-based capital for systemically important institutions; and be empowered to serve as a ready mechanism for identifying emerging risks and minimizing the regulatory arbitrage that can lead to a regulatory race to the bottom. To balance the weakness of monitoring systemic risk through the lens of any single regulator, the Council would permit us to assess emerging risks from the vantage of a multidisciplinary group of financial experts with responsibilities that extend to different types of financial institutions, both large and small. Members could include representatives of the Department of the Treasury, SEC, CFTC, FRB, OCC, and FDIC. The Council should have authority to identify institutions, practices, and markets that create potential systemic risks and set standards for liquidity, capital and other risk management practices at systemically important institutions. The SRR would then be responsible for implementing these standards. The Council also should provide a forum for discussing and recommending regulatory standards across markets, helping to identify gaps in the regulatory framework before they morph into larger problems. This hybrid approach can help minimize systemic risk in a number of ways: First, a Council would ensure different perspectives to help identify risks that an individual regulator might miss or consider too small to warrant attention. These perspectives would also improve the quality of systemic risk requirements by increasing the likelihood that second-order consequences are considered and flushed out; Second, the financial regulators on the Council would have experience regulating different types of institutions (including smaller institutions) so that the Council would be more likely to ensure that risk-based capital and leverage requirements do not unintentionally foster systemic risk. Such a result could occur by giving large, systemically important institutions a competitive advantage over smaller institutions that would permit them to grow even larger and more risky; and Third, the Council would include multiple agencies, thereby significantly reducing potential conflicts of interest (e.g., conflicts with other regulatory missions). The Council also would monitor the development of financial institutions to prevent the creation of institutions that are either too-big-to-fail or too-big-to-succeed. In that regard, I believe that insufficient attention has been paid to the risks posed by institutions whose businesses are so large and diverse that they have become, for all intents and purposes, unmanageable. Given the potential daily oversight role of the SRR, it would likely be less capable of identifying and avoiding these risks impartially. Accordingly, the Council framework is vital to ensure that our desire to minimize short-term systemic risk does not inadvertently undermine our system's long-term health.Coordination of Council/SRR With Primary Regulators In most times, I would expect the Council and SRR to work with and through primary regulators of systemically important institutions. The primary regulators understand the markets, products and activities of their regulated entities. The SRR, however, can provide a second layer of review over the activities, capital, and risk management procedures of systemically important institutions as a backstop to ensure that no red flags are missed. If differences arise between the SRR and the primary regulator regarding the capital or risk management standards of systemically important institutions, I strongly believe that the higher (more conservative) standard should govern. The systemic risk regulatory structure should serve as a ``brake'' on a systemically important institution's riskiness; it should never be an ``accelerator.'' In emergency situations, the SRR may need to overrule a primary regulator (for example, to impose higher standards or to stop or limit potentially risky activities). However, to ensure that authority is checked and decisions are not arbitrary, the Council should be where general policy is set, and only then to implement a more rigorous policy than that of a primary regulator. This will reduce the ability of any single regulator to ``compete'' with other regulators by lowering standards, driving a race to the bottom.Unwinding Systemic Risk--A Third Option I agree with the Administration, the FDIC, and others that the Government needs a credible resolution mechanism for unwinding systemically important institutions. Currently, banks and broker-dealers are subject to well-established resolution processes under the Federal Deposit Insurance Corporation Improvement Act and the Securities Investor Protection Act, respectively. No corresponding resolution process exists, however, for the holding companies of systemically significant financial institutions. In times of crisis when a systemically important institution may be teetering on the brink of failure, policy makers are left in the difficult position of choosing between two highly unappealing options: (1) providing Government assistance to a failing institution (or an acquirer of a failing institution), thereby allowing markets to continue functioning but potentially fostering more irresponsible risk taking in the future; or (2) not providing Government assistance but running the risk of market collapses and greater costs in the future. Markets recognize this Hobson's choice and can actually fuel more systemic risk by ``pricing in'' the possibility of a Government backstop of large-interconnected institutions. This can give them an advantage over their smaller competitors and make them even larger and more interconnected. A credible resolution regime can help address these risks by giving policy makers a third option: a controlled unwinding of the institution over time. Structured correctly, such a regime could force market participants to realize the full costs of their decisions and help reduce the ``too-big-to-fail'' dilemma. Structured poorly, such a regime could strengthen market expectations of Government support, as a result fueling ``too-big-to-fail'' risks. Avoidance of conflicts of interest in this regime will be paramount. Different regulators with different missions may have different priorities. For example, both customer accounts with broker-dealers and depositor accounts in banks must be protected and should not be used to cross-subsidize other efforts. A healthy consultation process with a regulated entity's primary regulator will provide needed institutional knowledge to ensure that potential conflicts such as this are minimized.Conclusion To better ensure that systemwide risks will be identified and minimized without inadvertently creating larger risk down the road, I recommend that Congress establish a strong Financial Stability Oversight Council, comprised of the primary regulators. The Council should have responsibility for identifying systemically significant institutions and systemic risks, making recommendations about and implementing actions to address those risks, promoting effective information flow, setting liquidity and capital standards, and ensuring key supervisors apply those standards appropriately. The various primary regulators offer broad perspectives across markets that represent a wide range of institutions and investors. This array of perspectives is essential to build a foundation for the development of a robust regulatory framework better designed to withstand future periods of market or economic volatility and help restore investors' confidence in our Nation's markets. I believe a structure such as this provides the best balance for reducing sudden systemic risk without undermining the competitive and resilient capital markets needed over the long term. Thank you again for the opportunity to present my views. I look forward to working with the Committee on any financial reform efforts it may undertake, and I would be pleased to answer any questions. FinancialCrisisReport--8 Between 2004 and 2007, Moody’s and S&P issued credit ratings for tens of thousands of U.S. residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO). Taking in increasing revenue from Wall Street firms, Moody’s and S&P issued AAA and other investment grade credit ratings for the vast majority of those RMBS and CDO securities, deeming them safe investments even though many relied on high risk home loans. 1 In late 2006, high risk mortgages began incurring delinquencies and defaults at an alarming rate. Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to issue investment grade ratings for numerous RMBS and CDO securities. Then, in July 2007, as mortgage delinquencies intensified and RMBS and CDO securities began incurring losses, both companies abruptly reversed course and began downgrading at record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a year old. Investors like banks, pension funds, and insurance companies, who are by rule barred from owning low rated securities, were forced to sell off their downgraded RMBS and CDO holdings, because they had lost their investment grade status. RMBS and CDO securities held by financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS market initially froze and then collapsed, leaving investors and financial firms around the world holding unmarketable subprime RMBS securities that were plummeting in value. A few months later, the CDO market collapsed as well. Traditionally, investments holding AAA ratings have had a less than 1% probability of incurring defaults. But in 2007, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Analysts have determined that over 90% of the AAA ratings given to subprime RMBS securities originated in 2006 and 2007 were later downgraded by the credit rating agencies to junk status. In the case of Long Beach, 75 out of 75 AAA rated Long Beach securities issued in 2006, were later downgraded to junk status, defaulted, or withdrawn. Investors and financial institutions holding the AAA rated securities lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the viability of U.S. financial markets. Inaccurate AAA credit ratings introduced risk into the U.S. financial system and constituted a key cause of the financial crisis. In addition, the July mass downgrades, which were unprecedented in number and scope, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the beginning of the financial crisis. 1 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this Report will refer to both ratings as “AAA.” CHRG-111hhrg53234--155 Mr. Galbraith," Thank you very much, Mr. Chairman. And as a member or an alumnus of this committee staff, it is again a pleasure and privilege to be here. I want to begin with a comment on this question of independence which has been touched on repeatedly. Vice Chairman Kohn said, and I think with very carefully chosen words, that the Congress granted a substantial degree of independence to the Federal Reserve. That independence is, of course, independence from the Executive Branch. It is not and cannot be independence from the Congress itself. The Federal Reserve may be delegated certain functions by the Congress, but the Congress can always choose to hold it accountable, and this committee, of course, has the responsibility of oversight precisely for that reason. So I think we should be very clear that, when speaking of the independence of the Federal Reserve, it is a legal independence of a kind that other regulatory institutions have had over the course of our history. It is not an independence which is specific to monetary policy per se. The question before us is whether the Federal Reserve is the best agency to take on the responsibility for regulating systemic risk, and I have some reservations about that, and I would classify them in three broad categories. The first one we might call constitutional, and I would pick up the point that was already made this afternoon by Congressman Sherman, concerning the fact that the Federal Reserve is constituted in part of regional Federal Reserve, of Federal Reserve district banks, who have boards of directors who are formed from the member banks themselves. And it is, of course, true that the district banks are represented on the Federal Open Market Committee with a voting power whose constitutionality, incidentally, was challenged in court by the chairman of this committee back in the 1970's when I was serving here on the staff. The issue was never resolved on the legal merits. It is also the case, as I understand it, that the examiners under a systemic risk supervision regime would actually reside in the district banks rather than at the Federal Reserve Board, and it seems to me this does raise a question at least of perception; that is to say, whether it is appropriate to have systemic risk regulators who are part of institutions that report in part and are accountable in part to boards of directors consisting in part of the member banks of those institutions for two reasons. One, there may be a systematic conflict between the interests of the member banks and the interests of system stability. And, secondly, there may be conflicts between the interests of member banks and the interests of other Tier I financial holding companies who are not member banks. So it seems to me that is at least a question which is worth considering as you think about the architecture of this particular system. The second concern that I would have is institutional. It is whether, in an agency whose primary functions are macroeconomic, one would ever have a commitment to the systemic risk regulation, to the supervisory responsibilities that are commensurate with the importance of that particular function. It seems to me worth pointing out that there is in the Treasury proposal basically a two-stage process, one of which is analytical, and the other one has more of an enforcement character. The analytical question is to determine what is a systemically dangerous institution to be classified as a Tier I financial holding company. That, it seems to me, would be an appropriate function to vest in the Federal Reserve Board, where an office that is incremental in the sense that Vice Chairman Kohn stipulated could decide amongst the relatively small number of large institutions who is and who is not in that category. The enforcement, the supervision, and the regulation of the behavior of the institutions, it seems to me, naturally would be more appropriately placed in an agency for whom that is the primary priority, an agency such as the FDIC. The third concern that I have is a question of really the leadership of the Federal Reserve. Historically this is--the chairmanship of the Board of Governors of the Federal Reserve is an extremely high-profile appointment. It is an individual who tends to be close to and to need the confidence of the financial markets, and there is a real question as to whether there is any record in the history of the Federal Reserve of effective response to systemic risk in advance of crisis. This was not the case of Benjamin Strong of the 1920's, who was the leading figure at the time, although not the Chairman of the Board. It was not the case of Alan Greenspan in the run-up to the latest crisis. We had a doctrine which, in effect, denied that systemic risk could, in fact, bring down the system. That doctrine was articulated at the peak of the Federal Reserve, and it seems to me that we had a test of that proposition, and it came up wanting. So it does seem to me that there are reasons to be worried about investing the authority for systemic risk in the Federal Reserve. Thank you very much. [The prepared statement of Dr. Galbraith can be found on page 50 of the appendix.] " CHRG-111shrg55278--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. At the core of the Administration's financial regulatory reform proposal is the concept of systemic risk. The President believes that it can be regulated and that the Fed should be the regulator. But as we begin to consider how to address systemic risk, my main concern is that while there appears to be a growing consensus on the need for a systemic risk regulator, there is no agreement on how to define systemic risk, let alone how to manage it. I believe that it would be legislative malfeasance to simply tell a particular regulator to manage all financial risk without having reached some consensus on what systemic risk is and whether it can be regulated at all. Should we reach such a consensus, I believe we then must be very careful not to give our markets a false sense of security that could actually exacerbate our ``too-big-to-fail'' problem. If market participants believe that they no longer have to closely monitor risk presented by financial institutions, the stage will be set for our next economic crisis. If we can decide what systemic risk is and that it is something that should and can be regulated, I believe our next question should be: Who should regulate it? Unfortunately, I believe the Administration's proposal largely places the Federal Reserve in charge of regulating systemic risk. It would grant the Fed, as I understand the white paper, authority to regulate any bank, securities firm, insurer, investment fund, or any other type of financial institution that the Fed deems a systemic risk. The Fed would be able to regulate any aspect of these firms, even over the objections of other regulators. In effect, the Fed would become a regulator giant of unprecedented size and scope. I believe that expanding the Fed's power in this manner could be very dangerous. The mixing of monetary policy and bank regulation has proven to be a formula for taxpayer-funded bailouts and poor monetary policy decisions. Giving the Fed ultimate responsibility for the regulation of systemically important firms will provide further incentives for the Fed to hide its regulatory failures by bailing out troubled firms. Rather than undertaking the politically painful task of resolving failed institutions, the Fed could take the easy way out and rescue them by using its lender-of-last-resort facilities or open market operations. Even worse, it could undertake these bailouts without having to obtain the approval of the Congress. In our system of Government, elected officials should make decisions about fiscal policy and the use of taxpayers' dollars, not unelected central bankers. Handing over the public purse to an enhanced Fed is simply inconsistent with the principles of democratic Government. Augmenting the Federal Reserve's authority also risks burdening it with more responsibility than one institution can reasonably be expected to handle. In fact, the Federal Reserve is already overburdened with its responsibility for monetary policy, the payment system, consumer protection, and bank supervision. I believe anointing the Fed as the systemic risk regulator will make what has proven to be a bad bank regulator even worse. Let us not forget that it was the Fed that pushed for the adoption of the flawed Basel II Capital Accords right here in this Committee which would have drained our banking system of capital. It was the Fed that failed to adequately supervise Citigroup and Bank of America, setting the stage for bailouts in excess of $400 billion there. It was the Fed that failed to adopt mortgage underwriting guidelines until well after this crisis was underway. Yes, it was the Fed that said there was no need to regulate derivatives right here in this Committee. It was also the Fed that lobbied to become the regulator of financial holding companies as part of Gramm-Leach-Bliley. The Fed won that fight and got the additional authority it sought. Ten years later, however, it is clear that the Fed has proven that it is incapable of handling that responsibility. Ultimately, I believe if we are able to reach some sort of agreement on systemic risk and whether it can be managed, I strongly believe that we should consider every possible alternative to the Fed as a systemic risk regulator. Thank you, Mr. Chairman. " CHRG-111shrg56376--136 Mr. Ludwig," Chairman Dodd, and to Ranking Member Shelby, who is not here, and other distinguished Members of this Committee, I am honored to be here today and I want to commend you and the staff for the thoughtful way in which you have examined the causes of the financial crisis and the need for reform in this area. Under your leadership, Chairman Dodd and Ranking Member Shelby, the bipartisan and productive traditions of the Senate Banking Committee have continued. In this regard, it should be noted that the need for an end-to-end independent consolidated banking regulator, the subject you have asked me to address today, has been championed over the years by Members of the Senate Banking Committee, including its Chairman, as well as Treasury Secretaries from both sides of the aisle. Consistent with this tradition, the Administration's white paper is directionally helpful and commendable. While refinements to the white paper are needed, this is an inevitable part of the policymaking process. I also want to commend the Treasury Department of former Secretary Henry Paulson for having developed its so-called ``Blueprint,'' which also has added important and positive developments to the debate in this area. Lamentably, the financial regulatory problem we face is not just the current crisis. Over the past 20-plus years, we have witnessed the failure of hundreds of U.S. banks and bank holding companies, supervised by every one of our regulatory agencies. By the end of this year alone, well over 100 U.S. banks will have failed, costing the Deposit Insurance Fund tens of billions of dollars. Before this crisis is over, we will witness the failure of hundreds more. In the face of this irrefutable evidence, it is impossible to say there is not a very serious problem with our regulation of financial services organizations. There are three things, however, this problem is not. It is not about the lack of talented people in our regulatory agencies. It is not about weak regulation or weaker bankers. The problem is in large part--the problem stems from a dysfunctional regulatory structure, a structure that exists nowhere else in the world and no one wants to copy, a structure that reflects history, not deliberation. The recent financial crisis has accentuated many of the shortcomings of the current regulatory system. Needless burdens that weaken safety and soundness focus, lack of scale needed to address problems in technical areas, regulatory arbitrage where the ability to select or threaten to select a weaker supervisor tears at the fabric of solid regulation, delayed rulemaking, regulatory gaps, limitations on investigations, where one agency cannot seamlessly examine and resolve a problem from a bank to its nonbank affiliate, and diminished international leadership. What is needed and what would resolve these problems is an end-to-end independent consolidated banking supervisor. Now, there have been a number of misconceptions about what a consolidated end-to-end institutional bank regulator is and what it is not. First, an end-to-end supervisor is not a super-regulator along the lines of Britain's FSA. The end-to-end consolidated institutional supervisor would not regulate financial markets like the FSA, would not establish consumer protection rules like the FSA, would not have resolution authority, would not have deposit insurance authority or any central banking functions. The consolidated end-to-end institutional regulator would focus only on the prudential issues applicable to financial institutions, and this model has been quite successful elsewhere in the world. I think this is really quite important. For example, the Office of the Superintendent of Financial Institutions, OSFI, in Canada, and the Australian Prudential Regulatory Authority, called APRA, in Australia have been quite successful consolidated supervisors even in the current crisis, where Canadian and Australian banks have fared much better than our own. There has been a second misconception that a consolidated regulator that regulates enterprises chartered at the national level cannot fairly supervise smaller community organizations and that it would do violence to our dual banking system. I might say as an aside, I, like the Chairman, believe the dual banking system is alive and well and an important fabric of our banking system and this would not do violence to it. In fact, interesting enough, even today, the OCC supervises well over a thousand community banking organizations whose businesses are local in character. That is, the national supervisor supervises over a thousand small banks. In fact, it is the majority of the banks it supervises, the vast majority, and they choose that as a matter of their own predilection, not by rule. Indeed, today, all our Federal regulators regulate large institutions and smaller institutions. A new consolidated supervisor at the Federal level would merely pick up the FDIC and Federal Reserve examination and supervisory authorities. To emphasize, all the consolidated supervisor would do is take the Federal component and move it to another Federal box. It would not change the regulation or the fabric of that supervision. Third, some have claimed that a consolidated institutional supervisor would not have the benefit of other regulatory voices. This would clearly not be the case, as a consolidated institutional supervisor would fulfill only one piece of the regulatory landscape. The Federal Reserve, Treasury, SEC, FDIC, CFTC, FINRA, FINCEN, OFAC, and the FHFA would continue to have important responsibilities with respect to the financial sector. In addition, proposals are being made to add additional elements to the U.S. financial regulatory landscape, the Systemic Risk Council and a new financial consumer agency. This would leave multiple financial regulators at the Federal level and 50 bank regulators, 50 insurance regulators, and 50 securities regulators at the State level. It seems to me that is a lot of voices. Fourth, some have also claimed that the primary work of the Federal Reserve--monetary policy, payment system, and acting as the bank of last resort--and the FDIC--deposit insurance--would be seriously hampered if they did not have supervisory responsibility. The evidence does not support these claims. One, a review of FOMC minutes does not suggest much, if any, use is made of supervisory data in monetary policy activities. In the case of the FDIC, it has long relied on a combination of publicly available data and examination data from the other agencies. Two, there are not now, to my knowledge, any limitations on the ability of the Federal Reserve or the FDIC to collect any bank supervisory data. Indeed, if need be, the Federal Reserve or the FDIC can accompany another agency's examination team to obtain relevant data or review relevant practices. Three, if the FDIC or the Federal Reserve does not have adequate cooperation on gathering information, Congress can make clear by statute that this must be the case. And four, even if the FDIC were not the supervisor of State chartered banking entities, the FDIC would continue to have back-up supervisory authority and be able to be resident--resident--in any bank it chose. Finally, I would note that it is important that the new consolidated supervisor be an independent agency for at least three reasons. First, banking supervision should not be subject to political influence. Second, the agency and the agency head needs the stature of the Federal Reserve, SEC, or FDIC to attract talented people and to be taken seriously by the other agencies. Third, and this, I think, is critically important, Congress, in fulfilling its oversight function--its critical oversight function--must hear the unfettered truth about the banking system from the head of its supervisory agency, not views filtered through another department or agency. And indeed, I would go further. I think it is incredibly difficult for you to fulfill your oversight responsibilities with an alphabet soup of regulators. Indeed, having regulators that have clear missions, it seems to me, makes it possible for you to exercise your critical function in a more effective way. If one pushed these together even more, as has been suggested by some, I think it becomes almost unmanageable for Congress. In sum, our country greatly needs a consolidated independent end-to-end institutional regulator. Without one, we will not have financial stability, in my view, and we will continue to be victimized by periods of bank failures and follow-on credit crunches that deteriorate our economy. Thank you very much. " CHRG-110shrg50369--41 Mr. Bernanke," Well, I believe the FDIC and the OCC have recently provided some information. There probably will be some bank failures. There are, for example, some small or in many cases de novo banks that are heavily invested in real estate in locales where prices have fallen, and, therefore, they would be under some pressure. So I expect there will be some failures. Among the largest banks, the capital ratios remain good, and I do not anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system. Senator Shelby. Do you see some of those larger banks seeking additional capital to bolster themselves? " CHRG-110hhrg46591--38 Mr. Stiglitz," Mr. Chairman and members of the committee, first let me thank you for holding these hearings. The subject could not have been more timely. Our financial system has failed us. A well-functioning financial system is essential for a well-functioning economy. Our financial system has not functioned well, and we are all bearing the consequences. There is virtual unanimity that part of the reason that it has performed so poorly is due to inadequate regulations and due to inadequate regulatory structures. I want to associate my views with Dr. Rivlin's in that it is not just a question of too much or too little; it is the right regulatory design. Some have argued that we should wait to address these problems. We have a boat with holes, and we must fix those holes now. Later, there will be time to address these longer-run regulatory problems. We know the boat has a faulty steering mechanism and is being steered by captains who do not know how to steer, least of all in these stormy waters. Unless we fix both, there is a risk that the boat will go crashing on some rocky shoals before reaching port. The time to fix the regulatory problems is, thus, now. Everybody agrees that part of the problem is a lack of confidence in our financial system, but we have changed neither the regulatory structures, the incentive systems nor even those who are running these institutions. As we taxpayers are pouring money into these banks, we have even allowed them to pour out moneys to their shareholders. This morning, I want to describe briefly the principal objectives and instruments of a 21st Century regulatory structure. Before doing so, I want to make two other prefatory remarks. The first is that the reform of financial regulation must begin with the broader reform of corporate governance. Why is it that so many banks have employed incentive structures that have served stakeholders, other than the executives, so poorly? The second remark is to renew the call to do something about the homeowners who are losing their homes and about our economy which is going deeper into recession. We cannot rely on trickle-down economics--throwing even trillions of dollars at financial markets is not enough to save our economy. We need a package simply to stop these things from getting worse and a package to begin the recovery. We are giving a massive blood transfusion to a patient who is hemorrhaging from internal bleeding, but we are doing almost nothing to stop that internal bleeding. Let me begin with some general principles. It is hard to have a well-functioning, modern economy without a good financial system. However, financial markets are not an end in themselves but a means. They are supposed to mobilize savings, to allocate capital, and to manage risk, transferring it from those less able to bear it to those more able. Our financial system encourages spendthrift patterns, leading to near zero savings. They have misallocated capital; and instead of managing risk, they have created it, leaving huge risks with ordinary Americans who are now bearing the huge costs because of these failures. These problems have occurred repeatedly and are pervasive. This is only the latest and the biggest of the bailouts that have become a regular feature of our peculiar kind of capitalism. The problems are systemic and systematic. These systems, in turn, are related to three more fundamental problems. The first is incentives. Markets only work well when private rewards are aligned with social returns, but, as we have seen, that has not been the case. The problem is not only with incentive structures and it is not just the level, but it is also the form, which is designed to encourage excessive risk-taking and to have shortsighted behavior. Transparency. The success of a market economy requires not just good incentive systems but good information. Markets fail to produce sufficient outcomes when information is imperfect or asymmetric. Problems of lack of transparency are pervasive in financial markets. Nontransparency is a key part of the credit crisis that we have experienced in recent weeks. Those in financial markets have resisted improvements such as more transparent disclosure of the cost of stock options, which provide incentives for bad accounting. They put liabilities off balance sheets, making it difficult to assess accurately their net worth. There is a third element of well-functioning markets--competition. There are a number of institutions that are so large that they are too big to fail. They are provided an incentive to engage in excessively risky practices. It was a ``heads I win,'' where they walk off with the profits, and a ``tails you lose,'' where we, the taxpayers, assume the losses. Markets often fail; and financial markets have, as we have seen, failed in ways that have large systemic consequences. The deregulatory philosophy that has prevailed during the past quarter century has no grounding in economic theory nor historical experience. Quite the contrary, modern economic theory explains why the government must take an active role, especially in regulating financial markets. Regulations are required to ensure the safety and soundness of individual financial institutions and of the financial system as a whole to protect consumers, to maintain competition, to ensure access to finance for all, and to maintain overall economic stability. In my remarks, I want to focus on the outlines of the regulatory structure, focusing on the safety and the soundness of our institutions and on the systematic stability of our system. In thinking about a new regulatory structure for the 21st Century, we need to begin by observing that there are important distinctions between financial institutions that are central to the functioning of the economic system whose failures would jeopardize the economy, those who are entrusted with the care of ordinary citizens' money, and those who prove investment services to the very wealthy. The former include commercial banks and pension funds. These institutions must be heavily regulated in order to protect our economic system and to protect the individuals whose money they are supposed to be taking care of. There needs to be strong ring-fencing of these core financial institutions. We have seen the danger of allowing them to trade with risky, unregulated parties, but we have even forgotten basic principles. Those who managed others' money inside commercial banks were supposed to do so with caution. Glass-Steagall was designed to separate more conservative commercial banking concerned with managing the funds of ordinary Americans with the more risky activities of investment banks aimed at upper income Americans. The repeal of Glass-Steagall not only ushered in a new era of conflicts of interest but also a new culture of risk-taking in what are supposed to be conservatively managed financial institutions. We need more transparency. A retreat from mark-to-market would be a serious mistake. We need to ensure that incentive structures do not encourage excessively risky, shortsighted behavior, and we need to reduce the scope of conflicts of interest, including at the rating agencies, conflicts of interest which our financial markets are rife with. Securitization for all of the virtues in diversification has introduced new asymmetries of information. We need to deal with the consequences. Derivatives and similar financial products should neither be purchased nor produced by highly regulated financial entities unless they have been approved for specific uses by a financial product safety commission and unless their uses conform to the guidelines established by that commission. Regulators should encourage the move to standardized products. We need countercyclical capital adequacy and provisionary requirements and speed limits. We need to proscribe excessively risky and exploitive lending practices, including predatory lending. Many of our problems are a result of lending that was both exploitive and risky. As I have said, we need a financial product safety commission, and we need a financial system stability commission to assess the overall stability of the system. Part of the problem has been our regulatory structures. If government appoints as regulators those who do not believe in regulation, one is not likely to get strong enforcement. The regulatory system needs to be comprehensive. Otherwise, funds will flow through the least regulated part. Transparency requirements in part of the system may help ensure the safety and soundness of that part of the system but will provide little information about systemic risks. This has become particularly important as different institutions have begun to perform similar functions. Anyone looking at our overall financial system should have recognized not only the problems posed by systemic leverage but also the problems posed by distorted incentives. Incentives also play a role in failed enforcement and help explain why self-regulation does not work. Those in financial markets had incentives to believe in their models. They seemed to be doing very well. That is why it is absolutely necessary that those who are likely to lose from failed regulation--retirees who lose their pensions, homeowners who lose their homes, ordinary investors who lose their life savings, workers who lose their jobs--have a far larger voice in regulation. Fortunately, there are competent experts who are committed to representing those interests. It is not surprising that the Fed failed in its job. The Fed is too closely connected with financial markets to be the sole regulator. This analysis should also make it clear why self-regulation will not work or at least will not suffice. " Mr. Kanjorski," [presiding] Doctor, please wrap up. " CHRG-110shrg50416--96 Mr. Montgomery," Well, that is one of ten things that wake us all up in the middle of the night. The reason why FHA didn't take part in the boom, there are a lot of them. One is we did not lower our underwriting criteria. We had this crazy notion that people should verify their income. They should produce tax returns. They needed to have atleast 2 years with their current employer. And we have not lowered those standards. And our ratios, our front-end ratios, our back-end ratios exist for a reason. I think because of that, I think you will see FHA continue to perform admirably over here on the long term. If I could just interject one thing here real quick, sir, on the servicing, FHA, and I referenced this number before, the last 3 years, we have saved 300,000 FHA borrowers from foreclosure, 300,000. That is a number you have not read anywhere. You don't see that, and it is because our loss mitigation program, which Congress put into place 10 years ago, is working, and the main reason it works is because we require it. Lenders and servicers know this. The borrowers know this. The investors know this. They are required to do loss mitigation. If they don't do that, they face treble damages from FHA and I think that is one of the keys to why this has been successful. You have not read about those borrowers going to foreclosure because they have not been. Senator Corker. Thank you, and if I could just--we have all traveled a long ways to be here and we thank you for having this hearing. Mr. Kashkari, I have to tell you that the concern about the--first of all, thank you for what you are doing and I appreciate the conversations that we have had. I do think the concern about the loans is somewhat unfounded. I mean, at the end of the day, people are paying 5 percent for this money. I know it raises at some point to 9 percent. At some point, the banks have to make a profit. I mean, they can't just hoard cash. I mean, it is pretty self-evident, is it not, that the way that money is going to be made is lending that money, and while there may be an initial hoarding, at some point, this money has to go out. Otherwise, these enterprises are not making money. I mean, that is just sort of self-evident. I wonder if you could just take maybe 10 seconds to address that issue. It concerns me. Obviously, I supported this measure and was involved in it. One of the things in the back of my mind was, once the camel nose goes under the tent and you get a bunch of Senators and a bunch of House members involved in the business of banking, all of a sudden, we are telling the banks what to do, which, let us face it, part of our problem with Fannie and Freddie, and I don't want to go into that now, we will deal with it after the election, but was that very thing, OK. And so I am very concerned about us making prescriptive arrangements with these banks. I don't think you are going to get many participants in that regard, but we are going to destroy our banking system if we do that. I appreciate the balance you are trying to create, but is it not self-evident that with paying for these through dividends--it is basically a loan, let us face it, that they can show as equity--they have got to make loans to make money and be in business. Is that a yes or no answer? " CHRG-111shrg57322--767 Mr. Viniar," Absolutely. Senator Ensign. You don't want to be part of the next financial collapse. " CHRG-110shrg50416--17 INSURANCE COMPANY Ms. Bair. Thank you, Mr. Chairman, Senator Shelby, and members of the Committee. I appreciate the opportunity to testify on recent efforts to stabilize the Nation's financial markets and to reduce foreclosures. Conditions in the financial markets have deeply shaken the confidence of people around the world in their financial systems. The events of the past several weeks are unprecedented, to say the least. The Government has taken a number of extraordinary steps to bolster public confidence in the U.S. banking system. The most recent were the measures last week to recapitalize our banks and provide temporary liquidity support to unlock credit markets, especially interbank lending. These moves match similar actions taken in Europe. Working with the Treasury Department and other bank regulators, the FDIC is prepared to do whatever it takes to preserve the public's trust in the financial system. Despite the current challenges, the bulk of the U.S. banking industry remains well capitalized. What we now face is a confidence problem, largely caused by uncertainty about the value of mortgage assets, which has made banks reluctant to lend to each other, as well as to consumers and businesses. Our efforts at the FDIC have been focused on liquidity. Last week, the FDIC Board and the Federal Reserve Board recommended that the Secretary of the Treasury invoke the ``systemic risk exception,'' which he did, after consulting with the President. The FDIC Board then used the authority to create a Temporary Liquidity Guarantee Program. This program has two features. The first guarantees new, senior unsecured debt issued by banks and thrifts and by most bank and thrift holding companies. This will help the banks fund their operations. Both term and overnight funding of banks have come under extreme pressure in recent weeks, with interest rates for short-term lending ballooning to several hundred basis points over the rate for comparable U.S. Treasuries. The guarantee will allow banks to roll maturing senior debt into new issues fully backed by the FDIC. The second feature of the new program provides insurance coverage for all deposits in non-interest bearing transaction accounts at participating institutions. These accounts are mainly for payment processing, such as payroll accounts used by businesses. Frequently, they exceed the $250,000 insurance limit and many smaller, healthy banks had expressed concerns about major outflows from these accounts. This guarantee, which runs through the end of next year, should stabilize those accounts and help us avoid having to close otherwise viable banks because of deposit withdrawals. This aspect of the program allows bank customers to conduct normal business knowing that their cash accounts are safe and sound. This is the fundamental goal of deposit insurance, safeguarding people's money, and it is vital to public confidence in the banking system. It is important to note that the new program does not use taxpayer money or the Deposit Insurance Fund. Instead, it will be paid for by direct user fees. We also remain focused on the borrower side of the equation. Everyone agrees that more needs to be done for homeowners. We need to prevent unnecessary foreclosures and we need to modify loans at a much faster pace. Preventing unnecessary foreclosures will be essential to stabilizing home prices and providing stability to mortgage markets and the overall economy. As you know, a number of steps have already been taken in this direction, but I think it is clear by now that a systematic approach is needed to help us finally get ahead of the curve. The FDIC is working closely and creatively with Treasury on ways to use the recent rescue law to create a clear framework and economic incentives for systematically modifying loans. The aim is for loan servicers to offer homeowners more affordable and sustainable mortgages. In sharing ideas with Treasury, we have drawn from the program that we are using for modifying loans at IndyMac Federal Bank since we took control of that bank in July. We have introduced a streamlined process to systematically modify troubled home mortgages owned or serviced by IndyMac. As we have done in some past bank failures, we initially suspended most foreclosures in order to evaluate the portfolio and to identify the best ways to maximize the value of the institution. Through this week, IndyMac has mailed more than 15,000 loan modification proposals to borrowers. More than 70 percent have already responded to the initial mailings in August. More than 3,500 borrowers to date have accepted the offers and thousands more are being processed. The hope is that our mortgage relief program can be a model and a catalyst to spur loan modifications across the country. It is a process that most servicers can use under existing legal arrangements. In conclusion, the FDIC is fully engaged in preserving trust and stability in the banking system. The FDIC remains committed to achieving what has been our core mission since we were created 75 years ago in the wake of the Great Depression, protecting depositors and maintaining public confidence in the financial system. Thank you very much. " FinancialCrisisInquiry--163 MAYO: If you mean oversight during the... WALLISON: Regulation. Oversight. That’s what I meant. MAYO: OK. WALLISON: What is the purpose of it other than to keep people from failing? And why do we want to keep people from failing if capitalism involves bankruptcy? MAYO: Well, I think the way I view regulation—and I will defer to others—and this is not my day job completely. But I’ll say, to the extent that there’s externalities caused by the banking system or any industry—in this case there’s very clear externalities in the banking industry due to the contingent liability to the government if a... WALLISON: Let me modify that then. Let’s leave the banks out, which are already subject to a system of resolution because of exactly what you’re saying; the government is backing them. But for institutions that are not backed by the government, what is the reason for having oversight and keeping them from going bankrupt? MAYO: CHRG-111hhrg53245--7 Mr. Royce," Thank you, Mr. Chairman. I would like to thank the witnesses for coming here today to testify, and a special thanks to Peter Wallison from AEI who for years warned about the systemic threat posed by the Government-Sponsored Enterprises Fannie Mae and Freddie Mac. I got to know Peter back in the old days when he was raising these concerns. Eventually, the Federal Reserve itself became convinced that Peter was absolutely right, and in about 2004, they began to warn on what he was warning that this represented a systemic threat to the financial system, not just here in the United States, but worldwide at one point, the Fed Chairman said. You know, for years there was this belief that should Fannie and Freddie run into trouble, the Federal Government would support them. After all, they had a line into the Treasury. They were Government-Sponsored Enterprises, and as Peter was warning, that perception allowed Fannie and Freddie to borrow at rates normally reserved for branches of the Federal Government, to take on excessive risk, and produce profits for shareholders and executives while they crowded out their competition. This was normally the result of when you have a government subsidy, this was the consequence. Well, the Federal Government had to step in to save Fannie and Freddie, and this could end up costing taxpayers $400 billion before it's through, besides the effect that it had on the housing market, the collapse of the housing market. Additionally, the Federal Government is taking drastic steps using trillions of dollars to prop-up failed institutions because it was believed these institutions were too big to fail. One of the most unfortunate consequences of the massive move to provide public assistance is that moral hazard may become more deeply imbedded in our financial markets. We can and should take steps to eliminate the need and possibility of official bailouts in the future by avoiding labeling institutions as systematically important and providing an enhanced bankruptcy procedure to deal with non-bank financial institutions as an alternative to the course that we seem to be on. And this will provide clarity to the market. It will reduce the perceived government safety net, and lessen the moral hazard problem that has been created in recent months. In terms of the problems we're going to deal with looming in the future, I think we have to take lessons from the mistakes made. And this panel here today I think will give us an opportunity to discuss just such issues. Thank you, Mr. Chairman. " CHRG-111shrg55117--117 Mr. Bernanke," Well, we agree with you that the community banks are very important, and as I was mentioning to one of your colleagues, in many cases where large banks are withdrawing from small business lending or from local lending, the community banks are stepping in, and we recognize that and think it is very important. The Federal Reserve provides similar support to small banks that we do to large banks in that you mentioned liquidity. We provide discount window loans or loans through the Term Auction Facility and smaller banks are eligible to receive that liquidity at favorable interest rates. It is not our department, but the Treasury has been working to expand the range of banks which can receive the TARP capital funds and they have made significant progress in dealing with banks that don't trade publicly. We have worked with smaller banks to try to address some of the regulatory burden that they face, and we have a variety of partnerships, for example, with minority banks to try to give them assistance, technical assistance, and the like. I agree. If I were a small banker, I would be a little bit annoyed because the big banks seem to have gotten a lot more of the attention because it was the big banks and their failures that have really threatened our system. And that is why it is very important as we do financial regulatory reform that we address this too big to fail problem so that we don't have this unbalanced situation where you either have to bail out a big bank or else it brings down the system. That is not acceptable and we have to fix that. But we are working with small banks, and personally, I always try to meet with small bank leaders and the ICBA and other trade associations, and I agree with you that they are very important. They are playing a very important role right now in our economy. Senator Kohl. You say you agree that they are important, that they play an important role in our economy. Are you satisfied that we are doing proportionately as much for small community banks as we are doing for the large banks? " FinancialCrisisReport--632 Investment banks that have no bank affiliation are not subject to the law's proprietary trading prohibition. If, however, an investment bank is designated by the newly-created Financial Stability Oversight Council as a systemically critical firm, the Dodd-Frank Act would subject its proprietary trading to additional capital requirements and quantitative limits. Those restrictions are intended to ensure large investment banks have sufficient safeguards in place when engaging in risky proprietary activities to prevent them from damaging the U.S. financial system as a whole or necessitating a taxpayer bailout if they get into financial trouble. Private Fund Restrictions. To ensure that the proprietary trading restrictions are effective, the Dodd-Frank Act prohibits banks and their affiliates, including any investment banks, from bailing out any private fund they advise or sponsor, including an affiliated hedge fund or private equity fund. 2841 This prohibition would apply, for example, to Deutsche Bank and its affiliated hedge fund, Winchester Capital, which made a large proprietary investment in mortgage related products. 2842 These restrictions would not apply to investment banks that are not affiliated with a bank. If, however, the investment bank is designated as a systemically critical firm, it would become subject to additional capital charges to account for the risk that it may end up bailing out a private fund. The private fund provision also addresses the issue of eliminating any unfair advantage that banks may have from being able to rely on the special privileges of being a bank to implicitly guarantee a private fund, and ensures that a federally insured bank will not be put at risk if an affiliated private fund suffers losses. 2843 Conflict of Interest Prohibitions. In 2009, one well known investment adviser described the link between proprietary trading and conflicts of interest as follows: “Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners’ money.” 2844 2840 Id. at §13(d)(2). 2841 Id. at §13(d)(1)(G) and (I); (d)(4); and (f). 2842 Id. See section discussing Deutsche Bank, above. 2843 Id. See, e.g., 6/12/2010 Cambridge Winter Center report, “Test Case on the Charles,” (explaining how State Street Bank bailed out the funds it managed, but then itself needed several emergency taxpayer-backed programs). 2844 “Lesson Not Learned: On Redesigning Our Current Financial System,” GMO Newsletter Special Topic , at 2 (10/2009), available at http://www.scribd.com/doc/21682547/Jeremy-Grantham. CHRG-111shrg54789--30 Mr. Barr," Thank you, Senator Menendez. I would be happy to address those four concerns. First, with respect to community banks, community banks have endured a system under which they are forced to compete with independent mortgage companies and other unregulated lenders in the system. They have been forced essentially by market pressure to offer products and services that, if you are in their community and you talk to community bankers, they would rather not have offered. They would rather not have gotten engaged in pay option ARMs. But because or the unlevel playing field in supervision and regulation, the market tilted to bad practices, and market pressure drove the market to a place that was bad for community banks and it was bad for consumers. What we are saying here is there is going to be a level playing field for community banks, for big banks, for independent mortgage brokers, for anybody else in the marketplace. One regulator is going to set the standards, everybody can compete equally, on an equal footing. Senator Menendez. Are you saying that the proposed legislation that the Administration advocates is going to reach to those previously unregulated entities? " CHRG-109hhrg28024--99 Mr. Sherman," But I hope that you would, in your written response, comment on whether we can count on you to urge both spending restraint and restraint on tax cuts and push for adequate revenues. And I'll also be asking you whether you agree with your predecessor and his comments before this committee in response to my question in 2003, that tax cuts do not pay for themselves, that they do reduce revenue; unless through some mysterious legislative process that I've been unable to observe, a tax cut bill leads to spending reductions. The next series of questions I hope you can respond to is the fact that we have this enormous trade deficit. Several have commented on it. An adjustment in currency values is inevitable, and I would like you to set forth how we can work with other countries to make sure that any realignment of the value of the dollar compared to other currencies is smooth and does not result in a sudden crash of the dollar where circuit breaker agreements are necessary, et cetera, but after running trade deficit after trade deficit that are the most enormous of history, we ought to be expecting an eventual decline in the value of the dollar, and we hope it is not sudden. How is the Fed preparing for such a possibility? Finally, there is the controversy about mixing commerce in banking. We have seen in Japan how that leads to the misdirection of capital and how it can impair the banking system. More important, just as importantly, we know that mixing banking and commerce is wrong because it's illegal, as we established in the bill that came through this committee. Yet, I'm troubled that this prohibition, logical as it is, between mixing commerce and finance, is being evaded in part through the device of saying well, any commercial activity is financial if the buyer needs financing. We are told that sellling homes or cars is a financial activity. I would say I've been paying the bank for this suit ever since, well, it's been let out and let in again. I'm still paying for it on that credit card. We can argue that my tailor is engaged in a financial as well as a frustrating activity. In December, the Office of the Controller of the Currency issued several legal opinions. Many think that existing law allows banks to own real estate to accommodate their banking business, and now that seems to be interpreted to allow them to build luxury hotels, to develop residential condominiums for sale. This sounds like speculative real estate investment of the very type that brought down the savings and loans. Do you think the OCC is giving the banks too much freedom so as to create a risk to the deposit insurance system? I'm particularly concerned about a recent opinion that allows a national bank to own a 70 percent ownership stake in a wind mill farm, and that means that the deposit insurance fund is dependent upon which way the wind blows. I know that others have already asked you about the ILC loop hole, so I hope that you will be able to address the mixing of banking and commerce and what steps the Fed should take to protect our financial system from both a violation of the spirit of Gramm/Leach/Bliley and also from what has imperiled and really held back the growth of the Japanese economy as well as imperiling its financial system. " CHRG-111shrg55117--130 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 22, 2009 Chairman Dodd, Ranking Member Shelby, and other Members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress.Economic and Financial Developments in the First Half of 2009 Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy. Even so, the financial shocks that hit the global economy in September and October were the worst since the 1930s, and they helped push the global economy into the deepest recession since World War II. The U.S. economy contracted sharply in the fourth quarter of last year and the first quarter of this year. More recently, the pace of decline appears to have slowed significantly, and final demand and production have shown tentative signs of stabilization. The labor market, however, has continued to weaken. Consumer price inflation, which fell to low levels late last year, remained subdued in the first 6 months of 2009. To promote economic recovery and foster price stability, the Federal Open Market Committee (FOMC) last year brought its target for the Federal funds rate to a historically low range of 0 to \1/4\ percent, where it remains today. The FOMC anticipates that economic conditions are likely to warrant maintaining the Federal funds rate at exceptionally low levels for an extended period. At the time of our February report, financial markets at home and abroad were under intense strains, with equity prices at multiyear lows, risk spreads for private borrowers at very elevated levels, and some important financial markets essentially shut. Today, financial conditions remain stressed, and many households and businesses are finding credit difficult to obtain. Nevertheless, on net, the past few months have seen some notable improvements. For example, interest rate spreads in short-term money markets, such as the interbank market and the commercial paper market, have continued to narrow. The extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets. Reflecting this greater investor receptivity, corporate bond issuance has been strong. Many markets are functioning more normally, with increased liquidity and lower bid-asked spreads. Equity prices, which hit a low point in March, have recovered to roughly their levels at the end of last year, and banks have raised significant amounts of new capital. Many of the improvements in financial conditions can be traced, in part, to policy actions taken by the Federal Reserve to encourage the flow of credit. For example, the decline in interbank lending rates and spreads was facilitated by the actions of the Federal Reserve and other central banks to ensure that financial institutions have adequate access to short-term liquidity, which in turn has increased the stability of the banking system and the ability of banks to lend. Interest rates and spreads on commercial paper dropped significantly as a result of the backstop liquidity facilities that the Federal Reserve introduced last fall for that market. Our purchases of agency mortgage-backed securities and other longer-term assets have helped lower conforming fixed mortgage rates. And the Term Asset-Backed Securities Loan Facility (TALF), which was implemented this year, has helped restart the securitization markets for various classes of consumer and small business credit. Earlier this year, the Federal Reserve and other Federal banking regulatory agencies undertook the Supervisory Capital Assessment Program (SCAP), popularly known as the stress test, to determine the capital needs of the largest financial institutions. The results of the SCAP were reported in May, and they appeared to increase investor confidence in the U.S. banking system. Subsequently, the great majority of institutions that underwent the assessment have raised equity in public markets. And, on June 17, 10 of the largest U.S. bank holding companies--all but one of which participated in the SCAP--repaid a total of nearly $70 billion to the Treasury. Better conditions in financial markets have been accompanied by some improvement in economic prospects. Consumer spending has been relatively stable so far this year, and the decline in housing activity appears to have moderated. Businesses have continued to cut capital spending and liquidate inventories, but the likely slowdown in the pace of inventory liquidation in coming quarters represents another factor that may support a turnaround in activity. Although the recession in the rest of the world led to a steep drop in the demand for U.S. exports, this drag on our economy also appears to be waning, as many of our trading partners are also seeing signs of stabilization. Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook. In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2009 through 2011. FOMC participants generally expect that, after declining in the first half of this year, output will increase slightly over the remainder of 2009. The recovery is expected to be gradual in 2010, with some acceleration in activity in 2011. Although the unemployment rate is projected to peak at the end of this year, the projected declines in 2010 and 2011 would still leave unemployment well above FOMC participants' views of the longer-run sustainable rate. All participants expect that inflation will be somewhat lower this year than in recent years, and most expect it to remain subdued over the next 2 years.Policy ChallengesMonetary Policy In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery. Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period. However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. \1\ The FOMC has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate.--------------------------------------------------------------------------- \1\ For further discussion of the Federal Reserve's ``exit strategy'' from its current policy stance, see ``Monetary Policy as the Economy Recovers'' in Board of Governors of the Federal Reserve System (2009), Monetary Policy Report to the Congress (Washington: Board of Governors, July), pp. 34-37.--------------------------------------------------------------------------- To some extent, our policy measures will unwind automatically as the economy recovers and financial strains ease, because most of our extraordinary liquidity facilities are priced at a premium over normal interest rate spreads. Indeed, total Federal Reserve credit extended to banks and other market participants has declined from roughly $1.5 trillion at the end of 2008 to less than $600 billion, reflecting the improvement in financial conditions that has already occurred. In addition, bank reserves held at the Fed will decline as the longer-term assets that we own mature or are prepaid. Nevertheless, should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed. Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the Federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve. Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits. But interest on reserves is by no means the only tool we have to influence market interest rates. For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at a later date. Reverse repurchase agreements, which can be executed with primary dealers, Government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer-term securities. Not only would such sales drain reserves and raise short-term interest rates, but they also could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets. In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability.Fiscal Policy Our economy and financial markets have faced extraordinary near-term challenges, and strong and timely actions to respond to those challenges have been necessary and appropriate. I have discussed some of the measures taken by the Federal Reserve to promote economic growth and financial stability. The Congress also has taken substantial actions, including the passage of a fiscal stimulus package. Nevertheless, even as important steps have been taken to address the recession and the intense threats to financial stability, maintaining the confidence of the public and financial markets requires that policy makers begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in the costs of Medicare and Medicaid. Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult. Moreover, agreeing on a sustainable long-run fiscal path now could yield considerable near-term economic benefits in the form of lower long-term interest rates and increased consumer and business confidence. Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth.Regulatory Reform A clear lesson of the recent financial turmoil is that we must make our system of financial supervision and regulation more effective, both in the United States and abroad. In my view, comprehensive reform should include at least the following key elements: a prudential approach that focuses on the stability of the financial system as a whole, not just the safety and soundness of individual institutions, and that includes formal mechanisms for identifying and dealing with emerging systemic risks; stronger capital and liquidity standards for financial firms, with more-stringent standards for large, complex, and financially interconnected firms; the extension and enhancement of supervisory oversight, including effective consolidated supervision, to all financial organizations that could pose a significant risk to the overall financial system; an enhanced bankruptcy or resolution regime, modeled on the current system for depository institutions, that would allow financially troubled, systemically important nonbank financial institutions to be wound down without broad disruption to the financial system and the economy; enhanced protections for consumers and investors in their financial dealings; measures to ensure that critical payment, clearing, and settlement arrangements are resilient to financial shocks, and that practices related to the trading and clearing of derivatives and other financial instruments do not pose risks to the financial system as a whole; and improved coordination across countries in the development of regulations and in the supervision of internationally active firms. The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight. For example, we are expanding our use of horizontal reviews of financial firms to provide a more comprehensive understanding of practices and risks in the financial system. The Federal Reserve also remains strongly committed to effectively carrying out our responsibilities for consumer protection. Over the past 3 years, the Federal Reserve has written rules providing strong protections for mortgage borrowers and credit card users, among many other substantive actions. Later this week, the Board will issue a proposal using our authority under the Truth in Lending Act, which will include new, consumer-tested disclosures as well as rule changes applying to mortgages and home equity lines of credit; in addition, the proposal includes new rules governing the compensation of mortgage originators. We are expanding our supervisory activities to include risk-focused reviews of consumer compliance in nonbank subsidiaries of holding companies. Our community affairs and research areas have provided support and assistance for organizations specializing in foreclosure mitigation, and we have worked with nonprofit groups on strategies for neighborhood stabilization. The Federal Reserve's combination of expertise in financial markets, payment systems, and supervision positions us well to protect the interests of consumers in their financial transactions. We look forward to discussing with the Congress ways to further formalize our institution's strong commitment to consumer protection.Transparency and Accountability The Congress and the American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayers' resources. The Federal Reserve is committed to transparency and accountability in its operations. We report on our activities in a variety of ways, including reports like the one I am presenting to the Congress today, other testimonies, and speeches. The FOMC releases a statement immediately after each regularly scheduled meeting and detailed minutes of each meeting on a timely basis. We have increased the frequency and scope of the published economic forecasts of FOMC participants. We provide the public with detailed annual reports on the financial activities of the Federal Reserve System that are audited by an independent public accounting firm. We also publish a complete balance sheet each week. We have recently taken additional steps to better inform the public about the programs we have instituted to combat the financial crisis. We expanded our Web site this year to bring together already available information as well as considerable new information on our policy programs and financial activities. \2\ In June, we initiated a monthly report to the Congress (also posted on our Web site) that provides even more information on Federal Reserve liquidity programs, including breakdowns of our lending, the associated collateral, and other facets of programs established to address the financial crisis. \3\ These steps should help the public understand the efforts that we have taken to protect the taxpayer as we supply liquidity to the financial system and support the functioning of key credit markets.--------------------------------------------------------------------------- \2\ See ``Credit and Liquidity Programs and the Balance Sheet'' on the Board's Web site at www.federalreserve.gov/monetarypolicy/bst.htm. \3\ See the monthly reports on the Board's Web site at ``Credit and Liquidity Programs and the Balance Sheet'', Congressional Reports and Other Resources, Federal Reserve System Monthly Reports on Credit and Liquidity Programs and the Balance Sheet, www.federalreserve.gov/monetarypolicy/bst_reportsresources.htm.--------------------------------------------------------------------------- The Congress has recently discussed proposals to expand the audit authority of the Government Accountability Office (GAO) over the Federal Reserve. As you know, the Federal Reserve is already subject to frequent reviews by the GAO. The GAO has broad authority to audit our operations and functions. The Congress recently granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to ``single and specific'' companies under the authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities provided to, or created for, American International Group and Bear Stearns. The GAO and the Special Inspector General have the right to audit our TALF program, which uses funds from the Troubled Assets Relief Program. The Congress, however, purposefully--and for good reason--excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in the making and execution of monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence. FinancialCrisisReport--241 Risk Factors in Insurance Fees. Under a new FDIC deposit insurance pricing system that takes effect in 2011, large depository institutions with higher risk activities will be required to pay higher fees into the Deposit Insurance Fund. 948 This new assessment system is designed to “better capture risk at the time large institutions assume the risk, to better differentiate among institutions for risk and take a more forward-looking view of risk, [and] to better take into account the losses that the FDIC may incur if such an insured depository institution fails.” 949 It is the product of both past FDIC revisions and changes to the insurance fund assessment system made by the Dodd-Frank Act. 950 It is intended to impose higher assessments on large banks “with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure,” and impose those higher assessments when the banks “assume these risks rather than when conditions deteriorate.” 951 Under this new system, banks with higher risk activities will be assessed higher fees, not only to safeguard the insurance fund and allocate insurance costs more fairly, but also to help discourage high risk activities. Financial Stability Oversight Council. The Dodd-Frank Act has also established a new intra-governmental council, the Financial Stability Oversight Council (FSOC), to identify systemic risks and respond to emerging threats to the stability of the U.S. financial system. 952 The council is comprised of ten existing regulators in the financial services sector, including the Chairman of the Federal Reserve Board of Governors, the Chairman of the FDIC, and the Comptroller of the Currency, and is chaired by the Secretary of the Treasury. This Council is intended to ensure that U.S. financial regulators consider the safety and soundness of not only individual financial institutions, but also of U.S. financial markets and systems as a whole. (2) Recommendations To further strengthen oversight of financial institutions to reduce risk, protect U.S. financial markets and the economy, and safeguard the Deposit Insurance Fund, this Report makes the following recommendations. 1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC) should complete the dismantling of the Office of Thrift Supervision (OTS), despite attempts by some OTS officials to preserve the agency’s identity and influence within the OCC. 2. Strengthen Enforcement. Federal banking regulators should conduct a review of their major financial institutions to identify those with ongoing, serious deficiencies, and review their enforcement approach to those institutions to eliminate any policy of deference to bank management, inflated CAMELS ratings, or use of short term profits to excuse high risk activities. 948 See 2/7/2011 FDIC Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing, RIN 3064. 949 Id. 950 See Sections 331, 332 and 334 of the Dodd-Frank Act. 951 2/7/2011 FDIC press release, “FDIC Approves Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing,” http://www.fdic.gov/news/news/press/2011/pr11028.html. 952 See Title I, Subtitle A, of the Dodd-Frank Act establishing the Financial Stability Oversight Council, including Section 112(a) which provides its purposes and duties. 3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a comprehensive review of the CAMELS ratings system to produce ratings that signal whether an institution is expected to operate in a safe and sound manner over a specified period of time, asset quality ratings that reflect embedded risks rather than short term profits, management ratings that reflect any ongoing failure to correct identified deficiencies, and composite ratings that discourage systemic risks. 4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council should undertake a study to identify high risk lending practices at financial institutions, and evaluate the nature and significance of the impacts that these practices may have on U.S. financial systems as a whole. FinancialCrisisInquiry--17 In an effort to stem the panic, Morgan Stanley moved up its announcement of its strong third-quarter earnings to September the 16 th , but our stock remained under heavy pressure. It lost nearly a quarter of its value the following day, falling from 28.7 to 21.75. Despite these strong results, it continued to trade low and, finally, traded as low as $6.71. This crisis of confidence in the market had a chain reaction to the broader economy as lower prices for financial assets undermined confidence and led to lower prices throughout the rest of the economy. This period was marked by rampant rumors and speculation. My management team, like those of my peers here, worked around the clock to address these rumors and provide investors, clients, and employees accurate information. We also worked closely with our regulators to keep them informed and achieve the right result for the markets and the economy. Our position began to stabilize after Mitsubishi agreed to invest $9 billion in our firm as part of a broader strategic alliance. Morgan Stanley also converted to a bank-holding company providing direct oversight and access to the Federal Reserve. The U.S. government announced its TARP investment a short while later, which also helped stabilize the broader market. And the SEC instituted a temporary ban on shorting financial stocks. Morgan Stanley appreciates the many steps the government took to prevent the collapse of the financial system and the support provided by American taxpayers. I believe every firm in the industry and the broader financial markets as a whole benefited from this support. As you know, Morgan Stanley has since repaid our TARP funds providing taxpayers a 20 percent annualized return on that investment. CHRG-111hhrg48867--89 Mr. Royce," Thank you, Mr. Chairman. I wanted to just start with the observation that it was Mr. Wallison who warned us many years ago about the systemic risk to the broader financial system. In 1992, we passed the GSE Act in Congress, and as a consequence of passing that Act, we set up goals, affordable housing goals, and when the Federal Reserve looked at the consequences of that, they began to see the same thing that Mr. Wallison saw, and they sought to get Congress involved in this because, as was observed, banks are regulated and so they can only leverage 10 to 1, right? But we were allowing Fannie Mae and Freddie Mac to leverage 100 to 1 and to go into arbitrage, and the reason they were allowed to do that was because there was an attempt to have them meet these goals. Somebody had to buy those subprimes from Countrywide, and it was Fannie and Freddie that had the requirement in terms of the goals to buy these subprime loans and these faulty loans. In 2005, I brought an amendment to the Floor of the House of Representatives to regulate these GSEs or to allow the Fed and allow OFHEO, allow the regulator to regulate them for systemic risk, because the regulator had asked for this ability to regulate them for systemic risk to the wider financial system. And at that time that amendment was voted down. In the meantime, as you know, we also passed legislation here that allowed the government basically to bully the market, to bully the banks in terms of the types of loans that they would make, and to rig the system so that originally what was 20 percent down became 10 percent down, became 3 percent down, became 0 percent down, because we had to meet those goals for very-low-income and low-income affordable housing. Now, the reason I think it is important that Mr. Wallison be here is because through all of this debate, he and the Federal Reserve were the ones coming up here warning us that because of the power they had in the market they were crowding out the competition. They were becoming the majority holder of and purchasers of these mortgage-backed securities, securitization. They were the market. And as a consequence of the risks they were taking and the excessive leverage, we had a situation where it was helping to balloon the market and create a situation where once these standards had been lowered, 30 percent of the market participants were now flippers. In other words, we did it for a good cause, Congress did it for a good cause. We lowered these standards. We pushed affordable housing. But we forgot, or some of us forgot, that flippers would come in and take advantage of those new 3 percent down or 0 percent down programs and would be able to eventually constitute 30 percent of the entire market, which is what happened come 2005, according to the Federal Reserve, 2006, 2007, and that further, of course, you know ballooned up this problem. Now, understanding the potential implications of labeling certain companies as systemically significant, as you explained in your testimony, Mr. Wallison, do you believe it is important to take steps in overhauling our regulatory structure because, you know, the previous Treasury Secretary issued this Blueprint for Regulatory Reform in March of last year, and in many respects, at least from my perspective, that would close systemic gaps in the system. It merged duplicative regulatory bodies. It ended those who were redundant, who weren't necessary anymore as a result of consolidating them, and central in that Treasury plan was that in many respects banks, security firms, insurance companies, actually represent a single financial services industry, not three separate industries, and ought to be regulated as such. And these firms are all competing with one another and, as long as this is true, it makes no sense to regulate them separately from the standpoint of Treasury. While the Treasury Blueprint was not perfect, I believe it was a step in the right direction. It is important this this Congress not talk about systemic risk regulation in a vacuum but, rather, consider the regulatory framework as a whole. So I would ask if you agree with this sentiment: Should Congress be looking at the broader structure that has been in place for 75 years when it debates systemic risk in looking at a way to give--well, anyway, let me ask your response, Mr. Wallison. " CHRG-111hhrg52397--97 Mr. Pickel," Well, there would be the reporting to the warehouse. There would be most of the dealers who are engaged in these transactions and would continue to be regulated, primarily by the banking regulators. And then for those entities that would fall into this category of taking on significant exposure to counterparties, the systemically important entities, you would have the systemic risk regulator overseeing their activities. " CHRG-111shrg55117--114 Mr. Bernanke," Well, it is not inconsistent. The stress test, first of all, applied to the top 19 banks and we found that there is still $600 billion of losses to be experienced in the next 2 years, so that is quite substantial. And our conclusion was that even after that $600 billion of losses, they would still be able to meet well-capitalized requirements. The other aspect is that a lot of the commercial real estate loans are in smaller banks, and so some smaller banks which were not counted in the stress test, were not examined in the stress test, will be facing those costs going forward. So it is a major challenge to the banking system. I discussed with a couple of your colleagues some of the things that the Fed is doing, and I think what we will see is that banks faced with commercial real estate loans which cannot perform at the original terms will be trying to find renegotiations to allow at least partial performance on---- Senator Bennet. And it is my sense that up until now, there has been an inclination to roll over these financings, but what hasn't happened yet is a resetting of the underlying valuation of the assets, which is still something that we are going to be facing, I think, in the next 12 months--over the next 12 months. One very quick question and then a longer one. I will be very brief. You mentioned twice this morning that I heard that you thought that the TALF had had an effect on small business lending and consumer lending and I just wondered what the evidence of that is. " FinancialCrisisInquiry--517 MAYO: Well, I think the way I view regulation—and I will defer to others—and this is not my day job completely. But I’ll say, to the extent that there’s externalities caused by the banking system or any industry—in this case there’s very clear externalities in the banking industry due to the contingent liability to the government if a... CHRG-111shrg57709--241 PREPARED STATEMENT OF PAUL A. VOLCKER Chairman, President's Economic Recovery Advisory Board February 2, 2010 Mr. Chairman, Members of the Banking Committee: You have an important responsibility in considering and acting upon a range of issues relevant to needed reform of the financial system. That system, as you well know, broke down under pressure, posing unacceptable risks for an economy already in recession. I appreciate the opportunity today to discuss with you one key element in the reform effort that President Obama set out so forcibly a few days ago. That proposal, if enacted, would restrict commercial banking organizations from certain proprietary and more speculative activities. In itself, that would be a significant measure to reduce risk. However, the first point I want to emphasize is that the proposed restrictions should be understood as a part of the broader effort for structural reform. It is particularly designed to help deal with the problem of ``too big to fail'' and the related moral hazard that looms so large as an aftermath of the emergency rescues of financial institutions, bank and non-bank, in the midst of crises. I have attached to this statement a short essay of mine outlining that larger perspective. The basic point is that there has been, and remains, a strong public interest in providing a ``safety net''--in particular, deposit insurance and the provision of liquidity in emergencies--for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds--taxpayer funds--protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions. Those quintessential capital market activities have become part of the natural realm of investment banks. A number of the most prominent of those firms, each heavily engaged in trading and other proprietary activity, failed or were forced into publicly assisted mergers under the pressure of the crisis. It also became necessary to provide public support via the Federal Reserve, The Federal Deposit Insurance Corporation, or the Treasury to the largest remaining American investment banks, both of which assumed the cloak of a banking license to facilitate the assistance. The world's largest insurance company, caught up in a huge portfolio of credit default swaps quite apart from its basic business, was rescued only by the injection of many tens of billions of dollars of public loans and equity capital. Not so incidentally, the huge financial affiliate of one of our largest industrial companies was also extended the privilege of a banking license and granted large assistance contrary to long-standing public policy against combinations of banking and commerce. What we plainly need are authority and methods to minimize the occurrence of those failures that threaten the basic fabric of financial markets. The first line of defense, along the lines of Administration proposals and the provisions in the Bill passed by the House last year, must be authority to regulate certain characteristics of systemically important non-bank financial institutions. The essential need is to guard against excessive leverage and to insist upon adequate capital and liquidity. It is critically important that those institutions, its managers and its creditors, do not assume a public rescue will be forthcoming in time of pressure. To make that credible, there is a clear need for a new ``resolution authority'', an approach recommended by the Administration last year and included in the House bill. The concept is widely supported internationally. The idea is that, with procedural safeguards, a designated agency be provided authority to intervene and take control of a major financial institution on the brink of failure. The mandate is to arrange an orderly liquidation or merger. In other words, euthanasia not a rescue. Apart from the very limited number of such ``systemically significant'' non-bank institutions, there are literally thousands of hedge funds, private equity funds, and other private financial institutions actively competing in the capital markets. They are typically financed with substantial equity provided by their partners or by other sophisticated investors. They are, and should be, free to trade, to innovate, to invest--and to fail. Managements, stockholders or partners would be at risk, able to profit handsomely or to fail entirely, as appropriate in a competitive free enterprise system. Now, I want to deal as specifically as I can with questions that have arisen about the President's recent proposal. First, surely a strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multi-national banks and active financial markets. The needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood. Second, the functional definition of hedge funds and private equity funds that commercial banks would be forbidden to own or sponsor is not difficult. As with any new regulatory approach, authority provided to the appropriate supervisory agency should be carefully specified. It also needs to be broad enough to encompass efforts sure to come to circumvent the intent of the law. We do not need or want a new breed of bank-based funds that in all but name would function as hedge or equity funds. Similarly, every banker I speak with knows very well what ``proprietary trading'' means and implies. My understanding is that only a handful of large commercial banks--maybe four or five in the United States and perhaps a couple of dozen worldwide--are now engaged in this activity in volume. In the past, they have sometimes explicitly labeled a trading affiliate or division as ``proprietary'', with the connotation that the activity is, or should be, insulated from customer relations. Most of those institutions and many others are engaged in meeting customer needs to buy or sell securities: stocks or bonds, derivatives, various commodities or other investments. Those activities may involve taking temporary positions. In the process, there will be temptations to speculate by aggressive, highly remunerated traders. Given strong legislative direction, bank supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and of the relative volatility of gains and losses would go a long way toward informing such judgments. For instance, patterns of exceptionally large gains and losses over a period of time in the ``trading book'' should raise an examiner's eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements. Third, I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a ``customer'', i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. ``Inside'' hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same ``inside'' funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades. I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses. But neither am I so naive as to think that, even with the best efforts of boards and management, so-called Chinese Walls can remain impermeable against the pressures to seek maximum profit and personal remuneration. In concluding, it may be useful to remind you of the wide range of potentially profitable services that are within the province of commercial banks. First of all, basic payments services, local, national and worldwide, ranging from the now ubiquitous automatic teller machines to highly sophisticated cash balance management; Safe and liquid depository facilities, including especially deposits contractually payable on demand; Credit for individuals, governments and businesses, large and small, including credit guarantees and originating and securitizing mortgages or other credits under appropriate conditions; Analogous to commercial lending, underwriting of corporate and government securities, with related market making; Brokerage accounts for individuals and businesses, including ``prime brokerage'' for independent hedge and equity funds; Investment management and investment advisory services, including ``Funds of Funds'' providing customers with access to independent hedge or equity funds; Trust and estate planning and Administration; Custody and safekeeping arrangements for securities and valuables. Quite a list. More than enough, I submit to you, to provide the base for strong, competitive--and profitable--commercial banking organizations, able to stand on their own feet domestically and internationally in fair times and foul. What we can do, what we should do, is recognize that curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services. Recurrent pressures, volatility and uncertainties are inherent in our market-oriented, profit-seeking financial system. By appropriately defining the business of commercial banks, and by providing for the complementary resolution authority to deal with an impending failure of very large capital market institutions, we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek. ______ fcic_final_report_full--246 These institutions had relied for their operating cash on short-term funding through commercial paper and the repo market. But commercial paper buyers and banks became unwilling to continue funding them, and repo lenders became less and less willing to accept subprime and Alt-A mortgages or mortgage-backed securities as collateral. They also insisted on ever-shorter maturities, eventually of just one day—an inherently destabilizing demand, because it gave them the option of with- holding funding on short notice if they lost confidence in the borrower. Another sign of problems in the market came when financial companies began to report more detail about their assets under the new mark-to-market accounting rule, particularly about mortgage-related securities that were becoming illiquid and hard to value. The sum of more illiquid Level  and  assets at these firms was “eye- popping in terms of the amount of leverage the banks and investment banks had,” ac- cording to Jim Chanos, a New York hedge fund manager. Chanos said that the new disclosures also revealed for the first time that many firms retained large exposures from securitizations. “You clearly didn’t get the magnitude, and the market didn’t grasp the magnitude until spring of ’, when the figures began to be published, and then it was as if someone rang a bell, because almost immediately upon the publica- tion of these numbers, journalists began writing about it, and hedge funds began talking about it, and people began speaking about it in the marketplace.”  In late  and early , some banks moved to reduce their subprime expo- sures by selling assets and buying protection through credit default swaps. Some, such as Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of the firm but increased it in others. Banks that had been busy for nearly four years cre- ating and selling subprime-backed collateralized debt obligations (CDOs) scrambled in about that many months to sell or hedge whatever they could. They now dumped these products into some of the most ill-fated CDOs ever engineered. Citigroup, Merrill Lynch, and UBS, particularly, were forced to retain larger and larger quanti- ties of the “super-senior” tranches of these CDOs. The bankers could always hope— and many apparently even believed—that all would turn out well with these super seniors, which were, in theory, the safest of all. With such uncertainty about the market value of mortgage assets, trades became scarce and setting prices for these instruments became difficult. Although government officials knew about the deterioration in the subprime markets, they misjudged the risks posed to the financial system. In January , SEC officials noted that investment banks had credit exposure to struggling subprime lenders but argued that “none of these exposures are material.”  The Treasury and Fed insisted throughout the spring and early summer that the damage would be lim- ited. “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,”  Fed Chairman Ben Bernanke testified before the Joint Economic Committee of Congress on March . That same day, Treasury Secretary Henry Paulson told a House Appropriations subcommittee: “From the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.”  CHRG-111hhrg55809--141 Mr. Bernanke," They made the decision based on what they thought would be the least negative effect on the banking system, and I don't want to second guess that. " CHRG-111hhrg48874--203 Mr. Wilson," Thank you very much. Chairman Frank, Ranking Member Bachus, and members of the committee, as introduced, my name is Steve Wilson. I am chairman and CEO of LCNB National Bank. We have over $650 million in assets and have served our community for 131 years. I appreciate the opportunity to testify on behalf of ABA. Everyone is frustrated about the current confused situation surrounding the Capital Purchase Program (CPP). We had hoped that by the time we were here today, the mixed messages and disincentives would have disappeared, but in fact they are worse today than they ever have been. If programs to stimulate the economy are to reach their full potential, the confusion must be clarified and the disincentives corrected Conflicting messages have characterized the Capital Purchase Program from the beginning. Banks were actively encouraged by Treasury and banking regulators to participate. Indeed, many healthy banks decided to participate even though they were already very well capitalized. And even though they were very nervous at the time, that already the program requirements could change dramatically, and unilaterally, at the will of Treasury or Congress. My bank, which is well capitalized, applied for and received $13.4 million of CPP in January. I am proud to point out that we were given that opportunity to receive these funds because of our past and current performance in providing loans to those in the communities we serve. We are strong and we are secure. The CPP funds enabled us to respond to our customers when they need credit. In fact, we continue to make loans, sticking to our traditional commitment of making responsible loans that make good economic sense for both the borrower and our bank. I would also note that we sent Treasury our first dividend check of $67,000 last month. The first dividend payment for all CPP banks totaled $2.4 billion, which shows that CPP is truly an investment by the government in health banks. Over the last few weeks, banks have received messages that discourage participation in the CPP. But it goes beyond banks that have received the capital injections. The entire industry is unfairly suffering from the perception of weakness perpetuated by government-created mixed messages. Banks hear the message to continue to lend, to help stimulate the economy. But they also hear messages that pull them back from lending, from field examiners that may apply overly conservative standards, requiring severe asset writedowns; from FDIC premium assessment rules that will take $15 billion out of the industry in the second quarter; and from misplaced accounting rules that overstate economic losses. Any one of these challenges could be handled on its own. But taken collectively, the impact is an absolute nightmare for banks. All of these forces work against lending, which is so critical to our economic recovery. Clarity is so important right now, particularly for CPP participants. The continued speculation of further government involvement continues to unnecessarily erode consumer confidence in the Nation's banking system. I cannot say strongly enough that the investment of private capital will not return until the fear of further government involvement or dilution of private equity investments in the banking system has been significantly abated. Private capital, rather than taxpayer money, is the foundation of our economic system. What the private capital markets are looking for is a steady hand and a predictable government. Wary investors will fear that the government will further change the rules that were in place when banks signed the contracts with the Treasury. That is why it is so critical that the role of government be clearly defined and limited. I thank you for the opportunity to testify today, and I'll look forward to answering questions. Thank you. [The prepared statement of Mr. Wilson can be found on page 176 of the appendix.] Mr. Wilson of Ohio. [presiding] Sorry, Mr. Ranking Member, sir. Let me repeat that. We will now hear from Brad Hunkler, vice president and controller, Western & Southern Financial Group, on behalf of the Financial Services Roundtable.STATEMENT OF BRADLEY J. HUNKLER, VICE PRESIDENT AND CONTROLLER, WESTERN & SOUTHERN FINANCIAL GROUP, ON BEHALF OF THE FINANCIAL FOMC20081216meeting--445 443,MR. DUDLEY.," No, I don't think that is quite right. We are in basically a market disequilibrium, where the traditional buyers of these securities have vanished. In a normal market environment, it would be completely reasonable to lend against these securities on a leveraged basis. But the people who would do that lending--banks and dealers--are balance sheet constrained, and that is why they are not willing to make those loans. If we had a normal banking and dealer situation today in which they were willing to extend loans to their counterparties, they would be providing the leverage. But that is just not happening. " CHRG-111shrg55278--110 PREPARED STATEMENT OF PAUL SCHOTT STEVENS President and CEO, Investment Company Institute July 23, 2009I. Introduction My name is Paul Schott Stevens. I am President and CEO of the Investment Company Institute, the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs) (collectively, ``funds''). Members of ICI manage total assets of $10.6 trillion and serve over 93 million shareholders. Millions of American investors have chosen funds to help meet their long-term financial goals. In addition, funds are among the largest investors in U.S. companies--they hold, for example, about 25 percent of those companies' outstanding stock, approximately 45 percent of U.S. commercial paper (an important source of short-term funding for corporate America), and about 33 percent of tax-exempt debt issued by U.S. municipalities. As both issuers of securities to investors and purchasers of securities in the market, funds have a strong interest in the ongoing consideration by policy makers and other stakeholders of how to strengthen our financial regulatory system in response to the most significant financial crisis many of us have ever experienced. In early March, ICI released a white paper outlining detailed recommendations on how to reform the U.S. financial regulatory system, with particular emphasis on reforms most directly affecting the functioning of the capital markets and the regulation of funds, as well as the subject of this hearing--how best to monitor for potential systemic risks and mitigate the effect of such risks on our financial system and the broader economy. \1\ At a March hearing before this Committee, I summarized ICI's recommendations and offered some of my own thoughts on a council approach to systemic risk regulation, based on my personal experience as the first Legal Adviser to and, subsequently, Executive Secretary of, the National Security Council. Since March, ICI has continued to develop and refine its reform recommendations and to study proposals advanced by others. I very much appreciate the opportunity to appear before this Committee again and offer further perspectives on establishing a framework for systemic risk regulation.--------------------------------------------------------------------------- \1\ See Investment Company Institute, Financial Services Regulatory Reform: Discussion and Recommendations (March 3, 2009), available at http://www.ici.org/pdf/ppr_09_reg_reform.pdf (ICI White Paper).--------------------------------------------------------------------------- Section II below offers general observations on establishing a formal mechanism for identifying, monitoring, and managing potential risks to our financial system. Section III comments on the Administration's proposed approach to systemic risk regulation. Finally, Section IV describes in detail a proposal to structure a systemic risk regulator as a statutory council of senior Federal financial regulators.II. Systemic Risk Regulation: General Observations The ongoing financial crisis has highlighted our vulnerability to risks that accompany products, structures, or activities that may spread rapidly throughout the financial system; and that may occasion significant damage to the system at large. Over the past year, various policy makers, financial services industry representatives, and other commentators have called for the establishment of a formal mechanism for identifying, monitoring, and managing risks of this dimension--one that would allow Federal regulators to look across the system and to better anticipate and address such risks. ICI was an early supporter of creating a systemic risk regulator. But we also have long advocated that two important cautions should guide Congress in determining the composition and authority of such a regulator. \2\ First, the legislation establishing a systemic risk regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system that may stifle innovations, impede competition, or impose needless inefficiencies. Second, a systemic risk regulator should not be structured to simply add another layer of bureaucracy or to displace the primary regulator(s) responsible for capital markets, banking, or insurance.--------------------------------------------------------------------------- \2\ See id. at 4.--------------------------------------------------------------------------- Accordingly, in our judgment, legislation establishing a systemic risk regulator should clearly define the nature of the relationship between this new regulator and the primary regulator(s) for the various financial sectors. It should delineate the extent of the authority granted to the systemic risk regulator, as well as identify circumstances under which the systemic risk regulator and primary regulator(s) should coordinate their efforts and work together. We believe, for example, that the primary regulators should continue to act as the first line of defense in addressing potential risks within their spheres of expertise. In view of the two cautions outlined above, ICI was an early proponent of structuring a systemic risk regulator as a statutory council comprised of senior Federal regulators. As noted above, I testified before this Committee at a March hearing focused on investor protection and the regulation of securities markets. At that time, I recommended that the Committee give serious consideration to the council model, based on my personal experience with the National Security Council (NSC), a body which has served the Nation well for more than 60 years. As the first Legal Adviser to the NSC in 1987, I was instrumental in reorganizing the NSC system and staff following the Iran-Contra affair. I subsequently served from 1987 to 1989 as chief of the NSC staff under National Security Adviser Colin Powell.III. The Administration's Proposed Approach The council approach to a systemic risk regulator has received support from Federal and State regulators and others. \3\ It is noteworthy that the Administration's white paper on regulatory reform likewise includes recommendations for a Financial Services Oversight Council (Oversight Council). \4\ The Oversight Council would monitor for emerging threats to the stability of the financial system, and would have authority to gather information from the full range of financial firms to enable such monitoring. As envisioned by the Administration, the Oversight Council also would serve to facilitate information sharing and coordination among the principal Federal financial regulators, provide a forum for consideration of issues that cut across the jurisdictional lines of these regulators, and identify gaps in regulation. \5\--------------------------------------------------------------------------- \3\ See, e.g., Statement of Damon A. Silvers, Associate General Counsel, AFL-CIO, before the Senate Committee on Homeland Security and Government Affairs, Hearing on ``Systemic Risk and the Breakdown of Financial Governance'' (March 4, 2009); Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation, before the Senate Committee on Banking, Housing, and Urban Affairs, Hearing on ``Regulating and Resolving Institutions Considered `Too-Big-To-Fail' '' (May 6, 2009) (``Bair Testimony''); Senator Mark R. Warner, ``A Risky Choice for a Risk Czar'', Washington Post (June 28, 2009). \4\ See Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation (June 17, 2009), available at http://www.financialstability.gov/docs/regs/FinalReport_web.pdf (Administration white paper), at 17-19. \5\ See id. at 18.--------------------------------------------------------------------------- Unfortunately, the Administration's proposal would vest the lion's share of authority and responsibility for systemic risk regulation with the Federal Reserve, relegating the Oversight Council to at most an advisory or consultative role. In particular, the Administration recommends granting broad new authority to the Federal Reserve in several respects. \6\ The Administration's white paper acknowledges that ``[t]hese proposals would put into effect the biggest changes to the Federal Reserve's authority in decades.'' \7\--------------------------------------------------------------------------- \6\ Under this new authority, the Federal Reserve would have: (1) the ultimate voice in determining which financial firms would potentially pose a threat to financial stability, through designation of so-called ``Tier 1 Financial Holding Companies;'' (2) the ability to collect reports from all financial firms meeting minimum size thresholds and, in certain cases, to examine such firms, in order to determine whether a particular firm should be classified as a Tier 1 FHC; (3) consolidated supervisory and regulatory authority over Tier 1 FHCs and their subsidiaries, including the application of stricter and more conservative prudential standards than those applicable to other financial firms; and (4) the role of performing ``rigorous assessments of the potential impact of the activities and risk exposures of [Tier 1 FHCs] on each other, on critical markets, and on the broader financial system.'' See id. at 19-24. \7\ Id. at 25.--------------------------------------------------------------------------- I believe that the Administration's approach would strike the wrong balance. Significantly, it fails to draw in a meaningful way on the experience and expertise of other regulators responsible for the oversight of capital markets, commodities and futures markets, insurance activities, and other sectors of the banking system. The Administration's white paper fails to explain why its proposed identification and regulation of Tier 1 Financial Holding Companies (Tier 1 FHCs) is appropriate in view of concerns over market distortions that could accompany ``too-big-to-fail'' designations. The standards that would govern determinations of Tier 1 FHC status are highly ambiguous. \8\ Finally, by expanding the mandate of the Federal Reserve well beyond its traditional bounds, the Administration's approach could jeopardize the Federal Reserve's ability to conduct monetary policy with the requisite degree of independence.--------------------------------------------------------------------------- \8\ The Administration proposes requiring the Federal Reserve to consider certain specified factors (including the firm's size and leverage, and the impact its failure would have on the financial system and the economy) and to get input from the Oversight Council. The Federal Reserve, however, would have discretion to consider other factors, and the final decision of whether to designate a particular firm for Tier 1 FHC status would be its alone. See id. at 20-21. This approach, in our view, would vest wide discretion in the Federal Reserve and provide financial firms with insufficient clarity about what activities, lines of business, or other factors might result in a Tier 1 FHC designation.--------------------------------------------------------------------------- The shortcomings that we see with the Administration's plan reinforce our conclusion that a properly structured statutory council would be the most effective mechanism to orchestrate and oversee the Federal Government's efforts to monitor for potential systemic risks and mitigate the effect of such risks. Below, we set forth our detailed recommendations for the composition, role, and scope of authority that should be afforded to such a council.IV. Fashioning an Effective Systemic Risk Council In concept, an effective Systemic Risk Council (Council) could be similar in structure and approach to the National Security Council, which was established by the National Security Act of 1947. In the aftermath of World War II, Congress recognized the need to assure better coordination and integration of ``domestic, foreign, and military policies relating to the national security'' and the ongoing assessment of ``policies, objectives, and risks.'' The 1947 Act established the NSC under the President as a Cabinet-level council with a dedicated staff. In succeeding years, the NSC has proved to be a key mechanism used by Presidents to address the increasingly complex and multifaceted challenges of national security policy.a. Composition of the Council and Its Staff As with formulating national security policy, addressing risks to the financial system at large requires diverse inputs and perspectives. The Council's standing membership accordingly should draw upon a broad base of expertise, and should include the core Federal financial regulators--the Secretary of the Treasury, Chairman of the Board of Governors of the Federal Reserve System, Chairman of the Securities and Exchange Commission, Chairman of the Commodity Futures Trading Commission, the Comptroller of the Currency (or head of any combined Office of the Comptroller of the Currency and of the Office of Thrift Supervision), the Chairman of the Federal Deposit Insurance Corporation, and the head of a Federal insurance regulator, if one emerges from these reform efforts. As with the NSC, flexibility should exist for the Council to enlist other Federal and State regulators into the work of the Council on specific issues as required--including, for example, self-regulatory organizations and State regulators for the banking, insurance or securities sectors. The Secretary of the Treasury, as a Presidential appointee confirmed by the Senate and the senior-most member of the Council, should be designated chairman. An executive director, appointed by the President, should run the day-to-day operations of the Council and serve as head of the Council's staff. The Council should meet on a regular basis, with an interagency process coordinated through the Council's staff to support and follow through on its ongoing deliberations. To accomplish its mission, the Council should have the support of a dedicated, highly experienced staff. The staff should represent a mix of disciplines (e.g., economics, accounting, finance, law) and areas of expertise (e.g., securities, commodities, banking, insurance). It should consist of individuals seconded from Government departments and agencies, as well as individuals having a financial services business, professional, or academic background recruited from the private sector. The Council's staff should operate, and be funded, independently from the functional regulators. \9\ Nonetheless, the background and experience of the staff, including those seconded from other parts of Government, would help assure the kind of strong working relationships with the functional regulators necessary for the Council's success. Such a staff could be recruited and at work in a relatively short period of time. The focus in recruiting a staff should be on quality, not quantity, and the Council's staff accordingly need not and should not be large.--------------------------------------------------------------------------- \9\ A Council designed in this way would differ from the Administration's Oversight Council, which would be staffed and operated within the Treasury Department.---------------------------------------------------------------------------b. Mission and Operation of the Council By statute, the Council should have a mandate to monitor conditions and developments in the domestic and international financial markets, and to assess their implications for the health of the U.S. financial system at large. The Council would be responsible for making threshold determinations concerning the systemic risks posed by given products, structures, or activities. It would identify regulatory actions to be taken to address these systemic risks as they emerge, would assess the effectiveness of these actions, and would advise the President and Congress regularly on emerging risks and necessary legislative or regulatory responses. The Council would be responsible for coordinating and integrating the national response to such risks. Nonetheless, it would not have a direct operating role (just as the NSC coordinates and integrates military and foreign policy that is implemented by the Defense or State Department and not by the NSC itself). Rather, responsibility for addressing identified risks would lie with the existing functional regulators, which would act pursuant to their normal statutory authorities but--for these purposes only--under the Council's direction. Similar to the Administration's Oversight Council proposal, the Council should have two separate but interrelated mandates--(1) the prevention and mitigation of systemic risk and (2) policy coordination and information sharing across the various functional regulators. Under this model, where all the functional regulators have an equal voice and stake in the success of the Council, the stronger working relationships and the sense of shared purpose that would grow out of the Council's collaborative efforts would greatly assist in sound policy development, prioritization of effort, and cooperation with the international regulatory community. Further, the staffing and resources of the Council could be leveraged for both purposes. This would address some of the criticisms and limitations of the existing President's Working Group on Financial Markets (PWG). Information will be the lifeblood of the Council's deliberations and the work of the Council's staff. Having information flow from regulated entities through their functional regulators to the Council and its staff would appropriately draw upon the regulators' existing information and data collection capabilities and avoid unnecessary duplication of effort. To the extent that a particular financial firm is not subject to direct supervision by a Council member, the Council should have the authority to require periodic or other reporting from such firm as the Council determines is necessary to evaluate the extent to which a particular product, structure, or activity poses a systemic risk. \10\--------------------------------------------------------------------------- \10\ The Administration likewise proposes to grant its Oversight Council the authority to require periodic reporting from financial firms, but the authority would extend to all firms, with simply a caveat that the Oversight Council ``should, wherever possible,'' rely upon information already being collected by Council members. See Administration white paper, supra note 4, at 19.--------------------------------------------------------------------------- Although the Council and its staff would continually monitor conditions and developments in the financial markets, the range of issues requiring action by the Council itself should be fairly limited in scope--directed only at major unaddressed hazards to the financial system, as opposed to day-to-day regulatory concerns. As noted above, the Council should be required, as a threshold matter, to make a formal determination that some set of circumstances could pose a risk to the financial system at large. That determination would mark the beginning of a consultative process among the Council members, with support from the Council's staff, to develop a series of responses to the identified risks. The Council could then recommend or direct action by the appropriate functional regulators to implement these responses. Typically, the Council should be able to reach consensus, both on identifying potential risks and developing responses to such risks. To address the rare instance where Council members are unable to reach consensus on a course of action, however, there should be a mechanism--specified in the authorizing legislation--that would require the elevation of disputes to the President for resolution. There likewise should be reporting to Congress of such disputes and their resolution, so as to assure timely Congressional oversight. To ensure proper follow-through, we envision that the individual regulators would report back to the Council, which would monitor progress and ensure that the regulators are acting in accord with the policy direction set by the Council. At the same time, to ensure appropriate accountability, we recommend that the Council be required to report to Congress whenever it makes a threshold finding or recommends or directs a functional regulator to take action, so that the relevant oversight committees in Congress also may monitor progress and assess the adequacy of the regulatory response.c. Advantages of a Council Model We believe that the council model outlined above would offer several important advantages. First, the Council would avoid risks inherent in designating an existing agency like the Federal Reserve to serve essentially as an all-purpose systemic risk regulator. In such a role, the Federal Reserve understandably may tend to view risks and risk mitigation through its lens as a commercial bank regulator focused on prudential regulation and ``safety and soundness'' concerns, potentially to the detriment of consumer and investor protection concerns and of nonbank financial institutions. A Council with a diverse membership would bring all competing perspectives to bear and, as a result, would be more likely to strike the proper balance. In ICI's view, such perspectives most certainly must include those of the SEC and the CFTC. In this regard, we are pleased to note that the Administration's reform proposals would preserve the role of the SEC as a strong regulator with broad responsibilities for overseeing the capital markets and key market functions such as clearance, settlement and custody arrangements, while also maintaining its investor protection focus. It is implausible that we could effectively regulate systemic risk in the financial markets without fully incorporating the SEC into that process. Second, systemic risks may arise in different ways and affect different parts of the domestic and global financial system. No existing agency or department has a comprehensive frame of reference or the necessary expertise to assess and respond to any and all such risks. In contrast, the Council would enlist the expertise of the entire regulatory community in identifying and devising strategies to mitigate systemic risks. These diverse perspectives are essential if we are to successfully identify new and unanticipated risks, and avoid simply refighting the ``last war.'' Whatever may be the specified cause of a future financial crisis, it is certain to be different than the one we are now experiencing. Third, the Council would provide a high degree of flexibility in convening those Federal and State regulators whose input and participation is necessary to addressing a specific issue, without creating an unwieldy or bureaucratic structure. As is the case with the NSC, the Council should have a core membership of senior Federal officials and the ability to expand its participants on an ad hoc basis when a given issue so requires. It also could be established and begin operation in relatively short order. Creating an all-purpose systemic risk regulator, on the other hand, would be a long and complex undertaking, and would involve developing expertise that duplicates that which already exists in the various functional regulators. Fourth, with an independent staff dedicated solely to pursuing the Council's agenda, the Council would be well-positioned to test or challenge the policy judgments or priorities of various functional regulators. This would help address any concerns about ``regulatory capture,'' including those raised by the Administration's proposal concerning the Federal Reserve's exclusive oversight of Tier 1 FHCs. Moreover, by virtue of their participation on the Council, the various functional regulators would themselves likely be more attentive to emerging risks or regulatory gaps. This would help assure a far more coordinated and integrated approach. Over time, the Council also could assist in framing a political consensus about addressing significant regulatory gaps and necessary policy responses. Fifth, the functional regulators, as distinct from the Council itself, would be charged with implementing regulations to mitigate systemic risks as they emerge. This operational role is appropriate because the functional regulators have the greatest knowledge of their respective regulated industries. Nonetheless, the Council and its staff would have an important independent role in evaluating the effectiveness of the measures taken by functional regulators to mitigate systemic risk and, where necessary, in prompting further actions. Finally, the council model outlined above would be sufficiently robust to ensure sustained follow-through to address critical and complex issues posing risk to the financial system. By way of illustration, consider the case of Long-Term Capital Management (LTCM), a very large and highly leveraged U.S. hedge fund, which in September 1998 lost 90 percent of its capital and nearly collapsed. Concerned that the hedge fund's collapse might pose a serious threat to the markets at large, the Federal Reserve arranged a private sector recapitalization of LTCM. In the aftermath of this incident, there were studies, reports, and recommendations, including by the PWG and the U.S. Government Accountability Office (GAO). But 10 years later, a January 2008 GAO report noted ``the continuing relevance of questions raised over LTCM'' and concluded that it was still ``too soon to evaluate [the] effectiveness'' of the regulatory and industry response to the LTCM experience. \11\--------------------------------------------------------------------------- \11\ United States Government Accountability Office, ``Hedge Funds, Regulators, and Market Participants Are Taking Steps To Strengthen Market Discipline, But Continued Attention Is Needed'' (January 2008), at 3 and 8.--------------------------------------------------------------------------- Hopefully, had a Systemic Risk Council such as that described above been in operation at the time of LTCM's near collapse, it might have prompted more searching analysis of, and more timely and comprehensive regulatory action with respect to, the activities that led to LTCM's near collapse--such as the growing use of derivatives to achieve leverage. For example, under the construct outlined above, the Council would have the authority to direct functional regulators to take action to implement policy responses--authority that the PWG does not possess.d. Potential Criticisms--And How They Can Be Addressed It has been argued that, because of the Federal Reserve's unique crisis-management capability as the central bank and lender of last resort, it is the only logical choice as a systemic risk regulator. To be sure, should our Nation encounter serious financial instability, the Federal Reserve's authorities will be indispensable to remedy the problems. So, too, will be any new resolution authority established for failing large and complex financial institutions. But the overriding purpose of systemic risk regulation should be to identify in advance, and prevent or mitigate, the causes of such instability. This is a role to which the Council, with its diversity of expertise and perspectives, would seem best suited. Put another way, critics of a council model may contend that convening a committee is not the best way to put out a roaring fire. But a broad-based council is the best body for designing a strong fire code--without which we cannot hope to prevent the fire before it ignites and consumes our financial system. Another potential criticism of the Council is that it may diffuse responsibility and pose difficulties in assuring proper follow-through by the functional regulators. While it is true that each functional regulator would have responsibility for implementing responses to address identified risks, it must be made clear in the legislation creating the Council (and in corresponding amendments to the organic statutes governing the functional regulators) that these responses must reflect the policy direction determined by the Council. Additionally, as suggested by FDIC Chairman Bair, the Council should have the authority to require a functional regulator to act as directed by the Council. \12\ In this way, Congress would be assured of creating a Systemic Risk Council with ``teeth.''--------------------------------------------------------------------------- \12\ See Bair Testimony, supra note 3.--------------------------------------------------------------------------- Finally, claiming that a council of Federal regulators ``would add a layer of regulatory bureaucracy without closing the gaps that regulators currently have in skills, experience and authority needed to track systemic risk comprehensively,'' a recent report instead calls for the creation of a wholly independent board to serve as a systemic risk ``adviser.'' \13\ As proposed, the board's mission would be to: (1) collect and analyze risk exposure of bank and nonbank institutions and their practices and products that could threaten financial stability; (2) report on those risks and other systemic vulnerabilities; and (3) make recommendations to regulators on how to reduce those risks. We believe this approach would be highly problematic. It would have precisely the effect that its proponents wish to avoid--by adding another layer of bureaucracy to the regulatory system. It would engender a highly intrusive mechanism that would increase regulatory costs and burdens for financial firms. For example, duplication likely would result from giving a new advisory board the authority to gather the financial information it needs to assess potential systemic risks. And if the board's sole function were to look for systemic risks in the financial system, it almost goes without saying that it would surely find them.--------------------------------------------------------------------------- \13\ See ``Investors' Working Group, U.S. Financial Regulatory Reform: The Investors' Perspective'' (July 2009), available at http://www.cii.org/UserFiles/file/resource%20center/investment%20issues/Investors'%20Working%20Group%20Report%20(July%202009).pdf.---------------------------------------------------------------------------V. Conclusion I appreciate this opportunity to testify before the Committee, and I hope that the perspectives I have offered today will assist the Committee in its deliberations about the mechanism(s) needed to monitor and mitigate potential risks to our financial system. More broadly, I would like to commend Chairman Dodd, Ranking Member Shelby, and the other Members of the Committee for their considerable efforts in seeking meaningful reform of our financial services regulatory regime. I--and ICI and its members--look forward to working further with this Committee and Congress to achieve such reform. ______ CHRG-111hhrg53245--227 Mr. Zandi," I do not think you want to go back to any kind of regional kind of criteria. If you remember back historically, we had vicious regional economic cycles in large part because of unit banking, because the bank was stuck to its region and exacerbated the downturn in those regions. And so we had very severe regional economic cycles in large part because of the unit banking system that we had, so I think that would be very counterproductive, very counterproductive. " fcic_final_report_full--467 Association (MBA). 25 This data allows a comparison between the foreclosure starts that have thus far come out of the 1997-2007 bubble and the foreclosure starts in the two most recent housing bubbles (1977-1979 and 1985-1989) shown in Figure 1. After the housing bubble that ended in 1979, when almost all mortgages were prime loans of the traditional type, foreclosure starts in the ensuing downturn reached a high point of only .87 percent in 1983. After the next bubble, which ended in 1989 and in which a high proportion of the loans were the traditional type, foreclosure starts reached a high of 1.32 percent in 1994. However, after the collapse of the 1997-2007 bubble—in which half of all mortgages were NTMs—foreclosure starts reached the unprecedented level (thus far) of 5.3 percent in 2009. And this was true despite numerous government and bank efforts to prevent or delay foreclosures. All the foregoing data is significant for a proper analysis of the role of government policy and NTMs in the financial crisis. What it suggests is that whatever effect low interest rates or money flows from abroad might have had in creating the great U.S. housing bubble, the deflation of that bubble need not have been destructive. It wasn’t just the size of the bubble; it was also the content. The enormous delinquency rates in the U.S. (see Table 3 below) were not replicated elsewhere, primarily because other developed countries did not have the numbers of NTMs that were present in the U.S. financial system when the bubble deflated. As shown in later sections of this dissent, these mortgage defaults were translated into huge housing price declines and from there—through the PMBS they were holding—into actual or apparent financial weakness in the banks and other firms that held these securities. Accordingly, if the 1997-2007 housing bubble had not been seeded with an unprecedented number of NTMs, it is likely that the financial crisis would never have occurred. 3. Delinquency Rates on Nontraditional Mortgages NTMs are non-traditional because, for many years before the government adopted affordable housing policies, mortgages of this kind constituted only a small portion of all housing loans in the United States. 26 The traditional residential mortgage—known as a conventional mortgage—generally had a fixed rate, often for 15 or 30 years, a downpayment of 10 to 20 percent, and was made to a borrower who had a job, a steady income and a good credit record. Before the GSE Act, even subprime loans, although made to borrowers with impaired credit, often involved substantial downpayments or existing equity in homes. 27 Table 3 shows the delinquency rates of the NTMs that were outstanding on June 30, 2008. The grayed area contains virtually all the NTMs. The contrast in quality, based on delinquency rates, between these loans and Fannie and Freddie prime loans in lines 9 and 10 is clear. 25 26 Mortgage Bankers Association National Delinquency Survey. See Pinto, “Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study,” November 4, 2010, p.58, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis- Pinto-102110.pdf. 27 Id., p.42. CHRG-111hhrg54868--20 The Chairman," Next--and I am very proud that we have maintained the rule here of including our State colleagues in banking, insurance and in regulation and securities. There are people who consider you State regulators a nuisance, but we think you are an important part of the system. So we have Mr. Joseph Smith, who is the North Carolina Commissioner of Banks, and he is here on behalf of the Conference of State Bank Supervisors.STATEMENT OF JOSEPH A. SMITH, JR., NORTH CAROLINA COMMISSIONER OF BANKS, ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS " CHRG-111hhrg56776--273 Mr. Gerhart," Chairman Watt and members of the committee, I am Jeff Gerhart, president of the Bank of Newman Grove in Newman Grove, Nebraska. I'm also a former director of the Federal Reserve Bank of Kansas City. The Bank of Newman Grove is a State member bank supervised by the Federal Reserve with $32 million--that's ``M'' in million, not ``B'' in billion--in assets. Our bank was founded in 1891, and I'm the fourth generation of my family to serve as the bank's president. Newman Grove is an agricultural community of 800 in the rolling hills of northeast Nebraska. Our bank works hard to ensure Newman Grove is a vibrant community through loans to our local farmers, small businesses, and consumers. I am pleased to testify on behalf of the Independent Community Bankers of America and its 5,000 community bank members nationwide at this important hearing to link the Fed's examination--or supervision of monetary policy. Some in Congress have proposed that the Federal Reserve's supervision of State member banks be eliminated and that a supervision over holding companies be eliminated or limited to the very largest companies. Although the primary responsibility of the Federal Reserve is to conduct monetary policy, the ICBA opposes separating the Federal Reserve's monetary policy role from its role as financial supervisor. For decades, the Federal Reserve has played a critical role in the banking regulatory system as a supervisor of State member banks and holding companies. ICBA believes the local nature of the regional Federal Reserve banks, working in harmony with State bank regulators, gives them a unique ability to serve as a primary regulator for State member banks, the vast majority of which are community banks serving consumers and small businesses. This, in turn, gives the Federal Reserve an efficient means for gauging the soundness of the banking sector, information that is critical to developing and implementing sound monetary policy. Federal Reserve Chairman Bernanke recently testified that the Federal Reserve's supervision of community banks gives the Fed insight into what has happened at the grass roots level to lending and to the economy. This is particularly true with respect to the vital small business sector. While community banks represent about 12 percent of all bank assets, they make 40 percent of the dollar amount of all bank small business loans under a million dollars. The Federal Reserve monetary policy is to promote this important sector of the economy. The Federal Reserve's supervision of community banks must be maintained. In addition, regulation of community banks gives the Federal Reserve a window on the vast array of local economies served by community banks, many of which are not served by any larger institutions at all. The inside gain from the supervision of State member banks and holding companies, both large and small, allows the Federal Reserve to identify disruptions in all sectors of the financial system in order to meet its statutory goal of ensuring stability of the financial system. The record shows the Federal Reserve has been a very effective regulator of community banks, and this role should be preserved. ICBA is very concerned that limiting the Federal Reserve's oversight to only the largest or systemically dangerous holding companies could lead to a bias and favor the largest financial institutions. This is a risky approach to financial reorganization and a path that the United States should not go down. The Federal Reserve Bank of Kansas City, the Federal supervisor of my bank, brings to its bank supervisory role a highly regarded expertise in the agricultural economy. The Federal Reserve's expertise in agriculture enhances its ability to supervise Midwestern community banks like mine with a significant ag loan portfolio. It would be a mistake to remove the Federal Reserve's economic expertise from the country's financial supervisory structure. Having multiple Federal agencies supervising depository institutions provides valuable regulatory checks and balances and promotes best practices among those agencies. The contributions and views of the Federal Reserve have been an important part of this regulatory diversity, which would significantly be diminished if the Federal Reserve were stripped of all or most of its supervisory authority. I want to thank you for inviting me here today, and I would be glad to answer any questions. [The prepared statement of Mr. Gerhart can be found on page 73 of the appendix.] " FinancialCrisisReport--348 A similar view as to why the CDO business continued to operate despite increasing market risk was expressed by a former executive at the hedge fund Paulson & Co. in a January 2007 email exchange with another investor. The Paulson executive wrote: “It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytic tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.” 1331 At the end of September 2006, the head of Deutsche Bank’s sales force, Sean Whelan, wrote to Mr. Lippmann expressing concern that some CDO tranches were getting increasingly difficult to sell: “[T]he equity and the AAA were the parts we found difficult to place.” 1332 Mr. Lippmann told the Subcommittee that once firms could not sell an entire CDO to investors, it was a warning that the market was waning, and the investment banks should have stopped structuring new ones. 1333 Instead of getting out of the CDO business, however, he said, a new source of CDO demand was found – when new CDOs started buying old CDO securities to include in their assets. One media report explained how this worked: “As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created – and ultimately provided most of the money for – new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.” 1334 Research conducted by Thetica Systems, at the request of ProPublica, found that in the last years before the financial crisis, CDOs had become the dominant purchaser of high risk CDO securities, largely replacing real money investors like pension funds, insurance companies, and hedge funds. The CDO market analysis found that, by 2007, 67% of the high risk mezzanine CDO securities had been purchased by other CDOs, up from 36% in 2004. 1335 1331 1/14/2007 email from Paolo Pellegrini at Paulson to Ananth Krishnamurthy at 3a Investors, PAULSON ABACUS 0234459. 1332 9/27/2006 email from Sean Whelan to Greg Lippmann, DBSI_PSI_EMAIL02255361-63. 1333 Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann told the Subcommittee that he thought Mr. Lamont’s CDO Group at Deutsche Bank had too many CDOs in the pipeline in the spring of 2007, when it could not sell all of its CDO securities. He reported that he told Mr. Lamont that defaults would increase. 1334 “Banks’ Self-Dealing Super Charged Financial Crisis,” ProPublica , (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis. 1335 Id. ProPublica even found that, from 2006 to 2007, nearly half of all the CDOs sponsored by Merrill Lynch bought significant portions of other Merrill CDOs. CHRG-111shrg50814--147 Mr. Bernanke," The outcome of the stress test is not going to be fail or pass. The outcome of the stress test is, how much capital does this bank need in order to meet the needs of the credit--the credit needs of borrowers in our economy. You mentioned having majority ownership and so on. We don't need majority ownership to work with the banks. We have very strong supervisory oversight. We can work with them now to get them to do whatever is necessary to restructure, take whatever steps are needed to become profitable again, to get rid of bad assets. We don't have to take them over to do that. We have always worked with banks to make sure that they are healthy and stable, and we are going to work with them. I don't see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize a bank when it just isn't necessary. I think what we can do is make sure they have enough capital to fulfill their function and at the same time exert adequate control to make sure that they are doing what is necessary to become healthy and viable in the longer term. With respect to your question about too big to exist, as I have said before, there is a too big to fail problem which is very severe. We need to think hard going forward how we are going to address that problem, but right now, we are in the middle of the crisis. Senator Shelby. Have you thought about ways to deal with it? We understand that some banks pose, or some institutions like AIG, systemic risk to the whole financial system---- " FinancialCrisisReport--43 A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC to prohibit states from enforcing state consumer protection laws against national banks. 91 After the New York State Attorney General issued subpoenas to several national banks to enforce New York’s fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC regulation, and held that states were allowed to enforce state consumer protection laws against national banks. 92 During the intervening four years, however, state regulators had been effectively unable to enforce state laws prohibiting abusive mortgage practices against federally- chartered banks and thrifts. Systemic Risk. While bank and securities regulators focused on the safety and soundness of individual financial institutions, no regulator was charged with identifying, preventing, or managing risks that threatened the safety and soundness of the overall U.S. financial system. In the area of high risk mortgage lending, for example, bank regulators allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly sold the high risk loans to get them off their books. Securities regulators allowed investment banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as long as the securities received high ratings from the credit rating agencies and so were deemed “safe” investments. No regulatory agency focused on what would happen when poor quality mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO securities with high risk loans. In addition, none of the regulators focused on the impact derivatives like credit default swaps might have in exacerbating risk exposures, since they were barred by federal law from regulating or even gathering data about these financial instruments. F. Government Sponsored Enterprises Between 1990 and 2004, homeownership rates in the United States increased rapidly from 64% to 69%, the highest level in 50 years. 93 While many highly regarded economists and officials argued at the time that this housing boom was the result of healthy economic activity, in retrospect, some federal housing policies encouraged people to purchase homes they were ultimately unable to afford, which helped to inflate the housing bubble. Fannie Mae and Freddie Mac. Two government sponsored entities (GSE), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), were chartered by Congress to encourage homeownership primarily by providing a secondary market for home mortgages. They created that secondary market by purchasing loans from lenders, securitizing them, providing a guarantee that they would make up the cost of other requirements, the rules prohibited lenders “from making loans based on collateral without regard to [the borrower’s] repayment ability,” required lenders to “verify income and obligations,” and imposed “more stringent restrictions on prepayment penalties.” The rules also required lenders to “establish escrow accounts for taxes and mortgage related insurance for first-lien loans.” In addition, the rules “prohibit[ed] coercion of appraisers, define[d] inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages.”). 91 12 CFR § 7.4000. 92 Cuomo v. Clearing House Association , Case No. 08-453, 129 S.Ct. 2710 (2009). 93 U.S. Census Bureau, “Table 14. Homeownership Rates by Area: 1960 to 2009,” http://www.census.gov/hhes/www/housing/hvs/annual09/ann09t14.xls. any securitized mortgage that defaulted, and selling the resulting mortgage backed securities to investors. Many believed that the securities had the implicit backing of the federal government and viewed them as very safe investments, leading investors around the world to purchase them. The existence of this secondary market encouraged lenders to originate more loans, since they could easily sell them to the GSEs and use the profits to increase their lending. CHRG-111shrg54533--71 Secretary Geithner," Again, I want to just say no part of the system acquitted itself particularly well, and everybody is going to have to do a better job in the future, and that is why we are proposing, among many things, a comprehensive assessment of the basic record of supervision across agencies in the U.S. responsible for that. But we have to make choices going forward about how to build a stronger system, and what we have recommended, what the President recommended I think vests authority where it needs to be in institutions with the best capacity to discharge that responsibility well. Senator Merkley. Well, thank you, and I will yield back the balance of my time, and I do feel like the administration has put forward a very strong proposal for us to work with. Thank you. Senator Johnson. Senator Crapo. Senator Crapo. Thank you very much, Mr. Chairman. And, Mr. Secretary, thank you for being here. I want to indicate at the outset that I share a number of the concerns that have been raised by my colleagues here in reference to the new authorities to be given to the Fed. But since that has been gone over a lot, I want to in my short time focus on an issue that I do not think has had much attention here yet today, and that is the bifurcation of consumer protection from safety and soundness regulation. It seems to me that we can get the most effective consumer protection by not bifurcating those two functions and moving forward in a way that allows those who are really connected with the regulatory system of our banks to have the ability to implement statutory and regulatory policy on consumer protection. What I would like to do is to read you a statement by the Comptroller of the Currency, John Dugan, when he testified before our Committee in March, because he made the same points and made a number of points about why that is the case, and I would like you to respond to his points. He says, ``The best way to implement consumer protection regulation of banks, the best way to protect consumers, is to do so through the prudential supervision.'' He gives these following reasons: First, prudential supervisors' continual presence in the banks through the examination process put them in the very best position to ensure compliance with consumer protection requirements established by statute and regulation; Second, prudential supervisors' have strong enforcement powers and exceptional leverage over bank management to achieve corrective action; And, third, the examiners are continually exposed to practical effects of implementing consumer protection rules for bank customers. The prudential supervisory agency is in the best position to formulate and refine consumer protection regulations for the bank. Could you respond to those points? " CHRG-111shrg55278--125 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM DANIEL K. TARULLOQ.1. AIG--Governor Tarullo, I am very concerned that the Fed currently has too many responsibilities. The Fed's bail out of AIG has put the Fed in the position of having to unwind one of the world's largest and most complex financial institutions. Resolving AIG without imposing losses on the U.S. taxpayer is proving to be a time-consuming and difficult task. It could even potentially distract the Fed from its core mission of monetary policy. Approximately how many hours have you personally dedicated to overseeing the Fed's investments in AIG? How does this compare with the number of hours you have spent on monetary policy issues? What assurance can you provide that the Fed is devoting enough time and attention to both AIG and monetary policy?A.1. I joined the Board at the end of January 2009 and thus was not involved in matters involving the American International Group, Inc. (AIG) before that date. While we do not have records of the exact number of hours I have spent addressing AIG matters since I joined the Board, these matters do not occupy a significant part of my ongoing workload and do not detract from my other responsibilities as a member of the Board, including the conduct of monetary policy. The oversight of the Federal financial assistance provided to AIG is shared by the Federal Reserve, which has provided several credit facilities designed to stabilize AIG, and the Treasury Department, which holds equity interests in the company. The day-to-day oversight of the Federal Reserve credit facilities is carried out by a team ofstaff at the Federal Reserve Bank of New York and the Board of Governors, assisted by expert advisers we have retained. In our role as a creditor of AIG, the Federal Reserve oversight staff makes sure that we are adequately informed on such matters as funding, cash flows, liquidity, earnings, risk management, and progress in pursuing the company's divestiture plan, so that we can protect the interests of the System and the taxpayers in repayment of the credit extended. With respect to the credit facilities extended to special purpose entities that purchased assets connected with AIG operations, the staff's oversight activities consist primarily of monitoring the portfolio operations of each of the entities, which are managed by a third-party investment manager. The Federal Reserve staff involved in the ongoing oversight of AIG periodically report to the Board of Governors about material developments regarding the administration of these credit facilities. The Federal Reserve oversight staff for AIG works closely with the Treasury staff who oversee and manage the Treasury's relationship with AIG. As the holder of significant equity interests in the company, Treasury plays an important role in stabilizing AIG's financial condition, overseeing the execution of its divestiture plan, and protecting the taxpayers' interests. With respect to time expended by the Reserve Bank members of the Federal Open Market Committee, the President of the New York Reserve Bank devotes significant attention to AIG. However, as noted above, day-to-day responsibility for overseeing the Bank's interests as lender to AIG has been delegated to a team of senior Bank managers. The President regularly consults with the AIG team--in particular he receives a daily morning briefing on AIG as well as other significant Bank activities, receives updates throughout the day on an ad hoc basis circumstances warrant, and occasionally intervenes personally on particular issues. The President believes that he is able to adequately balance the time and resources he allocates to AIG with the other Bank activities that warrant his personal attention, including his responsibilities as a voting member of the FOMC.Q.2. Safety and Soundness Regulation--Governor Tarullo, in your testimony you state that there are synergies between monetary policy and systemic risk regulation. In order to capture these synergies, you argue that the Fed should become a systemic risk regulator. Yesterday, Chairman Bernanke testified that he believed there are synergies between prudential bank regulation and consumer protection. This argues in favor of establishing one consolidated bank regulator. In your judgment, is it on the whole better to have prudential supervision and consumer protection consolidated in one agency, or separated into two different agencies?A.2. There are important connections and complementarities between consumer protection and prudential supervision. For example, sound underwriting benefits consumers as well as the relevant financial institution, and strong consumer protections can add certainty to the markets and reduce risks to the institutions. Moreover, the most effective and efficient consumer protection requires the in-depth understanding of bank practices that is gained through the prudential supervisory process. Indeed, the Board's separate divisions for consumer protection and prudential supervision work closely in developing examination policy and industry gnidance. Both types of supervision benefit from this close coordination, which allows for a broader perspective on the quality of management and the risks facing a financial organization. Thus, placing consumer protection rule writing, examination, and enforcement activities in a separate organization that does not have prudential supervisory responsibilities would have costs, as well as benefits. Achieving the synergies between prudential supervision and consumer protection does not require that responsibility for both functions and for all banking organizations to be concentrated in a single, consolidated bank regulator. Under the current framework for bank supervision, the Board has prudential supervisory responsibilities for a substantial cross-section of banking organizations in the United States, as well as rule-writing, examination, and enforcement authority for consumer protection. Likewise, the other Federal banking agencies all have both prudential supervisory authority for certain types of banking organizations and consumer protection examination and enforcement responsibilities for these organizations. Moreover, as I indicated in my July 23rd testimony to the Committee, the United States needs a comprehensive agenda to contain systemic risk and address the problem of ``too-big-to-fail'' financial institutions. We should seek to marshal and build on the individual and collective expertise and resources of all financial supervisors in the effort to contain systemic risks within the financial system, rather than rely on a single ``systemic risk regulator.'' This means new or enhanced responsibilities for a number of Federal agencies and departments, including the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Deposit Insurance Corporation. One important aspect of such an agenda is ensuring that all systemically important financial institutions--and not just those that own a bank--are subject to a robust framework for supervision on a consolidated or groupwide basis, thereby closing an important gap in the current regulatory framework. The Federal Reserve already serves as the consolidated supervisor of all bank holding companies, including a number of the largest and most complex banking organizations and a number of very large financial firms--such as Goldman Sachs, Morgan Stanley, and American Express--that became a bank holding company during the financial crisis. This expertise, as well as the information and perspective that the Federal Reserve has as a result of its central bank responsibilities, makes the Federal Reserve well suited to serve as consolidated supervisor for all systemically important financial firms. As Chairman Bernanke recently noted, there are substantial synergies between the Federal Reserve's role as prudential supervisor and its other central bank responsibilities. Price stability and financial stability are closely related policy goals. The benefits of maintaining a Federal Reserve role in supervision have been particularly evident in the recent financial crisis. Over the past 2 years, supervisory expertise and information have helped the Federal Reserve to better understand the emerging pressures on financial firms and to use monetary policy and other tools to respond to those pressures. This understanding contributed to more timely and decisive monetary policy actions and proved invaluable in helping us to address potential systemic risks involving specific financial institutions and markets. More broadly, our supervisors' knowledge of interbank lending markets and other sources of bank funding contributed to the development of new tools to address financial stress. ------ CHRG-111shrg52619--190 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON FROM SHEILA C. BAIRQ.1. I have concerns about the recent decision by the Federal Deposit Insurance Corporation (FDIC) Board of Directors to impose a special assessment on insured institutions of 20 basis points, with the possibility of assessing an additional 10 basis points at any time as may be determined by the Board. Since this decision was announced, I have heard from many Texas community bankers, who have advised me of the potential earnings and capital impact on their financial institutions, and more importantly, the resulting loss of funds necessary to lend to small business customers and consumers in Texas communities. It is estimated that assessments on Texas banks, if implemented as proposed, will remove nearly one billion dollars from available capital. When leveraged, this results in nearly eight to twelve billion dollars that will no longer be available for lending activity throughout Texas. At a time when responsible lending is critical to pulling our nation out of recession, this sort of reduction in local lending has the potential to extend our economic downturn. I understand you believe that any assessments on the banking industry may be reduced by roughly half, or 10 basis points, should Congress provide the FDIC an increase in its line of credit at the Department of Treasury from $30 billion to $100 billion. That is why I have signed on as a cosponsor of The Depositor Protection Act of 2009, which accomplishes that goal. However, my banking community informs me that even this modest proposed reduction in the special assessments will still disproportionately penalize community banks, the vast majority of which neither participated nor contributed to the irresponsible lending tactics that have led to the erosion of the FDIC deposit insurance fund (DIF). I understand that there are various alternatives to ensure the fiscal stability of the DIF without adversely affecting the community banking industry, such as imposing a systemic risk premium, basing assessments on assets with an adjustment for capital rather than total insured deposits, or allowing banks to amortize the expenses over several years. I respectfully request the following: Could you outline several proposals to improve the soundness of the DIF while mitigating the negative effects on the community banking industry? Could you outline whether the FDIC has the authority to implement these policy proposals, or whether the FDIC would need additional authorities? If additional authority is needed, from which entity (i.e., Congress? Treasury?) Would the FDIC need those additional authorities?A.1. The FDIC realizes that assessments are a significant expense for the banking industry. For that reason, we continue to consider alternative ways to alleviate the pressure on the DIF. In the proposed rule on the special assessment (adopted in final on May 22, 2009), we specifically sought comment on whether the base for the special assessment should be total assets or some other measure that would impose a greater share of the special assessment on larger institutions. The Board also requested comment on whether the special assessment should take into account the assistance that has been provided to systemically important institutions. The final rule reduced the proposed special assessment to five basis points on each insured depository institutions assets, minus its Tier 1 capital, as of June 30, 2009. The assessment is capped at 10 basis points of an institution's domestic deposits so that no institution will pay an amount greater than they would have paid under the proposed interim rule. The FDIC has taken several other actions under its existing authority in an effort to alleviate the burden of the special assessment. On February 27, 2009, the Board of Directors finalized new risk-based rules to ensure that riskier institutions bear a greater share of the assessment burden. We also imposed a surcharge on guaranteed bank debt under the Temporary Liquidity Guarantee Program (TLGP) and will use the money raised by the surcharge to reduce the proposed special assessment. Several other steps to improve the soundness of the DIF would require congressional action. One such step would be for Congress to establish a statutory structure giving the FDIC the authority to resolve a failing or failed depository institution holding company (a bank holding company supervised by the Federal Reserve Board or a savings and loan holding company, including a mutual holding company, supervised by the Office of Thrift Supervision) with one or more subsidiary insured depository institutions that are failing or have failed. As the corporate structures of bank holding companies, their insured depository and other affiliates continue to become more complex, an insured depository institution is likely to be dependent on affiliates that are subsidiaries of its holding company for critical services, such as loan and deposit processing and loan servicing. Moreover, there are many cases in which the affiliates are dependent for their continued viability on the insured depository institution. Failure and the subsequent resolution of an insured depository institution whose key services are provided by affiliates present significant legal and operational challenges. The insured depository institutions' failure may force its holding company into bankruptcy and destabilize its subsidiaries that provide indispensable services to the insured depository institution. This phenomenon makes it extremely difficult for the FDIC to effectuate a resolution strategy that preserves the franchise value of the failed insured depository institution and protects the DIF. Bankruptcy proceedings, involving the parent or affiliate of an insured depository institution, are time-consuming, unwieldy, and expensive. The threat of bankruptcy by the bank holding company or its affiliates is such that the Corporation may be forced to expend considerable sums propping up the bank holding company or entering into disadvantageous transactions with the bank holding company or its subsidiaries in order to proceed with an insured depository institution's resolution. The difficulties are particularly extreme where the Corporation has established a bridge depository institution to preserve franchise value, protect creditors (including uninsured depositors), and facilitate disposition of the failed institution's assets and liabilities. Certainty regarding the resolution of large, complex financial institutions would also help to build confidence in the strength of the DIF. 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. 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. This problem could be ameliorated or cured if Congress provided the necessary authority to resolve a large, complex financial institution and to charge systemically important firms fees and assessments necessary to fund such a systemic resolution system. In addition, 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. Restrictions on leverage and the imposition of risk-based assessments on institutions and their activities also would act as disincentives to the types of growth and complexity that raise systemic concerns.Q.2. I commend you for your tireless efforts in helping our banking system survive this difficult environment, and I look forward to working closely with you to arrive at solutions to support the community banking industry while ensuring the long-term stability of the DIF to protect insured depositors against loss. Will each of you commit to do everything within your power to prevent performing loans from being called by lenders? Please outline the actions you plan to take.A.2. The FDIC understands the tight credit conditions in the market and is engaged in a number of efforts to improve the current situation. Over the past year, we have issued guidance to the institutions we regulate to encourage banks to maintain the availability of credit. Moreover, our examiners have received specific instructions on properly applying this guidance to FDIC supervised institutions. On November 12, 2008, we joined the other federal banking agencies in issuing the Interagency Statement on Meeting the Needs of Creditworthy Borrowers (FDIC FIL-128-2008). This statement reinforces the FDIC's view that the continued origination and refinancing of loans to creditworthy borrowers is essential to the vitality of our domestic economy. The statement encourages banks to continue making loans in their markets, work with borrowers who may be encountering difficulty during this challenging period, and pursue initiatives such as loan modifications to prevent unnecessary foreclosures. In light of the present challenges facing banks and their customers, the FDIC hosted in March a roundtable discussion focusing on how regulators and financial institutions can work together to improve credit availability. Representatives from the banking industry were invited to share their concerns and insights with the federal bank regulators and representatives from state banking agencies. The attendees agreed that open, two-way communication between the regulators and the industry was vital to ensuring that safety and soundness considerations are well balanced with the critical need of providing credit to businesses and consumers. One of the important points that came out of the session was the need for ongoing dialog between bankers and their regulators as they work jointly toward a solution to the current financial crisis. Toward this end, the FDIC created a new senior level position to expand community bank outreach. In conjunction with this office, the FDIC plans to establish an advisory committee to address the unique concerns of this segment of the banking community. As part of our ongoing supervisory evaluation of banks that participate in federal financial stability programs, the FDIC also is taking into account how available capital is deployed to make responsible loans. It is necessary and prudent for banking organizations to track the use of the funds made available through federal programs and provide appropriate information about the use of these funds. On January 12, 2009, the FDIC issued a Financial Institution Letter titled Monitoring the Use of Funding from Federal Financial Stability and Guarantee Programs (FDIC FIL-1-2009), advising insured institutions that they should track their use of capital injections, liquidity support, and/or financing guarantees obtained through recent financial stability programs as part of a process for determining how these federal programs have improved the stability of the institution and contributed to lending to the community. Equally important to this process is providing this information to investors and the public. This Financial Institution Letter advises insured institutions to include information about their use of the funds in public reports, such as shareholder reports and financial statements. Internally at the FDIC, we have issued guidance to our bank examiners for evaluating participating banks' use of funds received through the TARP Capital Purchase Program and the Temporary Liquidity Guarantee Program, as well as the associated executive compensation restrictions mandated by the Emergency Economic Stabilization Act. Examination guidelines for the new Public-Private Investment Fund will be forthcoming. During examinations, our supervisory staff will be reviewing banks' efforts in these areas and will make comments as appropriate to bank management. We will review banks' internal metrics on the loan origination activity, as well as more broad data on loan balances in specific loan categories as reported in Call Reports and other published financial data. Our examiners also will be considering these issues when they assign CAMELS composite and component ratings. The FDIC will measure and assess participating institutions' success in deploying TARP capital and other financial support from various federal initiatives to ensure that funds are used in a manner consistent with the intent of Congress, namely to support lending to U.S. businesses and households. ------ fcic_final_report_full--80 Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages increased from . trillion in  to . trillion in , or  annually. At Fred- die, they increased from  trillion to . trillion, or  a year.  As they grew, many financial firms added lots of leverage. That meant potentially higher returns for shareholders, and more money for compensation. Increasing leverage also meant less capital to absorb losses. Fannie and Freddie were the most leveraged. The law set the government- sponsored enterprises’ minimum capital requirement at . of assets plus . of the mortgage-backed securities they guaranteed. So they could borrow more than  for each dollar of capital used to guarantee mortgage-backed securities. If they wanted to own the securities, they could borrow  for each dollar of capital. Com- bined, Fannie and Freddie owned or guaranteed . trillion of mortgage-related as- sets at the end of  against just . billion of capital, a ratio of :. From  to , large banks and thrifts generally had  to  in assets for each dollar of capital, for leverage ratios between : and :. For some banks, leverage remained roughly constant. JP Morgan’s reported leverage was between : and :. Wells Fargo’s generally ranged between : and :. Other banks upped their leverage. Bank of America’s rose from : in  to : in . Citigroup’s increased from : to :, then shot up to : by the end of , when Citi brought off-balance sheet assets onto the balance sheet. More than other banks, Citi- group held assets off of its balance sheet, in part to hold down capital requirements. In , even after bringing  billion worth of assets on balance sheet, substantial assets remained off. If those had been included, leverage in  would have been :, or about  higher. In comparison, at Wells Fargo and Bank of America, in- cluding off-balance-sheet assets would have raised the  leverage ratios  and , respectively.  Because investment banks were not subject to the same capital requirements as commercial and retail banks, they were given greater latitude to rely on their internal risk models in determining capital requirements, and they reported higher leverage. At Goldman Sachs, leverage increased from : in  to : in . Morgan Stanley and Lehman increased about  and , respectively, and both reached : by the end of .  Several investment banks artificially lowered leverage ratios by selling assets right before the reporting period and subsequently buying them back. As the investment banks grew, their business models changed. Traditionally, in- vestment banks advised and underwrote equity and debt for corporations, financial institutions, investment funds, governments, and individuals. An increasing amount of the investment banks’ revenues and earnings was generated by trading and invest- ments, including securitization and derivatives activities. At Goldman, revenues from trading and principal investments increased from  of the total in  to  in . At Merrill Lynch, they generated  of revenue in , up from  in . At Lehman, similar activities generated up to  of pretax earnings in , up from  in . At Bear Stearns, they accounted for more than  of pretax earnings in some years after  because of pretax losses in other businesses.  CHRG-111shrg52619--42 Mr. Fryzel," Thank you, Senator. I agree with my colleagues that there should be the dual chartering system between State and Federal banks as well as credit unions. Chairman Bair says that there probably are too many bank regulators. Well, fortunately, we only have one credit union regulator, so I think that is something we should maintain. But again, I think we need to look at where are the problems? Which regulator perhaps hasn't done the job that they should have done, and maybe that is where the correction should be. I think the majority of regulators have done the best they possibly can considering what the circumstances are. I think they have taken the right types of moves to correct the situation that is out there with the economy the way it is. But for restructuring, I think we need to see where is the problem. Is it with the banks? Is it with the insurance companies? Is it with other types of financial institutions, and address that. And then making that improvement, determine whether or not we need the systemic risk regulator above these other institutions. " CHRG-111hhrg48874--2 The Chairman," The hearing will come to order. Members of this committee, as well as other Members of Congress, have been urging people in the banking system to increase the volume of loans. We hear from some of our constituents that they are not able to get loans that they think would be very helpful economically. And as obvious as we have said, the economy doesn't recover until the credit system does. Essentially, we have had a situation in which borrowers have complained about some of the banks. Banks have in turn complained about the regulators and we are here in one room sequentially. I would hope that our friends on the regulatory panel will be able to stay themselves, or through staff, hear what some of the bankers have said. And I assume they have read the testimony. You know, I don't think there's a matter of ill will. I call it the ``mixed message'' hearing, because I think it is. We do tell the regulators two things: one, tell people to make loans; and, two, tell people not to make loans. Now, they're not supposed to be the same loans, but there is this tension here. And it's a particularly exacerbated tension now, because I think in normal times, the role of regulators is to make sure that bad loans aren't made or to minimize the likelihood. But, we're not in a normal time now. We're in a time where there is a clear problem making good loans. So it is important that the ongoing important safety and soundness is the role of the regulators, and diminishing the number of imprudent loans coexists with the importance of making sure that loans are made that should be made. Now, part of the mixed message issue--and that is why Mr. Kroeker is here from the SEC--has to do with the effect of mark-to-market accounting. We do not want to be post-cyclical, but we also have that potential with regard, for instance, to assessments at the FDIC. Now, some of that is inevitable. If more banks fail, then the assessments go up. But if the assessments go up, some of the banks, small banks, have less ability to lend. It would be nice if we could simply abolish one or the other of the conflicting objectives. We can't. They are both important. So what we then have to do is to make sure they are done in coordination with each other, and in particular with regard to the question of lending standards, that we avoid the potential of there being compartmentalization, in which some parts of the agencies are urging people to lend, and other parts are urging them not to. We need to make sure that the same people are aware of the importance of both of those. We had a hearing in general on mark-to-market. It is of particular relevance, obviously, to banks, particularly to banks that are holding securities long-term. We had a special problem brought to our attention regarding mark-to-market with a couple of the Federal Home Loan Bank regents. So we want to be able to address that as well, and as I said, the purpose here is to make sure that we can increase loans in an atmosphere of security and soundness. And, I think, most importantly, demonstrate that those two objectives are not in fact in conflict, but that they go together, that we are capable of a sound banking system that produces an appropriate flow of credit without endangering the safety of the system. " fcic_final_report_full--13 While many of these mortgages were kept on banks’ books, the bigger money came from global investors who clamored to put their cash into newly created mortgage-re- lated securities. It appeared to financial institutions, investors, and regulators alike that risk had been conquered: the investors held highly rated securities they thought were sure to perform; the banks thought they had taken the riskiest loans off their books; and regulators saw firms making profits and borrowing costs reduced. But each step in the mortgage securitization pipeline depended on the next step to keep demand go- ing. From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin in the game. They all believed they could off-load their risks on a moment’s no- tice to the next person in line. They were wrong. When borrowers stopped making mortgage payments, the losses—amplified by derivatives—rushed through the pipeline. As it turned out, these losses were concentrated in a set of systemically im- portant financial institutions. In the end, the system that created millions of mortgages so efficiently has proven to be difficult to unwind. Its complexity has erected barriers to modifying mortgages so families can stay in their homes and has created further uncertainty about the health of the housing market and financial institutions. • We conclude over-the-counter derivatives contributed significantly to this crisis. The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis. From financial firms to corporations, to farmers, and to investors, derivatives have been used to hedge against, or speculate on, changes in prices, rates, or indices or even on events such as the potential defaults on debts. Yet, without any oversight, OTC derivatives rapidly spiraled out of control and out of sight, growing to  tril- lion in notional amount. This report explains the uncontrolled leverage; lack of transparency, capital, and collateral requirements; speculation; interconnections among firms; and concentrations of risk in this market. OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans. Companies sold protection—to the tune of  billion, in AIG’s case—to investors in these newfangled mortgage se- curities, helping to launch and expand the market and, in turn, to further fuel the housing bubble. Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system. Goldman Sachs alone packaged and sold  billion in synthetic CDOs from July , , to May , . Synthetic CDOs created by Goldman referenced more than , mortgage securities, and  of them were referenced at least twice. This is apart from how many times these securities may have been referenced in synthetic CDOs created by other firms. FOMC20050809meeting--109 107,MR. WILCOX., I can point to two main factors. One is simply the aging of the population. The baby boom cohorts are moving into an age of lower participation rates. CHRG-111shrg53176--147 PREPARED STATEMENT OF RICHARD C. BREEDEN Former Chairman, Securities and Exchange Commission March 26, 2009 Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee for the opportunity to offer my views on enhancing investor protection and improving financial regulation. These have been issues of concern to me for many years. In offering observations to the Committee today, I am drawing on past experience as SEC Chairman from 1989-1993, as well as my service as an Assistant to the President in the White House under President George H.W. Bush. During the savings and loan and banking crisis in the 1980s, which involved more than $1 trillion in bank and thrift assets, I was one of the principal architects of the program to restructure the savings and loan industry and its regulatory system. That effort was extremely successful, and became the model for many other countries including the Nordic countries in dealing with later banking sector meltdowns. Early in my White House tenure, in 1982-1985 when the future President Bush was Vice President, I was staff director of a 3-year study of how to improve the effectiveness and efficiency of the entire federal financial regulatory system. We looked carefully at many ideas for improving the effectiveness of federal financial regulation, including possible consolidation of banking agencies, SEC/CFTC merger and other topics. From 2002-2005 I served as the ``corporate monitor'' of WorldCom, after being appointed to that position by the Hon. Jed S. Rakoff of the U.S. District Court for the Southern District of New York. Among other things, it was my job on behalf of the District Court to evaluate and approve or veto all compensation payments by WorldCom to any of its 66,000 employees in more than 50 countries. We didn't call it an ``AIG Problem'', but Judge Rakoff was determined to prevent exactly the type of compensation abuses that have occurred in AIG. Even though taxpayer funds were not injected into WorldCom, Judge Rakoff did not believe that a company that had destroyed itself through fraud should be free to pay corporate funds to insiders without strict monitoring and controls. I ultimately blocked hundreds of millions in proposed compensation payments that could not be justified, while allowing the company to do what it needed to do to compete for critical personnel and to emerge successfully from bankruptcy. Over the years I have served on many corporate boards, including the boards of two major European corporations as well as U.S. companies. Today I serve as nonexecutive Chairman of the Board of H&R Block, Inc., and as a director of two other U.S. public companies. \1\ As a board chairman and as a director, I have personally had to grapple with the issues of corporate governance, including accountability for performance and excessive compensation, that helped cause so many of our recent financial institution collapses.--------------------------------------------------------------------------- \1\ The views expressed here today are solely my own. They do not represent the views of any investors in investment funds managed by Breeden Capital Management, or of any companies on whose boards I serve.--------------------------------------------------------------------------- Of all my prior experiences, however, perhaps the most relevant is my experience as an investor. For the past few years my firm, Breeden Capital Management, has managed equity investments that today total approximately $1.5 billion in the U.S. and Europe. Our investors are for the most part major pension plans, and we indirectly invest on behalf of several million retired schoolteachers, firemen, policemen, civil servants and others. Their retirement security is dependent in part on how successful we are in generating investment returns. While I was pretty intense about investor protection as SEC Chairman, I can assure you that there is nothing like having billions on the line in investments on behalf of other people to make you really passionate on that subject.I. Overview By any conceivable yardstick, our Nation's financial regulatory programs have not worked adequately to protect our economy, our investors, or our taxpayers. In little more than a year, U.S. equities have lost more than $7 trillion in value. Investors in financial firms that either failed, or needed a government rescue, have had at least $1.6 trillion in equity wiped out. These are colossal losses, without any precedent since the Great Depression. Millions of Americans will live with reduced retirement incomes and higher taxes for many years as a result of misbehavior in our financial firms, failed oversight by boards of directors, and ineffective government regulation. To restore trust among investors in our financial system and government, we will need to make significant improvements in our existing regulatory programs. We also must make sure that ``new'' regulatory programs will actually be ``better'' than current programs. Any ``reforms'' worth the name must demand more effectiveness from government agencies, including the Federal Reserve and the SEC, that have responsibility for ``prudential supervision'' of banks and securities firms. It is worth noting that the disasters we have seen did not arise due to lack of resources for the Federal Reserve, the SEC or any of the other agencies that didn't perform as well as they needed to do. The U.S. regulatory system is enormous and powerful, and it generally has adequate, if not perfect, resources. When it comes to regulation, bigger doesn't mean smarter, better or more effective. Indeed, when agencies have too many resources they tend to become unwieldy, not more vigilant or effective. The problems also did not arise because of ``outdated laws from the 1930s'' or, except in limited circumstances, from ``gaps'' in statutory authority in the banking or securities sectors. The fact is that some of the laws enacted in the 1930s in the wake of the Depression, like the Glass-Steagall Act, helped prevent leverage or conflict problems. When they were repealed in order to allow the creation of Citigroup, and to permit other financial firms to expand across traditional legal barriers, we may have gone too far in ``modernizing'' our system without incorporating adequate alternative limits on conflicts and leverage. Other laws from the 1930s, such as the Securities Act of 1933 and the Securities Exchange Act of 1934, have been regularly updated over the years to maintain their relevance in modern markets. Many people are today pointing at ``gaps'' in the regulatory structure, including ``systemic risk authority''. If the Fed hasn't been worried about systemic risk all these years, then people really should be fired. The problems we have experienced grew in plain sight of all our regulators. For the most part, we lacked adequate leadership at major regulatory agencies, not legal jurisdiction. The banking and securities regulators generally had the tools to address the abusive practices, but just didn't use their powers forcefully enough or ask for new authority promptly when they needed it. Oversight of derivatives and swap markets is probably the major exception where firms like AIG were operating far outside of anyone's oversight authority. That is a good reason to refuse to bail out swap counterparties of AIG in my opinion, but we also ought to put formal oversight into place if we are going to force taxpayers to make good on defaulted swaps. Part of the problem was an excessive faith by some regulators in enlightened self interest by banks and securities firms, and an underestimation of the risks posed by compensation practices that encouraged unsustainable leverage. Short term profits went home with the CEOs, while long term risks stayed with the shareholders. There also was a too trusting acceptance of ``modern'' bank internal risk models, which were used to help rationalize dangerous levels of leverage. Some regulators acquiesced to stupid things like global banks running off balance sheet ``SIVs'' in order to try to boost profits and compensation, even if they involved serious potential liquidity risks. Unfortunately, the risk-adjusted Basle capital rules for banks proved too simplistic and ineffective. To be fair, the SEC at the highest levels could have cracked the whip harder on Bear, Lehman, and Merrill, but didn't do so. Rather than simply calling for more authority for people who didn't use the authority they already had, we need to reexamine why our regulators missed so many of the risks staring them in the face. My purpose is not to fault regulators who weren't perfect. I also don't want to obscure the fact that the greatest responsibility for the devastation of our economy should rightly fall on the executives of the firms engaging in wildly risky practices, and the boards that failed to provide effective oversight. However, we will never design sensible reforms if we aren't candid in acknowledging the performance failures all across the system. We can't fix things until we have a good handle on what went wrong. It isn't enough for regulators to write rules and give speeches. More time needs to be spent conducting examinations, analyzing results, discovering problems and, where necessary putting effective limits in place to prevent excessively risky activities. Directors and regulators need backbone, and a willingness to shut down a party that gets out of control. Regulators can't catch all the frauds any more than police can catch all the drug dealers. Nonetheless, when failures happen it shouldn't be acceptable to just ask for more resources without making the necessary corrections first. Regulators need accountability for performance failures just as much as any of us. While we need to demand better effectiveness from regulators, we must not shift the burden of running regulated businesses in a sound and healthy manner from management and the boards of directors that are supposed to oversee their performance. Excessive leverage, compensation without correlation to long term performance, misleading (or fraudulent) accounting and disclosure, wildly overstated asset values, failures to perform basic due diligence, wasteful capital expense and other factors contributed to the financial collapses that devastated investors and undermined confidence in the entire economy. These are all issues that boards are supposed to control, but over and over again boards at AIG, Fannie Mae, Lehman Brothers, Bank of America and other companies didn't address them adequately. In my experience, excessive entrenchment leads many directors to believe they don't need to listen to the shareholders they represent, and who have the most at stake if the board fails to do a good job. The national disaster of self-indulgence in compensation has been opposed by many shareholders, but too many boards feel free to disregard their concerns. It is frankly almost incomprehensible how few directors of firms requiring taxpayer assistance have been forced to step down, even after investors and taxpayers lost billions because directors didn't act prudently. If you allow your CEO to spend $35 billion on an acquisition without meaningful due diligence, for example, you should be replaced as a director without delay. The failure of boards to provide informed and independent oversight badly needs to be addressed both by Congress and the SEC. Taxpayers may have to protect our banking system, but they don't have to protect the bankers who caused their firms to fail or the directors who let them do it without proper oversight. Executives who gambled with the solvency of their firms and failed should be out of a job, and the same is true for the boards that didn't act as required. That is certainly how we handled the failures of the savings and loans. People who gambled and failed found new lines of work. There are few things today that would go farther to produce prudent behavior in the future than forcing the resignation of CEOs and directors when their firms have to take public funds to keep their doors open. It is long overdue to put accountability and personal responsibility front and center back into the system. Since we are going to need vast amounts of future savings and investment, the Committee's efforts to help develop answers to the many tough issues affecting our system could not be more important. I will try to address the issues raised by the Committee's thoughtful letter of invitation, as well as several of my suggestions for reform.A. Investor Protection With $7 trillion in investor losses, it would appear that we have not done enough in the area of investor protection. This was ironically once one of the preeminent strengths of the U.S. market. Investors from around the world invested in the U.S. because we had stronger and better accounting rules, more timely and detailed disclosure, a commitment to openness in corporate governance and above all enforcement of the rules and liability for those that committed illegal practices. Over time our governance standards have come to be weaker than those of many other countries, and our commitment to accuracy in accounting and disclosure has slipped considerably. The SEC's enforcement program in recent years has not been as effective as the times demanded, with too many smaller cases and not enough focus on the largest problems. We frankly spent too much time worrying about the underwriting fees of Wall Street and not enough time worrying about protecting investors from false and misleading information. Investors, those quaint people worried about their retirement, need to stop seeing the savings they worked hard to accumulate wiped out because executives took irresponsible gambles. If we care about generating a higher national savings rate, we need to start paying more attention to the interests of individual and institutional investors and spend less time listening to the CEOs of the very banks who created this mess. We shouldn't ever ignore opportunities to reduce unnecessary regulatory costs, but we can't lose sight of the fact that people who lie, cheat and steal from investors belong in jail. We expect the cops on the beat to arrest street criminals, and we should equally expect the financial cops on the beat to use their muscle to protect the investing public. The record of the SEC in recent years has not been perfect. The Madoff case is a tragic situation that should have been caught sooner, for example. Chairman Schapiro has made a good start to reinvigorating the agency's enforcement programs, and she deserves strong support in beefing up the agency's programs. The SEC is a critical institution, and Congress should not throw away 75 years of SEC experience by stripping the agency of its responsibilities under the guise of creating a ``systemic regulator'' or for any other reason. Make no mistake, as great as it is (and the Fed really is a great institution), the Federal Reserve is not equipped to protect investors. Transferring SEC accounting, disclosure or enforcement programs to the Fed would be a recipe for utter disaster. A strong and effective SEC is good for investors, and good for the health of our economy. If the agency stops behaving like a tiger for investors we need to fix it, not abandon it. There are many things that go into ``investor protection''. To me, the most critical need is for timely and accurate disclosure of material information regarding the performance of public companies. That means issuers should provide robust disclosure of information, and scrupulously accurate financial statements. Overstating the value of assets is never in investor interests, and if the system doesn't require accurate values to be disclosed investors will simply withdraw from the market due to lack of confidence. There must be serious consequences if you falsify asset values and thereby mislead investors no matter how big your company. Good disclosure includes marking liquid securities to market prices, whether or not a bank wishes to hide its mistakes. While care is needed in marking positions to models where there isn't a liquid market, in general the people who try to blame mark to market for the problems of insolvent institutions are simply wrong. The problem is that people bought stuff without considering all the risks, including a collapse of demand or liquidity. That isn't the problem of the yardstick for measurement, it is a problem of incompetent business decisions. If I bought a share of stock at $100 and it falls to $50, that dimunition of value is real, and I can't just wish it away. We need accuracy in accounting, not fairy tales. ``Transparency'' of results to investors is the touchstone of an efficient market, and a vital protection to make sure that investors can accurately evaluate a company and its condition if the information is there and they are willing to do the work. It should never be allowable to lie or mislead investors, and people who do it should expect to be sued no matter what might happen to them in other countries. In my opinion there can be no ``opt-out'' of accountability for fraud and deliberate misstatements of material information. This is a bedrock value of our system and has to be defended even if business lobby groups find accurate disclosure inconvenient. Choice is another core protection for investors. Government shouldn't try to make investment choices for investors, or allocate capital as it might wish. Particularly when it comes to sophisticated pension funds and other institutional investors, they need the right to manage their portfolios as they believe will generate the best returns without artificial limitations. Historically some states have tried to impose ``merit'' regulation in which bureaucrats made investment choices for even the most sophisticated investors. Investment choice is a vital right of investors, subject of course to basic suitability standards, even though we know that investors will sometimes lose. Healthy corporate governance practices are also vital to investors. This means accountability for performance, enforcement of fiduciary duties, maintaining checks and balances, creating sensible and proportionate incentives and many other things. One area of weakness today is excessive entrenchment of boards, and the consequent weakening of accountability for boards that fail to create value. Better corporate governance will over time lead to a stronger companies, and more sustainable earnings growth and wealth creation.B. Systemic Risk and Supervision of Market Participants There appears to be momentum in Washington for creating a ``systemic risk'' regulator, whether the Federal Reserve or some other agency. To me, this is a bad idea, and one that will weaken the overall supervisory system as well as damaging Congressional oversight. There is no single person, and no single agency, that can be omniscient about risk. Risk crops up in limitless forms, and in the most unexpected ways. Risk is as varied as life itself. To me, our system is stronger if every agency is responsible for watching for, and acting to control, systemic risk in its own area of expertise. It needs to be every regulator's responsibility to control risks when they are small, before they get big enough to have ``systemic'' implications. Our current system involves multiple federal and state decisionmakers, and multiple points of view. Like democracy itself, the system is a bit messy and at times leads to unproductive debate or disagreement, particularly among the three different bank regulators. However, Congress and the public have the benefit of hearing the different points of view from the Fed, the Treasury, the FDIC or the SEC, for example. This allows informed debate, and produces better decisions than would be the case if those different points of view were concealed from view within a single agency expressing only one ``official'' opinion. The alternative in some countries is a single regulator. Japan's Ministry of Finance, for example, traditionally brought banking, securities and insurance regulation under one roof. However, Japan still has had as many problems as other markets. Making agencies bigger often makes them less flexible, and more prone to complacency and mistakes. This can create inefficiency. More importantly, it can create systemic risk because if the regulatory ``czar'' proves wrong, every part of the system will be vulnerable to damage. Some regulators prove more effective than others, so a system with only one pair of eyes watching for risk is weaker than a system in which lots of people are watching. What counts is that somebody rings an alarm when problems are small enough to fix, not who pushes the button. Of course risk often comes about not just by the activity itself, but how it is conducted. Ultimately any economic activity can be conducted in a manner that creates risk, and hence there can be ``systemic'' risk anywhere. It won't work to try to assign planning for every potential risk in the economy to a single agency unless we want a centrally planned economy like the old Soviet Union. This is an area where interagency cooperation is the better solution, as it doesn't create the enormous new risks of concentration of power and the dangers of a single agency being asleep or flat out wrong as would a ``systemic risk'' supervisor. Supervision of market participants is best left in the hands of agencies that have the most experience with the particular type of activity, just as doctors and dentists need to be overseen by people who understand the practice of medicine or dentistry. It is particularly hard for me to see a case that any single group of regulators did such a good job that they deserve becoming the Uber Regulator of the country. The bank regulators missed massive problems at Wachovia, WaMu, Citicorp and other institutions. Insurance regulators missed the problems at AIG. The SEC missed some of the problems at Bear, Lehman and Merrill. There have been enough mistakes to go around, and I don't see evidence that putting all supervision under a monopoly agency will improve insight or judgment. Unfortunately, the reverse effect is more likely.C. Common Supervisory Rules During my time as SEC Chairman, I was pressured (mostly by foreign regulators) to agree to a new ``global'' capital rule that would have reduced the SEC's limits on leverage for the major U.S. securities firms by as much as 90 percent. The proposed new ``global'' capital rule on market risks represented a good theoretical endeavor, but it was too simplistic and unreliable in practice. It would have allowed firms that were long railroad stocks and short airline stocks to carry zero capital against those positions, even though they were not a true hedge. The ``netting'' arrangements in the proposed global rule weren't economically realistic, and as a result the rule itself was largely a rationalization for allowing firms to lever themselves to a much greater degree than the SEC allowed at that time. In addition, the rule didn't distinguish at all between securities firms that were marking securities portfolios to market, and banks that were using cost accounting, which meant that the capital required would vary dramatically from firm to firm for identical portfolio positions. The SEC staff and I believed that this new standard would have undercut the stability and solvency of the major U.S. securities firms. We didn't object to banking authorities adopting whatever standards they thought were appropriate, but we weren't willing to be stampeded into adopting something that we didn't believe would work. At the time, much of the force for pushing through a new rule came from the Basle banking committee, who wanted to be seen to be doing something relevant to market risk even if the proposed rule had problems. It was my rather contrarian view then, and remains so today, that adopting a ``global'' rule that is ineffective is worse than no global rule at all. This is because if all the world's major markets adopt the same rule and it fails, then financial contagion can spread throughout the world, not just one country. Global harmonization of standards creates some economic benefits by making operations in multiple countries more convenient and less complicated for global banks. These benefits must however be weighed against the risks that a ``one size fits all'' global rule may not work well in many individual markets because of differences in volatility, market size, the nature of the investor base or other economically relevant factors. Countries where the local regulator goes beyond the ``global'' norms to impose tougher standards on local banks, as the Bank of Spain did with reserves for derivatives and certain types of loans in the past few years, are better protected than those that have only a ``global'' standard that was worked out in international horse trading. When we back tested this proposed new lower capital standard against historic trading data from the 1987 Crash, the SEC staff found that the theoretical asset correlations didn't always work. As a result, firms that had followed the proposed rule would have failed (unlike the actual experience, where major firms did not fail because the SEC capital standards gave enough buffer for losses to prevent failures) when the market came under unexpected and extreme stress. My colleagues and I simply said ``No'' and kept our capital standards high in that case because we didn't believe the proposed new standard was ready for use. Here my fellow Commissioners and I believed in the KISS principle. It is a certainty that over time markets will encounter problems of liquidity or valuation that nobody anticipated. If you have enough capital and are conservatively financed, you will survive and won't risk massive loss to your investors, clients or taxpayers. This experience illustrates to me the very real risks that will be created by a ``systemic'' regulator if we try to do that, as well as from further ``globalization'' of regulation that makes the job of writing rules targeted narrowly to control specific risks more cumbersome. Active coordination across agencies and borders is vital to make sure that information and perspectives on risk are effectively communicated. Colleges of regulators work, and add real value. However, going beyond that to impose uniformity, especially on something like ``systemic risk'' that isn't even defined, quite possibly will end up making regulation more costly, less flexible and potentially weaker rather than stronger. An agency will adopt rules that sound great, but just may not work for one of a million reasons. That is a particular danger if the ``systemic'' regulator is free to overrule other agencies with more specific knowledge. The first thing a czar of ``systemic risk'' is likely to do is to create new systemic risk because whatever that agency chooses to look at may take on immediate ``too big to fail'' perceptions, and the moral hazards that go with that status. My preference would be to have a unified or lead banking supervisory agency, and active dialogue and discussion among agencies rather than putting the entire economy in one agency's straightjacket. There will inevitably also be risks to the independence of the Fed if it performs a systemic regulator's role, because you cannot allow an agency to impose needless costs on the entire economy without political accountability. When they fail to do anything about the next subprime issue, inevitably the Fed's stature will be tarnished. To me, we would lose a great deal from distracting the Fed's focus from monetary policy and stability of prices to have them traipsing around the country trying to figure out what risks GE or IBM pose to the economy.D. Reorganization of Failed Firms As SEC Chairman, I handled the 1990 closure and bankruptcy filing of Drexel Burnham Lambert, then one of the largest U.S. securities firms. We were able to prevent any losses to Drexel customers without cost to the taxpayers in our closure of Drexel. We froze and then sold the firm's regulated broker dealer, transferring customer funds and accounts to a new owner without loss. Having protected the regulated entity and its customers, we refused to provide assistance to the holding company parent that had a large ``unregulated'' portfolio of junk bonds financed by sophisticated investors (including several foreign central banks that were doing gold repos with Drexel's holding company parent). Though there were those who wanted us to bail Drexel out, we forced the holding company into Chapter 11 instead, and let the courts sort out the claims. A similar approach would work today for AIG and its unregulated derivative products unit, which could be left to sort out its claims from swaps customers in bankruptcy without taxpayer financing. This approach of stopping the safety net at regulated subsidiaries can be very helpful in unwinding failed firms where there are both regulated and unregulated entities at less cost and less damage to market disciplines than excessively broad bailouts.E. Risk Management Risk management is an important responsibility of every firm, and every regulator. However, a dangerous by-product of belief that we can manage risk in a very sophisticated manner is a willingness to tolerate higher levels of risk. After all, as long as risk is being ``managed'' it ought to be ok to have more of it. Ultimately unanticipated problems arise that cause even highly sophisticated models to fail to predict real life accurately. Every risk management system, and every risk adjusted capital rule, needs a minimum standard that is simple and comprehensive. Tangible capital as a percentage of total assets is a more comprehensive, and more reliable, measure of capital than the highly engineered ``Tier One'' Basle capital standards. I believe Congress should seriously study mandating that U.S. banking regulators establish a minimum percentage of tangible capital to total assets even if international capital rules might allow a lower number. Creating a ``solvency floor'' would have prevented at least some of the failures we have experienced.F. Credit Rating Problems The credit rating agencies failed in evaluating the risk of ``structured products''. In part this reflects inherent conflicts of interest in the ``for profit'' structure of the rating agencies and their reliance on fees from people seeking ratings in order to generate their own earnings growth. Unfortunately a ``AAA'' rating acts as an effective laughing gas that leads many investors to avoid necessary due diligence or healthy levels of skepticism. If the structured mortgage instruments that devastated the economies of the western world had been rated BBB, or even A-, a great many of the people (including boards and regulators) who got clobbered would have looked more carefully at the risks, and bought less. There is a serious issue of conflict of interest in getting paid to legitimize the risk in a highly complex ``structured'' product laced with derivatives.G. Levered Short Selling Short selling doesn't have the same benefit to the public as normal long investing. While short selling creates liquidity and shouldn't be prohibited, it doesn't have to be favored by regulators either. In my opinion the SEC should never have eliminated the uptick rule, which inhibits to some degree the ability of short sellers to step on the market's neck when it is down. Beyond that, I believe that regulators should seriously consider imposing margin requirements as high as 100 percent on short positions. Leveraging short positions simply creates extreme downward pressure on markets, and may seriously impair market stability.H. Credit Default Swaps The CDS market is large, but it lacks transparency. It may also involve unhealthy incentives to buy securities without adequate capital or study on the false presumption that you can always buy ``protection'' against default later. We don't appear to have enough capital for our primary financial institutions such as banks, insurance companies and brokerage firms, and there surely isn't enough capital available to ``insure'' every risk in the markets. But if the risks aren't really insured, then what are the swaps? Another thing that is troubling is the ability to use the CDS market for highly levered speculative bets that may create incentives to manipulate other markets. I can't buy fire insurance on my neighbor's house due to obvious concerns about not inciting arson. Yet hedge funds that didn't own any Lehman debt were free to hold default swap positions which would prove highly profitable if Lehman failed, and also to engage in heavy short selling in Lehman shares. I am concerned about allowing that much temptation in an unregulated and very opaque market, especially if taxpayers are supposed to underwrite it (although I can't comprehend that either). This is a market that certainly would benefit from greater oversight and transparency, particularly as to counterparty risk. It would be worthwhile for an interagency group to consider appropriate limits on issuance or reliance on credit default swaps by regulated firms within the ``official'' safety net. There are huge and very murky risks in this market, and it might be prudent to consider limiting the dependence of regulated firms on this opaque corner of the markets.I. Regulatory Reform Immediately prior to my service as SEC Chairman, I served as Assistant to the President in the White House under President George H.W. Bush where I helped lead the Administration's highly successful 1989 program to deal with the +$1 Trillion savings and loan crisis. This program was embodied in legislation called FIRREA that was passed by Congress in the summer of 1989. As some of you will remember, the savings and loan crisis, like our current crisis, had grown for years without effective government intervention to defuse the mortgage bomb of that era. Among other things, we created the Resolution Trust Corporation to take hundreds of billions in toxic mortgage assets out of bankrupt institutions, repackage them into larger and more coherent blocks of assets, and sell them back into private ownership as quickly as possible. We designed our intervention in the banking system to operate swiftly, and to recycle bad assets as quickly as possible rather than trying to hold assets hoping they would ultimately go up in value. Generally, troubled assets go down, not up, in value while under government ownership. Believing that the ice cube is always melting, we designed our intervention for speed. We also didn't believe that any zombie banks should be allowed to linger on government life support competing with healthier firms that had not bankrupted themselves. We didn't give bailouts to anyone, but we did provide fast funerals. One thing President Bush (41) was adamant about was that the taxpayers should never have had to divert hundreds of billions of dollars in tax revenues to paying for the mistakes and greed of bankers. I quite vividly remember his unambiguous instructions to me to design regulatory reforms to go along with the financial intervention so that ``as much as humanly possible we make sure this doesn't happen again.'' As part of that mandate, we imposed strict capital and accounting standards on the S&Ls, merged the FSLIC into the FDIC and beefed up its funding, established important new criminal laws (and the funding to enforce them), and abolished the former regulatory body, the Federal Home Loan Bank Board, which had failed in its supervisory responsibilities. Hopefully the Treasury's newly announced Public-Private Program for purchasing distressed bank assets will work as well as the RTC ultimately did. The principles of using private sector funding and workout expertise are similar, and this is an encouraging attempt to help unlock the current system. Hopefully we will also eventually look to marrying taxpayer TARP money with greater accountability and more effective oversight as we did then.II. Specific Reforms In response to the Committee's request, set forth below are several specific changes in law that I believe would improve the current system of investor protection and regulation of securities markets. 1. Merge the SEC, CFTC, and PCAOB into a single agency that oversees trading in securities, futures, commodities and hybrid instruments. That agency should also set disclosure standards for issuers and the related accounting and audit standards. Most importantly, this agency would be primarily focused on enforcing applicable legal standards as the SEC has historically done. These closely intertwined functions have nothing to do with bank regulation, but a great deal to do with each other. I do not suggest a merger out of any lack of respect for each of the three agencies. However, a merger would help eliminate overlap and duplication that wastes public resources, and also reduces effectiveness. If a similar consolidation occurred of the bank supervisory programs of the Fed, the Treasury and the FDIC, then we would have a strong agency regulating banks, and another strong agency regulating public companies, auditors, and trading markets. 2. Allow the five (or ten) largest shareholders of any public company who have owned shares for more than 1 year to nominate up to three directors for inclusion on any public company's proxy statement. Overly entrenched boards have widely failed to protect shareholder interests for the simple reason that they sometimes think more about their own tenure than the interests of the people they are supposed to be protecting. This provision would give ``proxy access'' to shareholder candidates without the cost and distraction of hostile proxy contests. At the same time, any such nomination would require support from a majority of shares held by the largest holders, thereby protecting against narrow special interest campaigns. This reform would make it easier for the largest shareowners to get boards to deal with excessive risks, poor performance, excessive compensation and other issues that impair shareholder interests. 3. Reverse or suspend the SEC decision to abandon U.S. accounting standards and to adopt so-called ``International Financial Reporting Standards'' for publicly traded firms headquartered in the U.S. At a time of the greatest investor losses in history and enormous economic stress, forcing every company to undergo an expensive transition to a new set of accounting standards that are generally less transparent than existing U.S. standards is not in investor's interests. This will avoid considerable unproductive effort at a time businesses need to minimize costs and focus on economic growth, not accounting changes. Investors need more transparency, not less, and the SEC should not abdicate its role of deciding on appropriate accounting and auditing standards for firms publicly traded in the U.S. 4. Broaden the ability of shareowners to put nonbinding resolutions on any topic related to a company's business on its annual proxy statement, including any proposal by shareholders relating to the manner of voting on directors, charter amendments and other issues. Legislation would clarify the confusing law relating to the ability of shareholders to hold a referendum on whether a company should adopt majority voting for directors, for example. Shareholders own the company, and in the internet age there is no reason to limit what shareholders can discuss, or how they may choose to conduct elections for directors. SEC resources should no longer be devoted to arbitrating whether shareholders should be allowed to vote on resolutions germane to a company's business. 5. Prohibit ``golden parachute'' payments to the CEO or other senior officers of any public company, in the same way that Sarbanes Oxley prohibits loans to such executives. Golden parachutes have proven to be extraordinarily abusive to shareholders, and boards have proven themselves unable to control excessive payouts. Eliminating supercharged severance will not unduly prejudice any company's ability to recruit since no company will be able to offer or make abusive awards to failed executives. This provision would NOT prohibit signing bonuses or annual bonuses, as it would solely apply to payouts to executives who are departing rather than continuing to work. The fact is that paying failed executives to walk out the door after damaging or destroying their company is wrong, and it is part of the culture of disregard of shareholder interests that needs to change. 6. Split the roles of Chairman of the Board and CEO in any company that receives federal taxpayer funds, or that operates under federal financial regulation. The traditional model of a Chairman and CEO combined in one individual weakens checks and balances and increases risks to shareholders compared with firms that separate those positions. Splitting these roles and requiring a prior shareholder vote to reintegrate them would reduce risks and improve investor protection. 7. Eliminate broker votes for directors unless any such vote is at the specific direction of a client. Brokers should not cast votes on an uninstructed basis to avoid unwarranted entrenchment of incumbents or tipping the outcome of elections under federal proxy rules. Indeed, it may be time to consider a broader Shareholder Voting Rights Act to address many barriers to effective shareholder exercise of the vote. 8. Establish a special ``systemic bankruptcy'' court composed of federal District or Circuit Court judges with prior experience in large bankruptcy or receivership cases similar to the Foreign Intelligence Surveillance Court. This new Systemic Court would handle the largest and systemically important bankruptcies with enhanced powers for extraordinary speed and restructuring powers. Use of such a Systemic Court would help limit ad hoc decisions by administrative agencies including the Fed or Treasury in handling large financial institution failures and treatment of different types of classes of securities from company to company. Utilizing a court with enhanced and expedited reorganization powers would allow reorganization or conservatorship proceedings rather than nationalization, and would facilitate the ability to break up and reorganize the largest failed firms under highly expedited Court supervision. Fed and Treasury officials would be able to focus on liquidity assistance under the aegis of the Systemic Court, which would allow enhanced priorities for taxpayer funds and control of compensation and other nonessential expenses. The Systemic Court should be authorized to appoint a corporate monitor in any case pending before it to control compensation expense or other issues. 9. Establish effective and meaningful limitations on leverage in purchases of securities and derivative instruments where any person or entity is borrowing from a federally supervised bank or securities firm, or where such firms are establishing positions for their own account. 10. Establish a permanent insurance program or liquidity facility for money market funds. Given recent experience, the uninsured nature of MMFs is an uncomfortably large risk to market stability. 11. Establish strict liability for any rating agency if it awards a AAA or comparable other top rating grade to a security of a nonsovereign issuer that defaults within 3 years of issuance. While I would not create private rights of action for any other rating decisions, rating agencies should appreciate that awarding a AAA overrides many investor's normal diligence processes, such that liability is warranted if the agency proves to be wrong. The SEC should generally revoke commercial ratings as an element of its disclosure or other regulations. 12. Eliminate the deductibility of mortgage interest and replace it with deductibility of mortgage principal payments with appropriate overall limits. This would create incentives for paying off family debt, not perpetuating the maximum possible level of mortgage debt. At the same time, such a provision would result in significant new liquidity for banks as borrowers repaid performing mortgage loans. Middle class families would see real wealth increase if deductibility allows the effective duration of home mortgage loans to be reduced from 30 years to 15 years, for example, saving an average family hundreds of thousands of dollars in interest. Federal assistance would help families reduce the level of their debt, thereby strengthening the economy and boosting savings. Thank you for your consideration of these views and ideas. CHRG-110hhrg41184--127 Mr. Royce," Thank you, Mr. Chairman. I wanted to ask Chairman Bernanke a question. To date, the U.S. banking system, I think, has handled the stress originated in the housing sector. But I think this is a result of these institutions being adequately capitalized prior to the turmoil that we found ourselves into. And given the ability of these institutions now to adequately handle that stress with existing leverage ratio requirements, I wondered if it caused you to rethink your attitude toward implementation of Basel II? " CHRG-111shrg52619--196 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM DANIEL K. TARULLOQ.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. The best argument for maintaining supervision of consumer protection in the same agency that provides safety and soundness and supervision is that the two are linked both substantiveIy and practically. Thus there are substantial efficiency and information advantages from having the two functions housed in the same agency. For example, risk assessments related to an institution's management of consumer compliance functions are closely linked with other safety and soundness risks, and factor in to assessments of bank management and financial, legal, and reputation risks. Likewise, evaluations of management or controls in lending processes in safety and soundness examinations factor in to assessments of compliance risk management. Supervisory assessments for both safety and soundness and consumer protection, as well as enforcement actions or supervisory follow up, are best made with the benefit of the broader context of the entire organization's risks and capacity. Furthermore, determinations that certain products or practices are ``unfair and deceptive'' in some cases require an understanding of how products are priced, offered, and marketed in an individual institution. This information is best obtained through supervisory monitoring and examinations. A related point is that responsibility for prudential and consumer compliance examinations and enforcement benefits consumer protection rulewriting responsibilities. Examiners are often the first government officials to see problems with the application and implementation of rules in consumer transactions. Examiners are an important source of expertise in banking operations and lending activities, and they are trained to understand the interplay of all the risks facing individual banking organizations. The best argument for an independent consumer agency within the financial regulatory structure is that it will focus single-mindedly on consumer protection as its primary mission. The argument is that the leadership of an agency with multiple functions may trade one off against the other one, at times, be distracted by responsibilities in one area and less attentive to problems in the other. A corollary of this basic point is that the agency would be more inclined to act to deter use of harmful financial products and, if properly structured and funded, may be less susceptible to the sway of powerful industry influences. Proponents of a separate agency also argue that a single consumer regulator responsible for monitoring and enforcing compliance would end the competition among regulatory agencies that they believe promotes a ``competition in laxity'' for fear that supervised entities will engage in charter shopping. Apart from the relative merits of the foregoing arguments, two points of context are probably worth making: First, any agency assigned rulewriting authority will be effective only if it has considerable expertise in consumer credit markets, retail payments, banking operations, and economic analysis. Successful rulewriting requires an understanding of the likely effects of protections to prevent abuses on the availability of responsible and affordable credit. Second, the policies and performance of both an ``integrated'' agency and a free-standing consumer protection agency will depend importantly on the leadership appointed to head those entities.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. The problems created by AIG provide perhaps the best case study in showing the need for regulatory reform, enhanced consolidated supervision of institutions and business lines that perform the same function, and an explicit regulatory emphasis on systemic risk. Importantly, some of the largest counterparties to AIG were foreign institutions and investments banks not directly supervised by the Federal Reserve. Even then, however, established industry practices prior to the crisis among financial institution counterparties with high credit ratings called for little exchange of initial margins on OTC derivative contracts. Such practices and AIG's high credit rating thus inhibited the checks and balances initial margins would have placed on AIG's positions. Federal Reserve supervisory reviews of counterparty credit risk exposures at individual firms prior to the crisis did not flag AIG as posing significant counterparty credit risk since AIG was regularly able to post its variation margins on OTC derivative contracts thus reducing its exposure. Moreover, AIG spread its exposures across a number of different counterparties and instruments. The over-reliance on credit ratings in a number of areas leading up to the current crisis, as well as the need for better information on market-wide exposures in the OTC derivatives market, have motivated supervisory efforts to move the industry to the use of central clearing parties and the implementation of a data warehouse on OTC derivative transactions. This effort, reinforced with appropriate statutory authority, is a critical part of a systemic risk agenda. The Federal Reserve actively participates on an insurance working group, which includes other federal banking and thrift agencies and the National Association of Insurance Commissioners (NAIC). The working group meets quarterly to discuss developments in the insurance and banking sectors, legislative developments, and other topics of particular significant. In addition, to the working group, the Federal Reserve communicates regularly with the NAIC and insurance regulators on specific matters. With respect to the SEC, the Federal Reserve has information sharing arrangements in place for companies under our supervision. Since the Federal Reserve had no supervisory responsibility for AIG, we did not discuss the company or its operations with either the state insurance regulators or the SEC until the time of our initial discount window loan in September 2008. Credit default swap contracts may be centrally cleared (whether they are traded over the counter or listed on an exchange) only if they are sufficiently standardized. Presently, sufficiently standardized CDS contracts comprise those written on CDS indices, on tranches of CDS indices, and on some corporate single-name entities. The CDS contracts at the heart of the AIG collapse were written mainly on tranches of ABS CDOs, which are generally individually tailored (e.g., bespoke transactions) in nature and therefore not feasible either for exchange trading or central clearing. For such nonstandard transactions we are strongly advocating the use of centralized trade repositories, which would maintain official records of all noncentrally-cleared CDS deals. It is important to note that the availability of information on complex deals in a central repository or otherwise is necessary but not sufficient for fully understanding the risks of these positions. Even if additional information on AIG's positions had been available from trade repositories and other sources, the positions would have been as difficult to value and monitor for risk without considerable additional analysis. Most critically, both trade repositories and clearinghouses provide information on open CDS contracts. Of most value and interest to regulators are the open interest in CDS written on specific underliers and the open positions of a given entity vis-a-vis its counterparties. Both could provide regulators with information on aggregate and participant exposures in near real time. A clearinghouse could in addition provide information on collateral against these exposures and the CCP's valuation of the contracts cleared. An exchange on top of a clearinghouse would be able to provide real-time information on trading interest in terms of prices and volumes, which could be used by regulators to monitor market activity.Q.3. Systemic Risk Regulation--The Federal Reserve and the OTS currently have consolidated supervisory authority over bank and thrift holding companies respectively. This authority grants the regulators broad powers to regulate some of our Nation's largest, most complex firms, yet some of these firms have failed or are deeply troubled. Mr. Tarullo, do you believe there were failures of the Federal Reserve's holding company supervision regime and, if so, what would be different under a new systemic risk regulatory scheme?A.3. I expect that when the history of the financial crisis is finally written, culpability will be shared by essentially every part of the government responsible for constructing and implementing financial regulation, including the Federal Reserve. Since just about all financial institutions have been adversely affected by the financial crisis--not just those that have failed--all supervisors have lessons to learn from this crisis. As to what will be different going forward, I would suggest the following: First, the Federal Reserve is already implementing a number of changes, such as enhancing risk identification processes to more quickly detect emerging risks. The Board is also improving the processes to issue supervisory guidance and policies to make them more timely and effective. In 2008 the Board issued supervisory guidance on consolidated supervision to clarify the Federal Reserve's role as consolidated supervisor and to assist the examination staff as they carry out supervision of banking institutions, particularly large, complex firms with multiple legal entities. Second, I would hope that both statutory provisions and administrative practices would change so as to facilitate a truly comprehensive approach to consolidated supervision. This would include, among other things, amending the Gramm-Leach-Bliley Act, whose emphasis on ``functional regulation'' for prudential purposes is at odds with the comprehensive approach that is needed to supervise large, complex institutions effectively for safety and soundness and systemic risks. For example, the Act places certain limits on the Federal Reserve's ability to examine or obtain reports from functionally regulated subsidiaries of a bank holding company. Third, our increasing focus on risks that are created across institutions and in interactions among institutions should improve identification of incipient risks within specific institutions that may not be so evident based on examination of a single firm. In this regard, the Federal Reserve is expanding and refining the use of horizontal supervisory reviews. An authority charged with systemic risk regulatory tasks would presumably build on this kind of approach, but it is also important in more conventional, institution-specific consolidated supervision. Fourth, I believe it is fair to say that there is a different orientation towards regulation and supervision within the current Board than may have been the case at times in the past.Q.4. 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.4. The current crisis has proven correct those who have maintained in recent years that liquidity risk management needed considerably more attention from banks, holding companies, and supervisors. As will be described below, a number of steps are already being taken to address this need, but additional analysis will clearly be needed. At the outset, though, it is worth emphasizing that maturity transformation through adequately controlled maturity mismatches is an important economic function that banks provide in promoting overall economic growth. Indeed, the current problems did not arise solely from balance sheet maturity mismatches that banks carried into the current crisis. For almost 2 years, many financial institutions have been unable to roll over short-term and maturing intermediate-term funding or have incurred maturity mismatches primarily because of their inability to obtain longer-term funds as a result of solvency concerns in the market. This has been exacerbated by some institutions having to take onto their balance sheets assets that were previously considered off-balance sheet. To elaborate this point, it is important to note that most of the serious mismatches that led to significant ``tail'' liquidity risks occurred in instruments and activities outside of traditional bank lending and borrowing businesses. The most serious mismatches encountered were engineered into various types of financial products and securitization vehicles such as structured investment vehicles (SIVs), variable rate demand notes (VRDNs) and other products sold to institutional and retail customers. In addition, a number of managed stable value investment products such as registered money market mutual funds and unregistered stable value investment accounts and hedge funds undertook significant mismatches that compromised their integrity. Many of these mismatches were transferred to banking organizations during the crisis through contractual commitments to extend liquidity to such vehicles and products. Where no such contractual commitments existed, assets came onto banks' balance sheets as a result of their decisions to support sponsored securitization vehicles, customer funding products, and investment management funds in the interest of mitigating the banks' brand reputation risks. However, such occurrences do not minimize the significant mismatches that occurred through financial institutions', and their hedge fund customers', significant use of short-term repurchase agreements and reverse repurchase agreements to finance significant potions off their dealer inventories and trading positions. Such systemic reliance on short-term funding placed significant pressures on the triparty repo market. The task for regulators and policy makers is to ensure that any mismatches taken by banking organizations are appropriately managed and controlled. The tools used by supervisors to achieve this goal include the clear articulation of supervisory expectations surrounding sound practices for liquidity risk management and effective on-site assessment as to whether institutions are complying with those expectations. In an effort to strengthen these tools, supervisors have taken a number of steps. In September 2008 the Basel Committee on Bank Supervision (BCBS) issued a revised set of international principles on liquidity risk management. The U.S. bank regulatory agencies plan to issue joint interagency guidance endorsing those principles and providing a single set of U.S. supervisory expectations that aggregates well-established guidance issued by each agency in the past. Both the international and U.S. guidance, which highlight the need for banks to assess the liquidity risk embedded in off-balance sheet exposures, should re-enforce both banks' efforts to enhance their liquidity risk management processes and supervisory actions to improve oversight of these processes. In addition, the BCBS currently has efforts underway to establish international standards on liquidity risk exposures that is expected to be issued for comment in the second half of 2009. Such standards have the potential for setting the potential limits on maturity mismatches and requirements for more stable funding of dealer operations, while acknowledging the important role maturity mismatches play in promoting economic growth.Q.5. What Is Really Off-Balance Sheet--Chairman Bair noted that structured investment vehicles (SIVs) played an important role in funding credit risk that are at the core of our current crisis. While the banks used the SIVs to get assets of their balance sheet and avoid capital requirements, they ultimately wound up reabsorbing assets from these SIVs. Why did the institutions bring these assets back on their balance sheet? Was there a discussion between the OCC and those with these off-balance sheet assets about forcing the investor to take the loss? How much of these assets are now being supported by the Treasury and the FDIC? Based on this experience, would you recommend a different regulatory treatment for similar transactions in the future? What about accounting treatment?A.5. Companies that sponsored SIVs generally acted as investment managers for the SIVs and funded holdings of longer-term assets with short-term commercial paper and medium-term notes. As the asset holdings began to experience market value declines and the liquidity for commercial paper offerings deteriorated, SIVs faced ratings pressure on outstanding debt. In addition, SIV sponsors faced legal and reputational risk as losses began accruing to third-party holders of equity interests in the SIVs. Market events caused some SIV sponsors to reconsider their interests in the vehicles they sponsored and to conclude that they were the primary beneficiary as defined in FASB Interpretation No. 46(R), which required them to consolidate the related SIVs. In addition, market events caused some SIV sponsors to commit formally to support SIVs through credit or liquidity facilities with the intention of maintaining credit ratings on outstanding senior debt. Those additional commitments caused the sponsors to conclude that they were the primary beneficiary of the related vehicles and, therefore, to consolidate. Very few U.S. banks consolidated SIV assets in 2007 and 2008. Citigroup disclosed in their 2008 Annual Report that $6.4 billion in SIV assets were part of an agreed asset pool covered in the U.S. government loss sharing arrangement announced November 23, 2008. We are not aware of other material direct support of SIV assets through the Treasury Department or the FDIC. Recent events have demonstrated the need for supervisors and banks to better assess risks associated with off-balance sheet exposures. The Federal Reserve participated in the development of proposed guidance published by the BCBS in January 2009, to strengthen supervisory expectations for capturing firm-wide risk concentrations arising from both on- and off-balance-sheet exposures. These include both contractual exposures, as well as the potential impact on overall risk, capital, and liquidity of noncontractual exposures such as reputational risk exposure to off-balance-sheet vehicles and asset management activities. Exercises to evaluate possible additional supervisory and regulatory changes to the requirements for off-balance-sheet exposures are ongoing and include the BCBS efforts to develop international standards surrounding banks' liquidity risk profiles. The Federal Reserve supports recent efforts by the Financial Accounting Standards Board to amend and clarify the accounting treatment for off-balance-sheet vehicles such as SIVs, securitization trusts, and structured finance conduits. We applauded the FASB for requiring additional disclosure of such entities in public company financials starting with year-end 2008 reports, as well. We are hopeful that the amended accounting guidance for consolidation of special purpose entities like SIVs will result in consistent application in practice and enhanced transparency. That outcome would permit financial statement users, including regulators, to assess potential future risks facing financial institutions by virtue of the securitization and structured finance activities in which it engages.Q.6. 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?A.6. The Board of Governors has the statutory responsibility for supervising bank holding companies, state member banks, and the other banking organizations for which the Federal Reserve System has supervisory authority under the Bank Holding Company Act, the Federal Reserve Act, and other federal laws. See, e.g., 12 U.S.C. 248(a) (state member banks), 1844 (bank holding companies), and 3106(c) (U.S. branches and agencies of foreign banks). Although the Board has delegated authority to the Reserve Banks to conduct many of the Board's supervisory functions with respect to banking organizations, applicable regulations and policies are adopted by the Board alone. The Reserve Banks conduct supervisory activities subject to oversight and monitoring by the Board. It is my expectation that the Board will exercise this oversight vigorously. The recently completed Supervisory Capital Assessment Program (SCAP) provides an excellent example of how this oversight and interaction can operate effectively in practice. The SCAP process was a critically important part of the government's efforts to promote financial stability and ensure that the largest banking organizations have sufficient capital to continue providing credit to households and businesses even under adverse economic conditions. The Board played a lead and active role in the design of the SCAP, the coordination and implementation of program policies, and the assessment of results across all Federal Reserve districts. These efforts were instrumental in ensuring that the SCAP was rigorous, comprehensive, transparent, effective, and uniformly applied. The Board is considering ways to apply the lessons learned from the SCAP to the Federal Reserve's regular supervisory activities to make them stronger, more effective, and more consistent across districts.Q.7. 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.7. As we have seen in the current financial crisis, large, complex, interconnected financial firms pose significant challenges to supervisors. Policymakers have strong incentives to prevent the failure of such firms because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm will receive special government assistance if it becomes troubled has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow in size and complexity, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, of course, the government rescues of such firms are potentially very costly to taxpayers. Improved resolution procedures for systemically important financial firms would help reduce the too-big-to-fail problem in two ways. First, such procedures would visibly provide the authorities with the legal tools needed to manage the failure of a systemically important firm while still ensuring that creditors and counterparties suffer appropriate losses in the event of the firm's failure. As a result, creditors and counterparties should have greater incentives to impose market discipline on financial firms. Second, by giving the government options other than general support to keep a distressed firm operating, resolution procedures should give the managers of systemically important firms somewhat better incentives to limit risk taking and avoid failure. While resolution authority of this sort is an important piece of an agenda to control systemic risk, it is no panacea. In the first place, resolving a large, complex financial institution is a completely different task from resolving a small or medium-sized bank. No part of the U.S. Government has experience in this task. Although one or more agencies could acquire relevant expertise as needed, we cannot be certain how this resolution mechanism would operate in practice. Second, precisely because of the uncertainties that will, at least for a time, surround a statutory mechanism of this sort, there must also be effective supervision and regulation of these institutions that is targeted more directly at their systemic importance.Q.8. 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.8. There is a good bit of evidence that current capital standards, accounting rules, certain other regulations, and even deposit insurance premiums have made the financial sector excessively pro-cyclical--that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, thereby intensifying cyclical changes. For example, capital regulations require that banks' capital ratios meet or exceed fixed minimum standards in order for the bank to be considered safe and sound by regulators. Because banks typically find raising capital to be difficult in economic downturns or periods of financial stress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment. As I noted in my testimony, the Federal Reserve is working with other U.S. and foreign supervisors to strengthen the existing capital rules to achieve a higher level and quality of required capital. As one part of this overall effort, we have been assessing various proposals for mitigating the pro-cyclical effects of existing capital rules, including dynamic provisioning or a requirement that financial institutions establish strong capital buffers above current regulatory minimums in good times, so that they can weather financial market stress and continue to meet customer credit needs. This is but one of a number of important ways in which the current pro-cyclical features of financial regulation could be modified, with the aim of counteracting rather than exacerbating the effects of financial stress.Q.9. 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.9. As you point out, the Federal Reserve has for many years worked with international organizations such as the Basel Committee on Banking Supervision, the Financial Stability Forum (now the Financial Stability Board), the Joint Forum and others on matters of mutual interest. Our participation reflects our long-held belief, reinforced by the current financial crisis, that the international dimensions of financial supervision and regulation and financial stability are critical to the health and stability of the U.S. financial system and economy, as well as to the competitiveness of our financial firms. Thus, it is very much in the self-interest of the United States to play an active role in international forums. Our approach in these groups has not been on the development of supranational authorities. Rather, it has been on the voluntary collection and sharing of information, the open discussion of views, the development of international contacts and knowledge, the transfer of technical expertise, cooperation in supervising globally active financial firms, and agreements an basic substantive rules such as capital requirements. As evidenced in the activities of the G20 and the earlier-mentioned international fora, the extraordinary harm worked by the current financial crisis on an international scale suggests the need for continued evolution of these approaches to ensure the stability of major financial firms and systems around the world.Q.10. Consolidated Supervised Entities--Mr. Tarullo, in your testimony you noted that ``the SEC was forced to rely on a voluntary regime'' because it lacked the statutory authority to act as a consolidated supervisor. Who forced the SEC to set up the voluntary regime? Was it the firm that wanted to avoid being subject to a more rigorous consolidated supervision regime?A.10. Under the Securities Exchange Act of 1934 (15 U.S.C. 78a, et seq.), the Securities and Exchange Commission (SEC) has broad supervisory authority over SEC-registered broker-dealers, but only limited authority with respect to a company that controls a registered broker-dealer. See 15 U.S.C. 78o and 78q(h). In 2002, the European Union (EU) adopted a directive that required banking groups and financial conglomerates based outside the EU to receive, by August 2004, a determination that the financial group was subject to consolidated supervision by its home country authorities in a manner equivalent to that required by the EU for EU-based financial groups. If a financial group could not obtain such a determination, the directive permitted EU authorities to take a range of actions with respect to the non-EU financial group, including requiring additional reports from the group or, potentially, requiring the group to reorganize all its EU operations into a single EU holding company that would be subject to consolidated supervision by a national regulator within the EU. See Directive 2002/87/EC of the European Parliament and of the Council of 16 (Dec. 2002). After this directive was adopted, several of the large U.S. investment banks that were not affiliated at the time with a bank holding company expressed concern that, if they were unable to obtain an equivalency determination from the EU, the firms' significant European operations could be subject to potentially costly or disruptive EU-imposed requirements under the directive. In light of these facts, and to improve its own ability to monitor and address the risks at the large U.S. investment banks that might present risks to their subsidiary broker-dealers, the SEC in 2004 adopted rules establishing a voluntary consolidated supervision regime for those investment banking firms that controlled U.S. broker-dealers with at least $1 billion in tentative net capital, and at least $500 million of net capital, under the SEC's broker-dealer capital rules. The Goldman Sachs Group, Inc. (Goldman Sachs), Morgan Stanley, Merrill Lynch & Co., Inc. (Merrill Lynch), Lehman Brothers Holdings, Inc. (Lehman), and The Bear Stearns Companies, Inc., each applied and received approval to become consolidated supervised entities (CSEs) under the SEC's rules. These rules were not the same as would have applied to these entities had they became bank holding companies. While operating as CSEs, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman also controlled FDIC-insured state banks under a loophole in current law that allows any type of company to acquire an FDIC-insured industrial loan company (LC) chartered in certain states without becoming subject to the prudential supervisory and regulatory framework established under the Bank Holding Company Act of 1956 (BHC Act). \1\ As I noted in my testimony, the Board continues to believe that this loophole in current law should be closed.--------------------------------------------------------------------------- \1\ The ownership of such ILCs also disqualified such firms from potential participation in the alternative, voluntary consolidated supervisory regime that Congress authorized the SEC to establish for ``investment bank holding companies'' as part of the Gramm-Leach-Bliley Act of 1999. See 15 U.S.C. 78q(i)(1)(A)(i).Q.11. Credit Default Swaps--Mr. Tarullo, the Federal Reserve Bank of New York has been actively promoting the central clearing of credit default swaps. How will you encourage market participants, some of whom benefit from an opaque market, to clear their trades? Is it your intent to see the establishment of one clearinghouse or are you willing to allow multiple central clearing facilities to exist and compete with one another? Is the Fed working with European regulators to coordinate efforts to promote clearing of CDS transactions? How will the Fed encourage market participants, some of whom benefit from an opaque market, to clear their credit default swap transactions? Is it the Fed's expectation that there will be only one credit default swap clearinghouse or do you envision multiple central clearing counterparties existing in the long run? How is the Fed working with European regulators to coordinate efforts to promote clearing of credit default swap transactions? What other classes of OTC derivatives are good candidates for central clearing and what steps is the Fed taking to encourage the development and use of central clearing counterparties?A.11. The Federal Reserve can employ supervisory tool to encourage derivatives dealers that are banks or part of a bank holding company to centrally clear CDS. These include the use of capital charges to provide incentives, as well as direct supervisory guidance for firms to ensure that any product to which such a dealer is a party will, if possible, be submitted to and cleared by a CCP. The Federal Reserve is also encouraging greater transparency in the CDS market. Through the Federal Reserve Bank of New York's (FRBW) ongoing initiatives with market participants, the major dealers have been providing regulators with data on the volumes of CDS trades that are recorded in the trade repository and will soon begin reporting data around the volume of CDS trades cleared through a CCP. There are multiple existing or proposed CCPs for CDS. The Federal Reserve has not endorsed any one CCP proposal. Our top priority is that any CDS CCP be well-regulated and prudently managed. We believe that market forces in a competitive environment should determine which and how many CDS CCPs exist in the long run. The FRBNY has hosted a series of meetings with U.S. and foreign regulators to discuss possible information sharing arrangements and other methods of cooperation within the regulatory community. Most recently, the FRBNY hosted a workshop on April 17, attended by 28 financial regulators including those with direct regulatory authority over a CCP, as well as other interested regulators and governmental authorities that are currently considering CDS market matters. Workshop participants included European regulators with broad coverage such as the European Commission, the European Central Bank and the Committee of European Securities Regulators. \2\ Participants discussed CDS CCP regulatory interests and information needs of other authorities and the market more broadly and agreed to a framework to facilitate information sharing and cooperation.--------------------------------------------------------------------------- \2\ Regulators and other interested authorities that attended the April 17 Workshop included: Belgian Banking, Finance and Insurance Commission (CBFA), National Bank of Belgium, Committee of European Securities Regulators (CESR), European Central Bank, European Commission, Bank of France, Commission Bancaire, French Financial Markets Authority (AMF), Deutsche Bundesbank, German Financial Supervisory Authority (BaFin), Committee on Payment and Settlement Systems (CPSS) Bank of Italy, Bank of Japan, Japan Financial Services Agency , Netherlands Authority for the Financial Markets (AFM), Netherlands Bank , Bank of Spain, Spanish National Securities Market Commission (CNMV), Swiss Financial Market Supervisory Authority (FINMA). Swiss National Bank, Bank of England, UK Financial Services Authority, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Federal Reserve Bank of New York, Federal Reserve Board, New York State Banking Department, Office of the Comptroller of the Currency, and the Securities and Exchange Commission.--------------------------------------------------------------------------- The FRBNY will continue to coordinate with other regulators in the U.S. and Europe to establish a coherent approach for communicating supervisory expectations, to encourage consistent treatment of CCPs across jurisdictions, and to ensure that regulators have adequate access to the information necessary to carry out their respective objectives. Additionally, since 2005 the FRBNY has been coordinating with foreign regulators \3\ in its ongoing work with major dealers and large buy-side firms to strengthen the operational infrastructure of the OTC derivatives market more broadly. The regulatory community holds monthly calls to discuss, these efforts, which include central clearing for CDS.--------------------------------------------------------------------------- \3\ Foreign regulators engaged in this effort include the UK Financial Services Authority, the German Federal Financial Supervisory Authority, the French Commission Bancaire, and the Swiss Financial Market Supervisory Authority.--------------------------------------------------------------------------- The degree of risk reduction and enhanced operational efficiency that might be obtained from the use of a CCP may vary across asset classes. However, a CCP for any OTC derivatives asset class must be well designed with effective risk management controls that meet, at a minimum, international standards for central counterparties. A number of CCPs are already in use for other OTC derivatives asset classes including LCH.Clearnet's SwapClear for interest rates and CME/NYMEX's ClearPort for energy and other OTC commodities. The FRBNY is working with the market participants to ensure that clearing members utilize more fully available clearing services and to encourage CCPs to support additional products and include a wider range of participants. The industry will provide further details to regulators and the public at the end of May addressing many of these issues for the various derivative asset classes. ------ CHRG-111shrg50564--112 Mr. Volcker," Well, we deliberately did not get into the specifics. We were at a high level of generality when it came to the administrative arrangements. But we do recognize the problem that you just described and that you had to have some kind of a unified system, at least for banks. Senator Crapo. And when you say at least for banks, I noticed one of your other points was that the activities of large insurance, investment banks and broker dealers require consolidated supervision. Are you not saying essentially the same thing there in other contexts? " CHRG-111hhrg51591--30 Mr. Harrington," Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, I am very pleased to be here to talk about issues of such fundamental importance to businesses and individuals. I have three main points. First, I want to stress that insurance is fundamentally different from banking and should not be regulated the same way. The anomaly of AIG notwithstanding, compared to banking, insurance markets are characterized by much less systemic risk and by reasonably strong market discipline for safety and soundness. Any new regulatory initiatives that affect insurance should be designed not to undermine that market discipline. Systemic risks, the risk that problems at one or a few institutions may affect many other institutions and the overall economy, is much greater in banking than in insurance. Depositor and creditor runs on banks threaten the entire payment system. The bills don't get paid. The checks don't get written. Banking crises involve immediate and widespread harm to economic activity and employment. Systemic risk in banking provides some rationale for relatively broad government guarantees such as deposit insurance. But because guarantees undermine market discipline, they create a need for tighter regulation and more stringent capital requirements. That in turn creates significant pressure for many banks to relax capital requirements and improve their accuracy, or to circumvent the requirements through regulatory arbitrage. Insurance is inherently different, especially property/casualty insurance and health insurance. There is much less systemic risk and then much less need for broad government guarantees to prevent runs that would destabilize the economy. Guarantees through the State guarantee associations have been appropriately narrow in insurance, or narrower than in banking, and capital requirements have been much less binding. And because they have been much less binding overall, their accuracy is less important. This is good economics. Any new insurance regulatory initiatives should follow this model and recognize the distinctions between banking and insurance. They should also recognize that apparently sophisticated capital regulation can produce significant distortions without sufficiently constraining excessive risk-taking. My second main point is the creation of a systemic risk regulator with authority to regulate systematically significant insurance organizations would likely have several adverse consequences. And I apologize for a bit of redundancy here, going last as I am. In general, the potential benefits of creating a systemic risk regulator encompassing non-bank institutions strike me as modest and highly uncertain. Regarding insurance specifically, if an entity were created with authority to regulate any insurer deemed systematically significant, market discipline could easily be undermined with an attendant increase in moral hazard and excessive risk-taking. An insurer designated as systematically significant would be regarded by many market participants very simply as too-big-to-fail. Implicit or explicit government backing would lower its funding costs and increase its incentives to take on risk. I am skeptical that truly tougher capital requirements or tighter regulation would be adopted for such firms, and if so, whether they would be effective in limiting risk-taking. Over time, government/taxpayer bailouts could become more rather than less prevalent. Even if moral hazard would not increase under that scenario, it is hardly certain that a systemic risk regulator would effectively limit risk in a dynamic global environment. It could well be ineffective in preventing a future crisis, especially once memories of the current crisis fade. In addition, level competition by insurers designated as systematically significant and those not so designated would simply not be possible. The former would likely have a material competitive advantage. The results would likely include higher market concentration. The big will get bigger. Less competition and more moral hazard. Apart from AIG and specialized bond insurers, we have already heard insurance markets have withstood recent problems tolerably well. It is not surprising that some life insurers have been stressed, given what has happened in the asset markets and the nature of their products. My third and last point is that legislative proposals for Federal intervention in insurance regulation, such as optional Federal chartering, should specifically seek to avoid expanding the scope of explicit or implicit government guarantees of insurers' obligations. The goal should be central to any debate. Insurance markets, with the AIG exception, have been largely outside the scope of too-big-to-fail regulatory policy. Consistent with relatively low systemic risks, State guarantees have been relatively narrow. State guarantee associations have performed reasonably well. The post-insolvency assessment scheme works well, and I elaborate in my statement how it has various advantages. So I encourage you, when you consider those issues about optional Federal chartering, to remember not--to keep very close attention to the nature of guarantees and how they can create moral hazard. And last, I would also urge you, as part of that debate, to consider alternatives to optional Federal chartering, whether it be preemption of anti-competitive State activity or some sort of system that would create greater regulatory competition among the States. Thank you. [The prepared statement of Professor Harrington can be found on page 85 of the appendix.] " CHRG-110hhrg46593--111 Secretary Paulson," I would say that the forest through the trees here was--the important step was the step that was taken to stabilize the banking system, and the combined step taken by-- " CHRG-111hhrg56776--332 Mr. Watt," That's the great big guys. I'm talking about the smaller banks. For systemic people, you are looking across a whole array of financial institutions. You are big enough to have a significant adverse systemic impact on the whole economy. I have jumped across that hurdle. I'm talking about the guys that don't fall into the systemic risk category. Why would you set up a different standard when it comes to consumer protection than the standard you would apply to safety and soundness? " CHRG-111hhrg56778--88 Mr. Garrett," Okay. That's on the supervisory side. I think my last question as far as time goes, you make the assertion with the issue that's always dear to me in dealing with the systemic risk issues, and you assert that the risk of the financial system is not just from the banking sector. It's from the insurance sector as well. We are all familiar with the AIG situation and how that plays out. Can you explain, though, specifically within the insurance sector, where the systemic risk problems are that you're specifically concerned about? " FinancialCrisisReport--289 In contrast to decades of actual performance data for 30-year mortgages with fixed interest rates, the new subprime, high risk products had little to no track record to predict their rates of default. In fact, Moody’s RMBS rating model was not even used to rate subprime mortgages until December 2006; prior to that time, Moody’s used a system of “benchmarking” in which it rated a subprime mortgage pool by comparing it to other subprime pools Moody’s had already rated. 1118 Lack of Data During Era of Stagnant or Falling Home Prices. In addition, the models operated with subprime data for mortgages that had not been exposed to stagnant or falling housing prices. As one February 2007 presentation from a Deutsche Bank investment banker explained, the models used to calculate “subprime mortgage lending criteria and bond subordination levels are based largely on performance experience that was mostly accumulated since the mid-1990s, when the nation’s housing market has been booming.” 1119 A former managing director in Moody’s Structured Finance Group put it this way: “[I]t was ‘like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” 1120 In September 2007, after the crisis had begun, an S&P executive testified before Congress that: “[W]e are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been.” 1121 The absence of relevant data for use in RMBS modeling left the credit rating agencies unable to accurately predict mortgage default and loss rates when housing prices stopped climbing. The absence of relevant performance data for high risk mortgage products in an era of stagnant or declining housing prices impacted the rating of not only RMBS transactions, but also CDOs, which typically included RMBS securities and relied heavily on RMBS credit ratings. Lack of Investment. One reason that Moody’s and S&P lacked relevant loan performance data for their RMBS models was not simply that the data was difficult to obtain, but 1117 9/30/2007 email from Belinda Ghetti to David Tesher, and others, Hearing Exhibit 4/23-33. 1118 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14- 0001-16, at 3. 1119 2/2007 “Shorting Home Equity Mezzanine Tranches,” Deutsche Bank Securities Inc., DBSI_PSI_EMAIL01988773-845, at 776. See also 6/4/2007 FDIC memorandum from Daniel Nuxoll to Stephen Funaro, “ALLL Modeling at Washington Mutual,” FDIC_WAMU_000003743-52, at 47 (“Virtually none of the data is drawn from an episode of severe house price depreciation. Even introductory statistics textbooks caution against drawing conclusions about possibilities that are outside the data. A model based on data from a relatively benign period in the housing market cannot produce reliable inferences about the effects of a housing price collapse.”). 1120 “Triple-A Failure,” New York Times (4/27/2008). 1121 Prepared statement of Vickie Tillman, S&P Executive Vice President, “The Role of Credit Rating Agencies in the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEN-PSI 0001945-71, at 46-47. that both companies were reluctant to devote the resources needed to improve their modeling, despite soaring revenues. FOMC20061025meeting--83 81,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our view of the national outlook hasn’t changed much since September. If monetary policy follows the path that’s laid out in the Greenbook, and it’s flat for the next few quarters, then we expect growth to return to a level close to 3 percent in ’07 and for inflation to moderate gradually from current levels. However, we still face the basic tension in the forecast—the combination of relatively high core inflation today and an economy that has slowed significantly below trend—and we still face the same basic questions: Will inflation moderate enough and soon enough to keep inflation expectations reasonably stable at reasonably low levels? Will weakness spread beyond housing and cumulate? Relative to September, we see somewhat less downside risk to growth and somewhat less upside risk to inflation, but as in September, I think inflation risks should remain our predominant concern. Relative to the Greenbook, we expect somewhat faster growth in ’07, but we have a higher estimate of potential. The difference is really mostly about hours and trend labor force growth. We expect more moderation in core PCE and expect it to fall just below 2 percent in ’07, but this difference is mostly the result of different assumptions about persistence. With these exceptions, our basic story about the contour of the expansion is fairly close to the Greenbook, and the implications for monetary policy are similar. The markets do seem relatively positive, a little more optimistic about the near-term outlook. Equity prices, credit spreads, and market interest rates all reflect somewhat less concern about both recession and inflation risks. Some of this, however, is probably the result of the exceptional factors supporting what the markets call liquidity. What is liquidity, and what’s behind it? I don’t know that we have a good answer to that. Most people would cite a combination of the facts that real interest rates are fairly low in much of the world still, that reserve accumulation by the countries that shadow the dollar is still quite large, that a big energy-price windfall is producing demand for financial assets, particularly in dollars, and that there is confidence in the willingness and ability of the central bank, particularly this central bank, to save the world from any significant risk of a recession. I don’t think all of this, therefore, is the result simply of confidence about fundamentals, so we shouldn’t take too much reassurance. But it still is a somewhat more positive constellation of asset prices, of market views about the outlook. Someone wrote this week that the fog over the outlook has lifted. I don’t think that’s quite right. It’s true that the economy still looks pretty good except for housing, and I do think it’s fair to say that core inflation is moderating and that expectations are behaving in ways that should be pretty reassuring to us. But it is too soon to be confident that inflation is going to moderate sufficiently soon enough with the path of monetary policy priced into markets today, and it is too soon to be confident also that the weakness we see in housing, in particular, won’t spread and won’t cumulate. So I think that overall the balance of risks hasn’t changed dramatically, and as in September, I still view the inflation risk as the predominant concern of the Committee." CHRG-110hhrg46596--81 Mr. Kashkari," That is correct. And, again, one of the keys here is we want to attract private capital to our banking system. To come in to healthy banks and wipe out all their dividends would drive away private capital. We want to encourage private capital. And may I respectfully repeat that this is a program for healthy institutions of all sizes. Hundreds, potentially thousands, of banks from across the country are applying. We feel great about that. " fcic_final_report_full--342 On September , executives from Lehman Brothers apprised executives at JP Morgan, Lehman’s tri-party repo clearing bank, of the third-quarter results that it would announce two weeks later. A . billion loss would reflect “significant asset write-downs.” The firm was also considering several steps to bolster capital, includ- ing an investment by Korea Development Bank or others, the sale of Lehman’s invest- ment management division (Neuberger Berman), the sale of real estate assets, and the division of the company into a “good bank” and “bad bank” with private equity sponsors.  The executives also discussed JP Morgan’s concerns about Lehman’s repo collateral. On Monday, September , more than  New York Fed officials were notified of a meeting the next morning “to continue the discussion of near-term options for deal- ing with a failing nonbank.” They received a list documenting Lehman’s tri-party repo exposure at roughly  billion. Before its collapse, Bear Stearns’s exposure had been only  to  billion. The documentation further noted that  counterpar- ties provided  of Lehman’s repo financing, and that intraday liquidity provided by Lehman’s clearing banks could become a problem. Indeed, JP Morgan, Citigroup, and Bank of America had all demanded more collateral from Lehman, with the threat they might “cut off Lehman if they don’t receive it.”  On Tuesday morning, September , news there would be no investment from Ko- rea Development Bank shook the market. Lehman’s stock plunged  from the day before, closing at .. To prepare for an afternoon call with Bernanke, Geithner di- rected his staff to “put together a quick ‘what’s different? what’s the same?’ list about [Lehman] vs [Bear Stearns], as well as about mid-March (then) vs. early Sept (now).”  The Fed’s Parkinson emailed Treasury’s Shafran about his concerns that Lehman would announce further losses the next week, that it might not be able to raise equity, and that even though its liquidity position was better than Bear Stearns’s had been, Lehman remained vulnerable to a loss of confidence.  At : P . M ., Paulson convened a call with Cox, Geithner, Bernanke, and Treasury staff “to deal with a possible Lehman bankruptcy.”  At : P . M ., Treasury Chief of Staff Jim Wilkinson emailed Michelle Davis, the assistant secretary for public affairs at Treasury, to express his distaste for government assistance: “We need to talk. . . . I just can’t stomach us bailing out lehman. . . . Will be horrible in the press don’t u think.”  That same day, Fuld agreed to post an additional . billion of collateral to JP Morgan. Lehman’s bankruptcy estate would later claim that Lehman did so because of JP Morgan’s improper threat to withhold repo funding. Zubrow said JP Morgan re- quested the collateral because of its growing exposure as a derivatives trading coun- terparty to Lehman.  Steven Black, JP Morgan’s president, said he requested  billion from Lehman, which agreed to post . billion.  He did not believe the re- quest put undue pressure on Lehman. On Tuesday night, executives of Lehman and JP Morgan met again at Lehman’s request to discuss options for raising capital. The JP Morgan group was not impressed. “[Lehman] sent the Junior Varsity,” JP Morgan executives reported to Black. “They have no proposal and are looking to us for ideas/credit line to bridge them to the first quarter when they intend to split into good bank/bad bank.” Black responded, “Let’s give them an order for the same drugs they have apparently been taking to think we would do something like that.”  The Lehman bankruptcy estate has a different view. It alleges Black agreed to send a due diligence team, following Dimon’s suggestion that his firm might be willing to pur- chase Lehman preferred stock, but instead sent over senior risk managers to probe Lehman’s confidential records and plans.  fcic_final_report_full--128 In , only five mortgage companies borrowed a total of  billion through as- set-backed commercial paper; in ,  entities borrowed  billion.  For in- stance, Countrywide launched the commercial paper programs Park Granada in  and Park Sienna in .  By May , it was borrowing  billion through Park Granada and . billion through Park Sienna. These programs would house subprime and other mortgages until they were sold.  Commercial banks used commercial paper, in part, for regulatory arbitrage. When banks kept mortgages on their balance sheets, regulators required them to hold  in capital to protect against loss. When banks put mortgages into off-bal- ance-sheet entities such as commercial paper programs, there was no capital charge (in , a small charge was imposed). But to make the deals work for investors, banks had to provide liquidity support to these programs, for which they earned a fee. This liquidity support meant that the bank would purchase, at a previously set price, any commercial paper that investors were unwilling to buy when it came up for renewal. During the financial crisis these promises had to be kept, eventually putting substantial pressure on banks’ balance sheets. When the Financial Accounting Standards Board, the private group that estab- lishes standards for financial reports, responded to the Enron scandal by making it harder for companies to get off-balance-sheet treatment for these programs, the fa- vorable capital rules were in jeopardy. The asset-backed commercial paper market stalled. Banks protested that their programs differed from the practices at Enron and should be excluded from the new standards. In , bank regulators responded by proposing to let banks remove these assets from their balance sheets when calculat- ing regulatory capital. The proposal would have also introduced for the first time a capital charge amounting to at most . of the liquidity support banks provided to the ABCP programs. However, after strong pushback—the American Securitization Forum, an industry association, called that charge “arbitrary,” and State Street Bank complained it was “too conservative”  —regulators in  announced a final rule setting the charge at up to ., or half the amount of the first proposal. Growth in this market resumed. Regulatory changes—in this case, changes in the bankruptcy laws—also boosted growth in the repo market by transforming the types of repo collateral. Prior to , repo lenders had clear and immediate rights to their collateral following the bor- rower’s bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy Abuse Prevention and Consumer Protection Act of , Congress ex- panded that provision to include many other assets, including mortgage loans, mort- gage-backed securities, collateralized debt obligations, and certain derivatives. The result was a short-term repo market increasingly reliant on highly rated non-agency mortgage-backed securities; but beginning in mid-, when banks and investors became skittish about the mortgage market, they would prove to be an unstable funding source (see figure .). Once the crisis hit, these “illiquid, hard-to-value se- curities made up a greater share of the tri-party repo market than most people would have wanted,” Darryll Hendricks, a UBS executive and chair of a New York Fed task force examining the repo market after the crisis, told the Commission.  CHRG-111shrg56415--3 Mr. Dugan," Thank you, Chairman Johnson, Senator Crapo, and members of the Subcommittee. I am pleased to testify on the current condition of the national banking system, including trends in bank lending, asset quality, and problem banks. The OCC supervises over 1,600 national banks and Federal branches, which constitute approximately 18 percent of all federally insured banks and thrifts, holding just over 61 percent of all bank and thrift assets. As described in my written statement, the OCC has separate supervisory programs for large, mid-sized, and community banks that are tailored to the unique challenges faced by each. Today I would like to focus on three key points. First, despite early signs of the recession ending, credit quality is continuing to worsen across almost every class of asset in banks of almost every size. The strains on borrowers that first appeared in the housing sector have spread to other retail and commercial borrowers. For some credit portfolio segments, the rate of nonperforming loans is at or near historical highs. In many cases, this declining asset quality reflects risks that have been built up over time. While we are seeing some initial signs of improvement in some asset classes, as the economy begins to recover, it will take time for problem credits to work their way through the banking system because credit losses often lag behind the return to economic growth. Second, it is very important to keep in mind that the vast majority of national banks are strong and have the financial capacity to withstand declining asset quality. As I noted in testimony before the full Committee last year, we anticipated that credit quality would worsen and that banks would need to further strengthen their capital and loan loss reserves. Net capital levels in national banks have increased by more than $186 billion over the last 2 years, and net increases to loan loss reserves have exceeded $92 billion. While these increases have considerably strengthened national banks, we anticipate additional capital and reserves will be needed to absorb additional potential losses in banks' portfolios. In some cases, that may not be possible, however, and as a result, there will continue to be a number of smaller institutions that are not likely to survive their mounting credit problems. In these cases, we are working closely with the FDIC to ensure timely resolutions in a manner that is least disruptive to local communities. Third, during this stressful period, we are extremely mindful of the need to maintain a balanced approach in our supervision of national banks. We strive continually to ensure that our examiners are doing just that. We are encouraging banks to work constructively with borrowers who may be facing difficulties and to make new loans to creditworthy borrowers, although it is true that in today's weaker economic environment, credit demand among businesses and consumers has significantly declined. And we have repeatedly and strongly emphasized that examiners should not dictate loan terms or require banks to charge off loans simply due to declines in collateral values. Balanced supervision, however, does not mean turning a blind eye to credit and market conditions or simply allowing banks to forestall recognizing problems on the hope that markets or borrowers may turn around. As we have learned in our dealings with problem banks, a key factor in restoring a bank to health is ensuring that bank management realistically recognizes and addresses problems as they emerge, even as they work with struggling borrowers. One area where national banks are stepping up efforts to work with distressed borrowers is in foreclosure prevention. Our most recent quarterly report on mortgage metrics shows that actions by national bank servicers to keep Americans in their homes rose by almost 22 percent in the second quarter. Notably, the percentage of modifications that reduced monthly principal and interest payments increased to more than 78 percent of all new modifications, up from about 54 percent the previous quarter. We view this as a positive development since modifications that result in lower monthly payments are less likely to redefault. While many challenges lie ahead, especially with regard to the significant decline in credit quality, I firmly believe that the collective measures that Government officials, bank regulators, and many bankers have taken in recent months have put our financial system on a much more sound footing. The OCC is firmly committed to a balanced approach that encourages bankers to lend and to work with borrowers in a safe and sound manner while recognizing and addressing problems on a timely basis. Thank you. Senator Johnson. Thank you, Mr. Dugan. " Mr. Tarullo," STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF GOVERNORS OF CHRG-111hhrg52397--80 Mr. Bachus," What lessons has the financial services industry learned from the Lehman Brothers' bankruptcy and from the near collapse of AIG, any of you? " CHRG-111shrg57322--754 Mr. Viniar," Yes, I---- Senator Ensign [continuing]. I am talking about blame in the financial collapse of the United States. " CHRG-111shrg61651--24 Mr. Scott," This Committee has been hard at work for several months on a broad range of issues of financial reform that are crucial to our Nation's future, including new resolution procedures to protect the taxpayers from loss, reduction of systemic risk through better capital requirements and central clearing for over-the-counter derivatives, and enhanced measures of consumer protection. Less than 2 weeks ago, the Administration announced the so-called ``Volcker rules.'' Whatever one thinks of the merits of these new proposals, it is undeniable that they will take considerable time to develop and debate. Tuesday's hearing certainly underscored this point. These new proposals should not hold up action on the pressing fundamental issues much further down the track, and I encourage this Committee's continuing efforts to reach a bipartisan consensus on these issues. The asserted objective of the new proposed rules is to limit systemic risk. In my judgment, they fail to do so. If the limits on proprietary trading only apply where banking organizations take positions ``unrelated to serving customers,'' they will have little impact. For example, with respect to Wells Fargo and Bank of America, such activity represents around 1 percent of revenues. While this has been estimated to be 10 percent of the revenues of Goldman Sachs, Goldman could easily avoid the requirements by divesting itself of its banking operations since deposit-taking constitutes only 5.19 percent of its liabilities. The real source of systemic risk in the banking system, as demonstrated by this crisis, is old-fashioned lending. It was mortgage lending that was at the heart of the financial crisis. I do not agree with Mr. Volcker that these traditional activities, by the way, are entitled to a safety net. Banks should not be bailed out, whatever the reason for their losses. Indeed, the focus should be, as it is in the pending legislation, to control risky activities of whatever kind. The Volcker rules would also prohibit banks from investing in, or sponsoring, private equity including venture capital funds. This would have little impact on the large banks whose investment in private equity accounted for less than 2 percent of their balance sheets. On the other hand, bank private equity investments are important to the private equity industry as a whole, accounting for $115 billion or 12 percent of private equity investment. Depriving the industry of this important source of funds could impede our economic recovery. Turning to the size limitation proposal, let me stress that this proposal does not purport to decrease the present size of any U.S. financial institution nor would it prevent any financial institution from increasing its size through internal growth. The proposal, as I understand it, would only limit the growth of nondeposit liabilities achieved through acquisition. Accordingly, if banks or other financial institutions are too big to fail, this proposal will have no impact on them. Indeed, it even permits them to get bigger. In thinking about size, our concern should be with the size of a bank or other financial institution's interconnected positions, not its total size, because it is the degree of interconnectedness that drives bailouts, and here I fully agree with what Mr. Reed said on this. I fail to see how market share of nondeposit liabilities could be a proxy for position size. Let me briefly turn to the international context. Without international consensus, adopting these proposals will only harm the competitive position of U.S. financial institutions. These proposals have not been agreed to, even in principle, by the G-20 or major market competitors, unlike most of the other proposals that the House has considered and that are presently before your Committee. While major market leaders and international organizations have been polite in welcoming these proposals, they have not endorsed them. In conclusion, do these proposals deserve further consideration and debate? Absolutely. But are they central to reform? In my view, they are not, and I would stress the fact that they should not in any event hold up action on the complex matters already before your Committee. Thank you. " CHRG-111hhrg53245--90 Mr. Bachus," Executives of the surviving large firms have every reason to believe they are too big to fail. They have no incentive to help bring system risk down to an acceptable level. That is exactly the problem we have today. Mr. Johnson goes on to say that when you have a situation like this, it is either bailout or collapse, but as it begins to affect other institutions, responsible official thinking shifts to bailout at any cost. We certainly have seen that over the past 6 months. Mr. Zandi says, and here is where I think we maybe can all come to a consensus, he said the Treasury and the Fed were seemingly confused as to whether they had the authority or ability to intervene to forestall a Lehman bankruptcy and ensure an orderly resolution of the broker-dealer's failure. The procedure was not in place. Mr. Mahoney today has said give them that procedure, as I understand it. Give them a procedure, but in bankruptcy. Is that right, Mr. Mahoney? " CHRG-111shrg51290--67 The combination of easing credit standards and a growing economy resulted in a sharp increase in homeownership rates through 2004. As the credit quality of loans steadily grew worse over 2005 through 2007,\13\ however, the volume of unsustainable loans grew and homeownership rates dropped.\14\ (See Table 1).--------------------------------------------------------------------------- \13\ Subprime mortgage originated in 2005, 2006 and 2007 had successively worse default experiences than vintages in prior years. See Freddie Mac, Freddie Mac Update 19 (December 2008), available at www.freddiemac.com/investors/pdffiles/investor-presentation.pdf. \14\ See Jesse M. Abraham, Andrey Pavlov & Susan Wachter, Explaining the United States' Uniquely Bad Housing Market, XII Wharton Real Estate Rev. 24 (2008).--------------------------------------------------------------------------- Table 1. U.S. Homeownership Rates, by Year (U.S. Census Bureau) The explosion of nontraditional mortgage lending was timed to maintain securitization deal flows after traditional refinancings weakened in 2003. The major take-off in these products occurred in 2002, which coincided with the winding down of the huge increase in demand for mortgage securities through the refinance process. Coming out of the recession of 2001, interest rates fell and there was a massive securitization boom through refinancing that was fueled by low interest rates. The private-label securitization industry had grown in capacity and profits. But in 2003, rising interest rates ended the potential for refinancing at ever lower interest rates, leading to an increased need for another source of mortgages to maintain and grow the rate of securitization and the fees it generated. The ``solution'' was the expansion of the market through nontraditional mortgages, especially interest-only loans and option payment ARMs offering negative amortization. (See Figure 1 supra). This expansion of credit swept a larger portion of the population into the potential homeowner pool, driving up housing demand and prices, and consumer indebtedness. Indeed, consumer indebtedness grew so rapidly that between 1975 and 2007, total household debt soared from around 43 percent to nearly 100 percent of gross domestic product.\15\--------------------------------------------------------------------------- \15\ U.S. Federal Reserve Board, Bureau of Economic Analysis.--------------------------------------------------------------------------- The growth in nonprime mortgages was accomplished through market expansion of nontraditional mortgages and by qualifying more borrowing through easing of traditional lending terms. For example, while subprime mortgages were initially made as ``hard money'' loans with low loan-to-value ratios, by the height of their growth, combined loan-to-value ratios exceeded that of the far less risky prime market. (See Figure 3 supra). While the demand for riskier mortgages grew fueled by the need for product to securitize, the potential risk due to deteriorating lending standards also grew.B. Consumer Confusion If borrowers had been able to distinguish safe loans from highly risky loans, risky loans would not have crowded out the market. But numerous borrowers were not able to do so, for three distinct reasons. First, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs were baffling in their complexity. Second, it was impossible to obtain binding price quotes early enough to permit meaningful comparison shopping in the nonprime market. Finally, borrowers usually did not know that mortgage brokers got higher compensation for steering them into risky loans. Hidden Risks--The arcane nature of hybrid ARMs, interest-only loans, and option payment ARMs often made informed consumer choice impossible. These products were highly complex instruments that presented an assortment of hidden risks to borrowers. Chief among those risks was payment shock--in other words, the risk that monthly payments would rise dramatically upon rate reset. These products presented greater potential payment shock than conventional ARMs, which had lower reset rates and manageable lifetime caps. Indeed, with these exotic ARMs, the only way interest rates could go was up. Many late vintage subprime hybrid ARMs had initial rate resets of 3 percentage points, resulting in increased monthly payments of 50 percent to 100 percent or more.\16\--------------------------------------------------------------------------- \16\ Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation, on Strengthening the Economy: Foreclosure Prevention and Neighborhood Preservation, before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, 538 Dirksen Senate Office Building, January 31, 2008, www.fdic.gov/news/news/speeches/chairman/spjan3108.html. --------------------------------------------------------------------------- For a borrower to grasp the potential payment shock on a hybrid, interest-only, or option payment ARM, he or she would need to understand all the moving parts of the mortgage, including the index, rate spread, initial rate cap, and lifetime rate cap. On top of that, the borrower would need to predict future interest rate movements and translate expected rate changes into changes in monthly payments. Interest-only ARMs and option payment ARMs had the added complication of potential deferred or negative amortization, which could cause the principal payments to grow. Finally, these loans were more likely to carry large prepayment penalties. To understand the effect of such a prepayment penalty, the borrower would have to use a formula to compute the penalty's size and then assess the likelihood of moving or refinancing during the penalty period.\17\ Truth-in-Lending Act disclosures did not require easy-to-understand disclosures about any of these risks.\18\--------------------------------------------------------------------------- \17\ Federal Reserve System, Truth in Lending, Part III: Final rule, official staff commentary, 73 Fed. Reg. 44522, 44524-25 (July 30, 2008); Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). \18\ Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harv. J. Legis. 123 (2007), available at http://www.law.harvard.edu/students/orgs/jol/vol44_1/mccoy.pdf. --------------------------------------------------------------------------- Inability to Do Meaningful Comparison Shopping--The lack of binding rate quotes also hindered informed comparison-shopping in the nonprime market. Nonprime loans had many rates, not one, which varied according to the borrower's risk, the originator's compensation, the documentation level of the loan, and the naivety of the borrower. Between their complicated price structure and the wide variety of products, subprime loans were not standardized. Furthermore, it was impossible to obtain a binding price quote in the subprime market before submitting a loan application and paying a non-refundable fee. Rate locks were also a rarity in the subprime market. In too many cases, subprime lenders waited until the closing to unveil the true product and price for the loan, a practice that the Truth in Lending Act rules countenanced. These rules, promulgated by the Federal Reserve Board, helped foster rampant ``bait-and-switch'' schemes in the subprime market.\19\--------------------------------------------------------------------------- \19\ Id.; Federal Reserve System, Truth in Lending--Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1675 (Jan. 9, 2008).--------------------------------------------------------------------------- As a result, deceptive advertising became a stock-in-trade of the nonprime market. Nonprime lenders and brokers did not advertise their prices to permit meaningful comparison-shopping. To the contrary, lenders treated their rate sheets--which listed their price points and pricing criteria--as proprietary secrets that were not to be disclosed to the mass consumer market. Subprime advertisements generally focused on fast approval and low initial monthly payments or interest rates, not on accurate prices. While the Federal Reserve exhorted people to comparison-shop for nonprime loans,\20\ in reality, comparison-shopping was futile. Nonprime lenders did not post prices, did not provide consumers with firm price quotes, and did not offer lock-in commitments as a general rule. Anyone who attempted to comparison-shop had to pay multiple application fees for the privilege and, even then, might not learn the actual price until the closing if the lender engaged in a bait-and-switch.--------------------------------------------------------------------------- \20\ See, e.g., Federal Reserve Board, Looking for the Best Mortgage, www.federalreserve.gov/pubs/mortgage/mortb_11.htm.--------------------------------------------------------------------------- As early as 1998, the Federal Reserve Board and the Department of Housing and Urban Development were aware that Truth in Lending Act disclosures did not come early enough in the nonprime market to allow meaningful comparison shopping. That year, the two agencies issued a report diagnosing the problem. In the report, HUD recommended changes to the Truth in Lending Act to require mortgage originators to provide binding price quotes before taking loan applications. The Federal Reserve Board dissented from the proposal, however, and it was never adopted.\21\ To this day, the Board has still not revamped Truth in Lending disclosures for closed-end mortgages.--------------------------------------------------------------------------- \21\ See Bd. of Governors of the Fed. Reserve Sys. & Dep't of Hous. & Urban Dev., Joint Report to the Congress, Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act, at 28-29, 39-42 (1998), available at www.federalreserve.gov/boarddocs/rptcongress/tila.pdf.--------------------------------------------------------------------------- Perverse Fee Incentives--Finally, many consumers were not aware that the compensation structure rewarded mortgage brokers for riskier loan products and higher interest rates. Mortgage brokers only got paid if they closed a loan. Furthermore, they were paid solely through upfront fees at closing, meaning that if a loan went bad, the losses would fall on the lender or investors, not the broker. In the most pernicious practice, lenders paid brokers thousands of dollars per loan in fees known as yield spread premiums (or YSPs) in exchange for loans saddling borrowers with steep prepayment penalties and higher interest rates than the borrowers qualified for, based on their incomes and credit scores. In sum, these three features--the ability to hide risk, thwart meaningful comparison-shopping, and reward steering--allowed lenders to entice unsuspecting borrowers into needlessly hazardous loans.C. The Crowd-Out Effect The ability to bury risky product features in fine print allowed irresponsible lenders to out-compete safe lenders. Low initial monthly payments were the most visible feature of hybrid ARMs, interest-only loans, and option payment ARMs. During the housing boom, lenders commonly touted these products based on low initial monthly payments while obscuring the back-end risks of those loans.\22\--------------------------------------------------------------------------- \22\ See, e.g., Julie Haviv & Emily Kaiser, Web lenders woo subprime borrowers despite crisis, Reuters (Apr. 22, 2007); E. Scott Reckard, Refinance pitches in sub-prime tone, Los Angeles Times, October 29, 2007.--------------------------------------------------------------------------- The ability to hide risks made it easy to out-compete lenders offered fixed-rate, fully amortizing loans. Other things being equal, the initial monthly payments on exotic ARMs were lower than on fixed-rate, amortizing loans. Furthermore, some nonprime lenders qualified borrowers solely at the low initial rate alone until the Federal Reserve Board finally banned that practice in July 2008.\23\--------------------------------------------------------------------------- \23\ In fall 2006, Federal regulators issued an interagency guidance advising option ARM lenders to qualify borrowers solely at the fully indexed rate. Nevertheless, Washington Mutual (WaMu) apparently continued to qualify applicants for option ARMs at the low, introductory rate alone until mid-2007. It was not until July 30, 2007 that WaMu finally updated its ``Bulk Seller Guide'' to require its correspondents to underwrite option ARMs and other ARMs at the fully indexed rate.--------------------------------------------------------------------------- Of course, many sophisticated customers recognized the dangers of these loans. That did not deter lenders from offering hazardous nontraditional ARMs, however. Instead, the ``one-sizefits-one'' nature of nonprime loans permitted lenders to discriminate by selling safer products to discerning customers and more lucrative, dangerous products to naive customers. Sadly, the consumers who were least well equipped in terms of experience and education to grasp arcane loan terms \24\ ended up with the most dangerous loans.--------------------------------------------------------------------------- \24\ Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15 Housing Pol'y Debate 533, 552-554 (2004), http://www.fanniemaefoundation.org/programs/hpd/pdf/hpd_1503_Lax.pdf. --------------------------------------------------------------------------- In the meantime, lenders who offered safe products--such as fixed-rate prime loans--lost market share to lenders who peddled exotic ARMs with low starting payments. As conventional lenders came to realize that it didn't pay to compete on good products, those lenders expanded into the nonprime market as well.II. The Regulatory Story: Race to the Bottom Federal banking regulators added fuel to the crisis by allowing reckless loans to flourish. It is a basic tenet of banking law that banks should not extend credit without proof of ability to repay. Federal banking regulators \25\ had ample authority to enforce this tenet through safety and soundness supervision and through Federal consumer protection laws. Nevertheless, they refused to exercise their substantial powers of rulemaking, formal enforcement, and sanctions to crack down on the proliferation of poorly underwritten loans until it was too late. Their abdication allowed irresponsible loans to multiply. Furthermore, their green light to banks to invest in investment-grade subprime mortgage-backed securities and CDOs left the nation's largest banks struggling with toxic assets. These problems were a direct result of the country's fragmented system of financial regulation, which caused regulators to compete for turf.--------------------------------------------------------------------------- \25\ The four Federal banking regulators include the Federal Reserve System, which serves as the central bank and supervises State member banks; the Office of the Comptroller of the Currency, which oversees national banks; the Federal Deposit Insurance Corporation, which operates the Deposit Insurance Fund and regulates State nonmember banks; and the Office of Thrift Supervision, which supervises savings associations.---------------------------------------------------------------------------A. The Fragmented U.S. System of Mortgage Regulation In the United States, the home mortgage lending industry operates under a fragmented regulatory structure which varies according to entity.\26\ Banks and thrift institutions are regulated under Federal banking laws and a subset of those institutions--namely, national banks, Federal savings associations, and their subsidiaries--are exempt from State anti-predatory lending and credit laws by virtue of Federal preemption. In contrast, mortgage brokers and independent non-depository mortgage lenders escape Federal banking regulation but have to comply with all State laws in effect. Only State-chartered banks and thrifts in some states (a dwindling group) are subject to both sets of laws.--------------------------------------------------------------------------- \26\ This discussion is drawn from Patricia A. McCoy & Elizabeth Renuart, The Legal Infrastructure of Subprime and Nontraditional Mortgage Lending, in Borrowing to Live: Consumer and Mortgage Credit Revisited 110 (Nicolas P. Retsinas & Eric S. Belsky eds., Joint Center for Housing Studies of Harvard University & Brookings Institution Press, 2008).--------------------------------------------------------------------------- Under this dual system of regulation, depository institutions are subject to a variety of Federal examinations, including fair lending, Community Reinvestment Act, and safety and soundness examinations, but independent nondepository lenders are not. Similarly, banks and thrifts must comply with other provisions of the Community Reinvestment Act, including reporting requirements and merger review. Federally insured depository institutions must also meet minimum risk-based capital requirements and reserve requirements, unlike their independent non-depository counterparts. Some Federal laws applied to all mortgage originators. Otherwise, lenders could change their charter and form to shop for the friendliest regulatory scheme.B. Applicable Law Despite these differences in regulatory regimes, the Federal Reserve Board did have the power to prohibit reckless mortgages across the entire mortgage industry. The Board had this power by virtue of its authority to administer a Federal anti-predatory lending law known as ``HOEPA.''1. Federal Law Following deregulation of home mortgages in the early 1980's, disclosure became the most important type of Federal mortgage regulation. The Federal Truth in Lending Act (TILA),\27\ passed in 1968, mandates uniform disclosures regarding cost for home loans. Its companion law, the Federal Real Estate Settlement Procedures Act of 1974 (RESPA),\28\ requires similar standardized disclosures for settlement costs. Congress charged the Federal Reserve with administering TILA and the Department of Housing and Urban Development with administering RESPA.--------------------------------------------------------------------------- \27\ 15 U.S.C. 1601-1693r (2000). \28\ 12 U.S.C. 2601-2617 (2000).--------------------------------------------------------------------------- In 1994, Congress augmented TILA and RESPA by enacting the Home Ownership and Equity Protection Act (HOEPA).\29\ HOEPA was an early Federal anti-predatory lending law and prohibits specific abuses in the subprime mortgage market. HOEPA applies to all residential mortgage lenders and mortgage brokers, regardless of the type of entity.--------------------------------------------------------------------------- \29\ 15 U.S.C. 1601, 1602(aa), 1639(a)-(b).--------------------------------------------------------------------------- HOEPA has two important provisions. The first consists of HOEPA's high-cost loan provision,\30\ which regulates the high-cost refinance market. This provision seeks to eliminate abuses consisting of ``equity stripping.'' It is hobbled, however, by its extremely limited reach--covering only the most exorbitant subprime mortgages--and its inapplicability to home purchase loans, reverse mortgages, and open-end home equity lines of credit.\31\ Lenders learned to evade the high-cost loan provisions rather easily by slightly lowering the interest rates and fees on subprime loans below HOEPA's thresholds and by expanding into subprime purchase loans.--------------------------------------------------------------------------- \30\ 15 U.S.C. Sec. 1602(aa)(1)-(4); 12 C.F.R. 226.32(a)(1), (b)(1). \31\ 15 U.S.C. Sec. 1602(i), (w), (bb); 12 C.F.R. 226.32(a)(2) (1997); Edward M. Gramlich, Subprime Mortgages: America's Latest Boom and Bust 28 (Urban Institute Press, 2007).--------------------------------------------------------------------------- HOEPA also has a second major provision, which gives the Federal Reserve Board the authority to prohibit unfair or deceptive lending practices and refinance loans involving practices that are abusive or against the interest of the borrower.\32\ This provision is potentially broader than the high-cost loan provision, because it allows regulation of both the purchase and refinance markets, without regard to interest rates or fees. However, it was not self-activating. Instead, it depended on action by the Federal Reserve Board to implement the provision, which the Board did not take until July 2008.--------------------------------------------------------------------------- \32\ 15 U.S.C. 1639(l)(2).---------------------------------------------------------------------------2. State Law Before 2008, only the high-cost loan provision of HOEPA was in effect as a practical matter. This provision had a serious Achilles heel, consisting of its narrow coverage. Even though the Federal Reserve Board lowered the high-cost triggers of HOEPA effective in 2002, that provision still only applied to 1 percent of all subprime home loans.\33\--------------------------------------------------------------------------- \33\ Gramlich, supra note 31 (2007, p. 28).--------------------------------------------------------------------------- After 1994, it increasingly became evident that HOEPA was incapable of halting equity stripping and other sorts of subprime abuses. By the late 1990s, some cities and states were contending with rising foreclosures and some jurisdictions were contemplating regulating subprime loans on their own. Many states already had older statutes on the books regulating prepayment penalties and occasionally balloon clauses. These laws were relatively narrow, however, and did not address other types of new abuses that were surfacing in subprime loans. Consequently, in 1999, North Carolina became the first State to enact a comprehensive anti-predatory lending law.\34\ Soon, other states followed suit and passed anti-predatory lending laws of their own. These newer State laws implemented HOEPA's design but frequently expanded coverage or imposed stricter regulation on subprime loans. By year-end 2005, 29 States and the District of Columbia had enacted one of these ``mini-HOEPA'' laws. Some States also passed stricter disclosure laws or laws regulating mortgage brokers. By the end of 2005, only six States--Arizona, Delaware, Montana, North Dakota, Oregon, and South Dakota--lacked laws regulating prepayment penalties, balloon clauses, or mandatory arbitration clauses, all of which were associated with exploitative subprime loans.\35\--------------------------------------------------------------------------- \34\ N.C. Gen Stat. 24-1.1E (2000). \35\ See Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross & Susan Wachter, State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms, 60 J. Econ. & Bus. 47-66 (2008), full working paper version available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1005423. --------------------------------------------------------------------------- Critics, including some Federal banking regulators, have blamed the states for igniting the credit crisis through lax regulation. Certainly, there were states that were largely unregulated and there were states where mortgage regulation was weak. Mortgage brokers were loosely regulated in too many states. Similarly, the states never agreed on an effective, uniform system of mortgage regulation. Nevertheless, this criticism of the states disregards the hard-fought efforts by a growing number of states--which eventually grew to include the majority of states--to regulate abusive subprime loans within their borders. State attorneys general and State banking commissioners spearheaded some of the most important enforcement actions against deceptive mortgage lenders.\36\--------------------------------------------------------------------------- \36\ For instance, in 2002, State authorities in 44 states struck a settlement with Household Finance Corp. for $484 million in consumer restitution and changes in its lending practices following enforcement actions to redress alleged abusive subprime loans. Iowa Attorney General, States Settle With Household Finance: Up to $484 Million for Consumers (Oct. 11, 2002), available at www.iowa.gov/government/ag/latest_news/releases/oct_2002/Household_Chicago.html. In 2006, forty-nine states and the District of Columbia reached a $325 million settlement with Ameriquest Mortgage Company over alleged predatory lending practices. See, e.g., Press Release, Iowa Dep't of Justice, Miller: Ameriquest Will Pay $325 Million and Reform its Lending Practices (Jan. 23, 2006), available at http://www.state.ia.us/government/ag/latest_news/releases/jan_2006/Ameriquest_Iowa.html. ---------------------------------------------------------------------------C. The Ability to Shop For Hospitable Laws and Regulators State-chartered banks and thrifts and their subsidiaries had to comply with the State anti-predatory lending laws. So did independent nonbank lenders and mortgage brokers. For the better part of the housing boom, however, national banks, Federal savings associations, and their mortgage lending subsidiaries did not have to comply with the State anti-predatory lending laws due to Federal preemption rulings by their Federal regulators. This became a problem because Federal regulators did not replace the preempted State laws with strong Federal underwriting rules.1. Federal Preemption The states that enacted anti-predatory lending laws did not legislate in a vacuum. In 1996, the Federal regulator for thrift institutions--the Office of Thrift Supervision or OTS--promulgated a sweeping preemption rule declaring that henceforth Federal savings associations did not have to observe State lending laws.\37\ Initially, this rule had little practical effect because any State anti-predatory lending provisions on the books then were fairly narrow.\38\--------------------------------------------------------------------------- \37\ 12 C.F.R. 559.3(h), 560.2. \38\ Bostic et al., supra note 35; Office of Thrift Supervision, Responsible Alternative Mortgage Lending: Advance notice of proposed rulemaking, 65 Fed. Reg. 17811, 17814-16 (2000).--------------------------------------------------------------------------- Following adoption of the OTS preemption rule, Federal thrift institutions and their subsidiaries were relieved from having to comply with State consumer protection laws. That was not true, however, for national banks, State banks, State thrifts, and independent nonbank mortgage lenders and brokers. The stakes rose considerably starting in 1999, when North Carolina passed the first comprehensive State anti-predatory lending law. As State mini-HOEPA laws proliferated, national banks lobbied their regulator--a Federal agency known as the Office of the Comptroller of the Currency or OCC--to clothe them with the same Federal preemption as Federal savings associations. They succeeded and, in 2004, the OCC issued its own preemption rule banning the states from enforcing their laws impinging on real estate lending by national banks and their subsidiaries.\39\ In a companion rule, the OCC denied permission to the states to enforce their own laws that were not federally preempted--state lending discrimination laws are one example--against national banks and their subsidiaries. After a protracted court battle, the controversy ended up in the U.S. Supreme Court, which upheld the OCC preemption rule.\40\--------------------------------------------------------------------------- \39\ Office of the Comptroller of the Currency, Bank Activities and Operations; Final rule, 69 Fed. Reg. 1895 (2004) (codified at 12 C.F.R. 7.4000); Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004) (codified at 12 C.F.R. 7.4007-7.4009, 34.4). National City Corporation, the parent of National City Bank, N.A., and a major subprime lender, spearheaded the campaign for OCC preemption. Predatory lending laws neutered, Atlanta Journal Constitution, Aug. 6, 2003. \40\ Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007); Arthur E. Wilmarth, Jr., The OCC's Preemption Rules Exceed the Agency's Authority and Present a Serious Threat to the Dual Banking System, 23 Ann. Rev. Banking & Finance Law 225 (2004). The Supreme Court recently granted certiorari to review the legality of the OCC visitorial powers rule. Cuomo v. Clearing House Ass'n, L.L.C.,__U.S.__, 129 S. Ct. 987 (2009). The OCC and the OTS left some areas of State law untouched, namely, State criminal law and State law regulating contracts, torts, homestead rights, debt collection, property, taxation, and zoning. Both agencies, though, reserved the right to declare that any State laws in those areas are preempted in the future. For fuller discussion, see. McCoy & Renuart, supra note 26.--------------------------------------------------------------------------- OTS and the OCC had institutional motives to grant Federal preemption to the institutions that they regulated. Both agencies depend almost exclusively on fees from their regulated entities for their operating budgets. Both were also eager to persuade State-chartered depository institutions to convert to a Federal charter. In addition, the OCC was aware that if national banks wanted Federal preemption badly enough, they might defect to the thrift charter to get it. Thus, the OCC had reason to placate national banks to keep them in its fold. Similarly, the OTS was concerned about the steady decline in thrift institutions. Federal preemption provided an inducement to thrift institutions to retain the Federal savings association charter.2. The Ability to Shop for the Most Permissive Laws As a result of Federal preemption, State anti-predatory lending laws applied to State-chartered depository institutions and independent nonbank lenders, but not to national banks, Federal savings associations, or their mortgage lending subsidiaries. The only anti-predatory lending provisions that national banks and federally chartered thrifts had to obey were HOEPA and agency pronouncements on subprime and nontraditional mortgage loans.\41\ Of these, HOEPA had extremely narrow scope. Meanwhile, agency guidances lacked the binding effect of rules and their content was not as strict as the stronger State laws.--------------------------------------------------------------------------- \41\ Board of Governors of the Federal Reserve System et al., Interagency Guidance on Subprime Lending (March 1, 1999); OCC, Abusive Lending Practices, Advisory Letter 2000-7 (July 25, 2000); OCC et al., Expanded Guidance for Subprime Lending Programs (Jan. 31, 2001); OCC, Avoiding Predatory and Abusive Lending Practices in Brokered and Purchased Loans, Advisory Letter 2003-3 (Feb. 21, 2003); OCC, Guidelines for National Banks to Guard Against Predatory and Abusive Lending Practices, Advisory Letter 2003-2 (Feb. 21, 2003); OCC, OCC Guidelines Establishing Standards for Residential Mortgage Lending Practices, 70 Fed. Reg. 6329 (2005); Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006); Department of the Treasury et al., Statement on Subprime Mortgage Lending; Final guidance, 72 Fed. Reg. 37569 (2007). Of course, these lenders, like all lenders, are subject to prosecution in cases of fraud. Lenders are also subject to the Federal Trade Commission Act, which prohibits unfair and deceptive acts and practices (UDAPs). However, Federal banking regulators were slow to propose rules to define and punish UDAP violations by banking companies in the mortgage lending area.--------------------------------------------------------------------------- This dual regulatory system allowed mortgage lender to play regulators off one another by threatening to change charters. Mortgage lenders are free to operate with or without depository institution charters. Similarly, depository institutions can choose between a State and Federal charter and between a thrift charter and a commercial bank charter. Each of these choices allows a lender to change regulators. A lender could escape a strict State law by switching to a Federal bank or thrift charter or by shifting its operations to a less regulated State. Similarly, a lender could escape a strict regulator by converting its charter to one with a more accommodating regulator. Countrywide, the nation's largest mortgage lender and a major subprime presence, took advantage of this system to change its regulator. One of its subsidiaries, Countrywide Home Loans, was supervised by the Federal Reserve. This subsidiary switched and became an OTS-regulated entity as of March 2007. That same month, Countrywide Bank, N.A., converted its charter from a national bank charter under OCC supervision to a Federal thrift charter under OTS supervision. Reportedly, OTS promised Countrywide's executives to be a ``less antagonistic'' regulator if Countrywide switched charters to OTS. Six months later, the regional deputy director of the OTS West Region, where Countrywide was headquartered, was promoted to division director. Some observers considered it a reward.\42\--------------------------------------------------------------------------- \42\ Richard B. Schmitt, Regulator takes heat over IndyMac, Los Angeles Times, Oct. 6, 2008; see also Binyamin Appelbaum & Ellen Nakashima, Regulator Played Advocate Over Enforcer, Washington Post, November 23, 2008.--------------------------------------------------------------------------- The result was a system in which lenders could shop for the loosest laws and enforcement. This shopping process, in turn, put pressure on regulators at all levels--state and local--to lower their standards or relax enforcement. What ensued was a regulatory race to the bottom.III. Regulatory Failure Federal preemption would not have been such a problem if Federal banking regulators had replaced State laws with tough rules and enforcement of their own. Those regulators had ample power to stop the deterioration in mortgage underwriting standards that mushroomed into a full-blown crisis. However, they refused to intervene in disastrous lending practices until it was too late. As a result, federally regulated lenders--as well as all lenders operating in states with weak regulation--were given carte blanche to loosen their lending standards free from meaningful regulatory intervention.A. The Federal Reserve Board The Federal Reserve Board had the statutory power, starting in 1994, to curb lax lending not only for depository institutions, but for all lenders across-the-board. It declined to exercise that power in any meaningful respect, however, until after the nonprime mortgage market collapsed. In the mortgage lending area, the Fed's supervisory process has three major parts and breakdowns were apparent in two out of the three. The only part that appeared to work well was the Fed's role as the primary Federal regulator for State-chartered banks that are members of the Federal Reserve System.\43\--------------------------------------------------------------------------- \43\ In general, these are community banks on the small side. In 2007 and 2008, only one failed bank--the tiny First Georgia Community Bank in Jackson, Georgia, with only $237.5 million in assets--was regulated by the Federal Reserve System. It is not clear whether the Fed's performance is explained by the strength of its examination process, the limited role of member banks in risky lending, the fact that State banks had to comply with State anti-predatory lending laws, or all three. In the following discussion on regulatory failure by the Federal Reserve Board, the OTS, and the OCC, the data regarding failed and near-failed banks and thrifts come from Federal bank regulatory and S.E.C. statistics, disclosures, press releases, and orders; rating agency reports; press releases and other web materials by the companies mentioned; statistics compiled by the American Banker; and financial press reports.--------------------------------------------------------------------------- As the second part of its supervisory duties, the Fed regulates nonbank mortgage lenders owned by bank holding companies but not owned directly or indirectly by banks or thrifts. During the housing boom, some of the largest subprime and Alt-A lenders were regulated by the Fed, including the top- and third-ranked subprime lenders in 2006, HSBC Finance and Countrywide Financial Corporation, and Wells Fargo Financial, Inc.\44\ The Fed's supervisory record with regard to these lenders was mixed. On one notable occasion, in 2004, the Fed levied a $70 million civil money penalty against CitiFinancial Credit Company and its parent holding company, Citigroup Inc., for subprime lending abuses.\45\ Apart from that, the Fed did not take public enforcement action against the nonbank lenders that it regulated. That may be because the Federal Reserve did not routinely examine the nonbank mortgage lending subsidiaries under its supervision, which the late Federal Reserve Board Governor Edward Gramlich revealed in 2007. Only then did the Fed kick off a ``pilot project'' to examine the nonbank lenders under its jurisdiction on a routine basis for loose underwriting and compliance with Federal consumer protection laws.\46\--------------------------------------------------------------------------- \44\ Data provided by American Banker, available at www.americanbanker.com. \45\ Federal Reserve, Citigroup Inc. New York, New York and Citifinancial Credit Company Baltimore, Maryland: Order to Cease and Desist and Order of Assessment of a Civil Money Penalty Issued Upon Consent, May 27, 2004. \46\ Edward M. Gramlich, Boom and Busts, The Case of Subprime Mortgages, Speech given August 31, 2007, Jackson Hole, Wyo., at symposium titled ``Housing, Housing Finance & Monetary Policy,'' sponsored by the Federal Reserve Bank of Kansas City, pp. 8-9, available at www.kansascityfed.org/publicat/sympos/2007/pdf/2007.09.04.gramlich.pdf; Speech by Governor Randall S. Kroszner At the National Bankers Association 80th Annual convention, Durham, North Carolina, October 11, 2007.--------------------------------------------------------------------------- Finally, the Board is responsible for administering most Federal consumer credit protection laws, including HOEPA. When former Governor Edward Gramlich served on the Fed, he urged then-Chairman Alan Greenspan to exercise the Fed's power to address unfair and deceptive loans under HOEPA. Greenspan refused, preferring instead to rely on non-binding statements and guidances.\47\ This reliance on statements and guidances had two disadvantages: one, major lenders routinely dismissed the guidances as mere ``suggestions'' and, two, guidances did not apply to independent nonbank mortgage lenders.--------------------------------------------------------------------------- \47\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 35, 37-38 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Greenspan told the House Oversight Committee in 2008: Well, let's take the issue of unfair and deceptive practices, which is a fundamental concept to the whole predatory lending issue. The staff of the Federal Reserve . . . say[ ] how do they determine as a regulatory group what is unfair and deceptive? And the problem that they were concluding . . . was the issue of maybe 10 percent or so are self-evidently unfair and deceptive, but the vast majority would require a jury trial or other means to deal with it . . . Id. at 89.--------------------------------------------------------------------------- The Federal Reserve did not relent until July 2008, when under Chairman Ben Bernanke's leadership, it finally promulgated binding HOEPA regulations banning specific types of lax and abusive loans. Even then, the regulations were mostly limited to higher-priced mortgages, which the Board confined to first-lien loans of 1.5 percentage points or more above the average prime offer rate for a comparable transaction, and 3.5 percentage points for second-lien loans. Although shoddy nontraditional mortgages below those triggers had also contributed to the credit crisis, the rule left those loans--plus prime loans--mostly untouched.\48\--------------------------------------------------------------------------- \48\ Federal Reserve System, Truth in Lending: Final rule; official staff commentary, 73 Fed. Reg. 44522, 44536 (July 30, 2008). The Board set those triggers with the intention of covering the subprime market, but not the prime market. See id. at 44536-37.--------------------------------------------------------------------------- The rules, while badly needed, were too little and too late. On October 23, 2008, in testimony before the U.S. House of Representatives Oversight Committee, Greenspan admitted that ``those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.'' House Oversight Committee Chairman Henry Waxman asked Greenspan whether ``your ideology pushed you to make decisions that you wish you had not made?'' Greenspan replied:\49\--------------------------------------------------------------------------- \49\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 36-37 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Mr. GREENSPAN. . . . [Y]es, I found a flaw, I don't know how significant or permanent it is, but I have been very distressed by that fact . . . Chairman WAXMAN. You found a flaw? Mr. GREENSPAN. I found a flaw in the model that defines how the world works, so to speak. Chairman WAXMAN. In other words, you found that your view of the world, your ideology, was not right, it was not working. Mr. GREENSPAN. Precisely. That's precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.\50\ \50\ Testimony of Dr. Alan Greenspan before the House of Representatives Committee of Government Oversight and Reform, October 23, 2008, available at http://oversight.house.gov/documents/20081023100438.pdf.---------------------------------------------------------------------------B. Regulatory Lapses by the OCC and OTS Federal preemption might not have devolved into a banking crisis of systemic proportions had OTS and the OCC replaced State regulation for their regulated entities with a comprehensive set of binding rules prohibiting lax underwriting of home mortgages. Generally, in lieu of binding rules, Federal banking regulators, including the OCC and OTS, issued a series of ``soft law'' advisory letters and guidelines against predatory or unfair mortgage lending practices by insured depository institutions.\51\ Federal regulators disavowed binding rules during the run-up to the subprime crisis on grounds that the guidelines were more flexible and that the agencies enforced those guidelines through bank examinations and informal enforcement actions.\52\ Informal enforcement actions were usually limited to negotiated, voluntary agreements between regulators and the entities that they supervised, which made it easy for management to drag out negotiations to soften any restrictions and to bid for more time. Furthermore, examinations and informal enforcement are highly confidential, making it easy for a lax regulator to hide its tracks.--------------------------------------------------------------------------- \51\ See note 41 supra. \52\ Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004).---------------------------------------------------------------------------1. The Office of Thrift Supervision Although OTS was the first agency to adopt Federal preemption, it managed to fly under the radar during the subprime boom, overshadowed by its larger sister agency, the OCC. After 2003, while commentators were busy berating the OCC preemption rule, OTS allowed the largest Federal savings associations to embark on an aggressive campaign of expansion through option payment ARMs, subprime loans, and low-documentation and no-documentation loans. Autopsies of failed depository institutions in 2007 and 2008 show that five of the seven biggest failures were OTS-regulated thrifts. Two other enormous thrifts during that period--Wachovia Mortgage, FSB and Countrywide Bank, FSB--were forced to arrange hasty takeovers by large bank holding companies to avoid failing. By December 31, 2008, thrifts totaling $355 billion in assets had failed in the previous sixteen months on OTS' watch. The reasons for the collapse of these thrifts evidence fundamental regulatory lapses by OTS. Almost all of the thrifts that failed in 2007 and 2008--and all of the larger ones--succumbed to massive levels of imprudent home loans. IndyMac Bank, FSB, which became the first major thrift institution to fail during the current crisis in July 2008, manufactured its demise by becoming the nation's top originator of low-documentation and no-documentation loans. These loans, which became known as ``liar's loans,'' infected both the subprime market and credit to borrowers with higher credit scores. By 2006 and 2007, over half of IndyMac's home purchase loans were subprime loans and IndyMac Bank approved up to half of those loans based on low or no documentation. Washington Mutual Bank, popularly known as ``WaMu,'' was the nation's largest thrift institution in 2008, with over $300 billion in assets. WaMu became the biggest U.S. depository institution in history to fail on September 25, 2008, in the wake of the Lehman Brothers bankruptcy. WaMu was so large that OTS examiners were stationed there permanently onsite. Nevertheless, from 2004 through 2006, despite the daily presence of the resident OTS inspectors, risky option ARMs, second mortgages, and subprime loans constituted over half of WaMu's real estate loans each year. By June 30, 2008, over one fourth of the subprime loans that WaMu originated in 2006 and 2007 were at least thirty days past due. Eventually, it came to light that WaMu's management had pressured its loan underwriters relentlessly to approve more and more exceptions to WaMu's underwriting standards in order to increase its fee revenue from loans.\53\--------------------------------------------------------------------------- \53\ Peter S. Goodman & Gretchen Morgenson, Saying Yes, WaMu Built Empire on Shaky Loans, N.Y. Times, Dec. 28, 2008.--------------------------------------------------------------------------- Downey Savings & Loan became the third largest depository institution to fail in 2008. Like WaMu, Downey had loaded up on option ARMs and subprime loans. When OTS finally had to put it into receivership, over half of Downey's total assets consisted of option ARMs and nonperforming loans accounted for over 15 percent of the thrift's total assets. In short, the three largest depository institution failures in 2007 and 2008 resulted from high concentrations of poorly underwritten loans, including low- and no-documentation ARMs (in the case of IndyMac) and option ARMs (in the case of WaMu and Downey) that were often only underwritten to the introductory rate instead of the fully indexed rate. During the housing bubble, OTS issued no binding rules to halt the proliferation by its largest regulated thrifts of option ARMs, subprime loans, and low- and no-documentation mortgages. Instead, OTS relied on oversight through guidances. IndyMac, WaMu, and Downey apparently treated the guidances as solely advisory, however, as evidenced by the fact that all three made substantial numbers of hazardous loans in late 2006 and in 2007 in direct disregard of an interagency guidance on nontraditional mortgages issued in the fall of 2006 and subscribed to by OTS that prescribed underwriting ARMs to the fully indexed rate.\54\--------------------------------------------------------------------------- \54\ Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006).--------------------------------------------------------------------------- The fact that all three institutions continued to make loans in violation of the guidance suggests that OTS examinations failed to result in enforcement of the guidance. Similarly, OTS fact sheets on the failures of all three institutions show that the agency consistently declined to institute timely formal enforcement proceedings against those thrifts prohibiting the lending practices that resulted in their demise. In sum, OTS supervision of residential mortgage risks was confined to ``light touch'' regulation in the form of examinations, nonbinding guidances, and occasional informal agreements that ultimately did not work.2. The Office of the Comptroller of the Currency The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.\55\ This mattered a lot, because the biggest national banks are considered ``too big to fail'' and pose systemic risk on a scale unmatched by independent nonbank lenders. We might not be debating the nationalization of Citibank and Bank of America today had the OCC stopped them from expanding into toxic mortgages, bonds, and SIVs.--------------------------------------------------------------------------- \55\ Testimony by John C. Dugan, Comptroller, before the Senate Committee on Banking, Housing, and Urban Affairs, March 4, 2008.--------------------------------------------------------------------------- Like OTS, ``light touch'' regulation was apparent at the OCC. Unlike OTS, the OCC did promulgate one rule, in 2004, prohibiting mortgages to borrower who could not afford to repay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007. Despite the 2004 rule, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans. In 2006, for example, fully 62.6 percent of the first-lien home purchase mortgages made by National City Bank, N.A., and its subsidiary, First Franklin Mortgage, were higher-priced subprime loans. Starting in the third quarter of 2007, National City Corporation reported five straight quarters of net losses, largely due to those subprime loans. Just as with WaMu, the Lehman Brothers bankruptcy ignited a silent run by depositors and pushed National City Bank to the brink of collapse. Only a shotgun marriage with PNC Financial Services Group in October 2008 saved the bank from FDIC receivership. The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans. The top-ranked Bank of America, N.A., had a thriving stated-income and no-documentation loan program which it only halted in August 2007, when the market for private-label mortgage-backed securities dried up. Bank of America securitized most of those loans, which may be why the OCC tolerated such lax underwriting practices. Similarly, in 2006, the OCC overrode public protests about a ``substantial volume'' of no-documentation loans by JPMorgan Chase Bank, N.A., the second largest bank in 2005, on grounds that the bank had adequate ``checks and balances'' in place to manage those loans. Citibank, N.A., was the third largest U.S. bank in 2005. In September 2007, the OCC approved Citibank's purchase of the disreputable subprime lender Argent Mortgage, even though subprime securitizations had slowed to a trickle. Citibank thereupon announced to the press that its new subsidiary--christened ``Citi Residential Lending''--would specialize in nonprime loans, including reduced documentation loans. But not long after, by early May 2008 after Bear Stearns narrowly escaped failure, Citibank was forced to admit defeat and dismantle Citi Residential's lending operations. The fourth largest U.S. bank in 2005, Wachovia Bank, N.A., originated low- and no-documentation loans through its two mortgage subsidiaries. Wachovia Bank originated such large quantities of these loans--termed Alt-A loans--that by the first half of 2007, Wachovia Bank was the twelfth largest Alt-A lender in the country. These loans performed so poorly that between December 31, 2006 and September 30, 2008, the bank's ratio of net write-offs on its closed-end home loans to its total outstanding loans jumped 2400 percent. Concomitantly, the bank's parent company, Wachovia Corporation, was reported its first quarterly loss in years due to rising defaults on option ARMs made by Wachovia Mortgage, FSB, and its Golden West predecessor. Public concern over Wachovia's loan losses triggered a silent run on Wachovia Bank in late September 2008, following Lehman Brothers' failure. To avoid receivership, the FDIC brokered a hasty sale of Wachovia to Wells Fargo after Wells Fargo outbid Citigroup for the privilege. Wells Fargo Bank, N.A., was in better financial shape than Wachovia, but it too made large quantities of subprime and reduced documentation loans. In 2006, over 23 percent of the bank's first-lien refinance mortgages were high-cost subprime loans. Wells Fargo Bank also securitized substantial numbers of low- and no-documentation mortgages in its Alt-A pools. In 2007, a Wells Fargo prospectus for one of those pools stated that Wells Fargo had relaxed its underwriting standards in mid-2005 and did not verify whether the mortgage brokers who had originated the weakest loans in that loan pool complied with its underwriting standards before closing. Not long after, as of July 25, 2008, 22.77 percent of the loans in that loan pool were past due or in default. As the Wells Fargo story suggests, the OCC depended on voluntary risk management by national banks, not regulation of loan terms and practices, to contain the risk of improvident loans. A speech by the then-Acting Comptroller, Julie Williams, confirmed as much. In 2005, Comptroller Williams, in a speech to risk managers at banks, coached them on how to ``manage'' the risks of no-doc loans through debt collection, higher reserves, and prompt loss recognition. Securitization was another risk management device favored by the OCC. Three years later, in 2008, the Treasury Department's Inspector General issued a report that was critical of the OCC's supervision of risky loans.\56\ Among other things, the Inspector General criticized the OCC for not instituting formal enforcement actions while lending problems were still manageable in size. In his written response to the Inspector General, the Comptroller, John Dugan, conceded that ``there were shortcomings in our execution of our supervisory process'' and ordered OCC examiners to start initiating formal enforcement actions on a timely basis.\57\--------------------------------------------------------------------------- \56\ Office of Inspector General, Department of the Treasury, ``Safety and Soundness: Material Loss Review of ANB Financial, National Association'' (OIG-09-013, Nov. 25, 2008). \57\ Id.--------------------------------------------------------------------------- The OCC's record of supervision and enforcement during the subprime boom reveals many of the same problems that culminated in regulatory failure by OTS. Like OTS, the OCC usually shunned formal enforcement actions in favor of examinations and informal enforcement. Neither of these supervisory tools obtained compliance with the OCC's 2004 rule prohibiting loans to borrowers who could not repay. Although the OCC supplemented that rule later on with more detailed guidances, some of the largest national banks and their subsidiaries apparently decided that they could ignore the guidances, judging from their lax lending in late 2006 and in 2007. The OCC's emphasis on managing credit risk through securitization, reserves, and loss recognition, instead of through product regulation, likely encouraged that laissez faire attitude by national banks.C. Judging by the Results: Loan Performance By Charter OCC and OTS regulators have argued that their agencies offer ``comprehensive'' supervision resulting in lower default rates on residential mortgages. The evidence shows otherwise. Data from the Federal Deposit Insurance Corporation show that among depository institutions, Federal thrift institutions had the worst default rate for one-to-four family residential mortgages from 2006 through 2008. (See Figure 5). Figure 5. Total Performance of Residential Mortgages by Depository Institution Lenders CHRG-111hhrg48674--334 Mr. Bernanke," Well, I certainly hope that doesn't happen, but our collateral, our loans are very short term. Our collateral is continually reevaluated. So even if the economy gets very bad, banks will almost certainly be able to make those short-term loan repayments. We are not concerned about that, we are concerned about the effects of such a situation on the banking system as a whole. " CHRG-111shrg51395--52 Mr. Bullard," Mine would be to--probably to expand on what Professor Coffee was saying, I think that from an investor protection point of view, what is important to understand is that investor protection actually assumes that we want investors to take risk. And, therefore, investor protection is about making sure that the risks that they take are consistent with their expectations. That is fundamentally inconsistent with a prudential oversight role. Prudential oversight is what you want when somebody buys life insurance and expects the money to be there if their spouse dies. They invest in a banking account, and they expect those assets to be there. They buy a money market fund, and they expect that to be a safe investment. That is antithetical to investor protection risk because there sometimes the disclosure of the truth undermines the confidence that you need that those people rely on to keep their investments in banks--to keep their assets in banks and money market funds. So I would say those have to be separated, and investor protection needs to be, again, as I mentioned earlier, kept distinct from customer protection, which again is not something that needs to be regulated with an eye to promoting risk taking--that is, risk taking based on high expected value investments. And then, finally, I would say that I am a little concerned about mixing the systemic issue and the prudential issue. The way I have always thought about prudential oversight is that you are making sure that the promises made with respect to generally liabilities on one side are matched by the kind of assets that are created to support those liabilities. Systemic oversight is where you assume that prudential regulation, being necessarily imperfect, will sometimes lead to a breakdown, and the question is: What is the role of the Government going to be to prevent that breakdown under a prudential system, which will happen sometimes, and what will it do when it steps in? I think that that is a fundamentally separate function from prudential regulation, and that is why--and I am not sure what a systemic regulator is as apart from a prudential regulator. But that is something, I think, that it would help to have more clarity on. " CHRG-111shrg52619--209 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM JOSEPH A. SMITH, JR.Q.1. Two approaches to systemic risk seem to be identified: (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse? If you support approach one how you would limit institution size and how would you identify new areas creating systemic importance? If you support approach two how would you identify systemically important institutions and what new regulations and market discipline would you recommend?A.1. CSBS endorses the first approach monitor institutions and take steps to reduce the size and activities of institutions that approach either ``too large to fail'' or ``too systemically important to fail.'' Our current crisis has shown that our regulatory structure was incapable of effectively managing and regulating the nation's largest institutions. CSBS believes the solution, however, is not to expand the federal government bureaucracy by creating a new super regulator, or granting those authorities to a single existing agency. Instead, we should enhance coordination and cooperation among the federal government and the states to identify systemic importance and mitigate its risk. We believe regulators must pool resources and expertise to better manage systemic risk. The FFIEC provides a vehicle for working towards this goal of seamless federal and state cooperative supervision. 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. 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.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. Regulatory and legal barriers exist at every level of state and federal government. These barriers can be cultural, regulatory, or legal in nature. Despite the hurdles, state and federal authorities have made some progress towards enhancing coordination. Since Congress added full state representation to the FFIEC in 2006, federal regulators are working more closely with state authorities to develop processes and guidelines to protect consumers and prohibit certain acts or practices that are either systemically unsafe or harmful to consumers. The states, working through CSBS and the American Association of Residential Mortgage Regulators (AARMR), have made tremendous strides towards enhancing coordination and cooperation among the states and with our federal counterparts. The model for cooperative federalism among state and federal authorities is the CSBS-AARMR Nationwide Mortgage Licensing System (NMLS) and the SAFE Act enacted last year. In 2003, CSBS and AARMR began a very bold initiative to identify and track mortgage entities and originators through a database of licensing and registration. In January 2008, NMLS was successfully launched with seven inaugural participating states. Today, 25 states plus the District of Columbia and Puerto Rico are using NMLS. The hard work and dedication of the states was recognized by Congress as you enacted the Housing and Economic Recovery Act of 2008 (HERA). Title V of HERA, known as the SAFE Act, is designed to increase mortgage loan originator professionalism and accountability, enhance consumer protection, and reduce fraud by requiring all mortgage loan originators be licensed or registered through NMLS. Combined, NMLS and the SAFE Act create a seamless system of accountability, interconnectedness, control, and tracking that has long been absent in the supervision of the mortgage market. Please see the Appendix of my written testimony for a comprehensive list of state initiatives to enhance coordination of financial supervision. ------ CHRG-111shrg52619--197 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM DANIEL K. TARULLOQ.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. 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? 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. Changing regulatory structures and--for that matter--augmenting existing regulatory authorities are necessary, but not sufficient, steps to engender strong and effective financial regulation. The regulatory orientation of agency leadership and staff are also central to achieving this end. While staff capacities and expertise will generally not deteriorate (or improve) rapidly, leadership can sometimes change extensively and quickly. While this fact poses a challenge in organizing regulatory systems, there are some things that can be done. Perhaps most important is that responsibilities and authorities be both clearly defined and well-aligned, so that accountability is clear. Thus, for example, assigning a particular type of rulemaking and rule implementation to a specific agency makes very clear who deserves either blame or credit for outcomes. Where a rulemaking or rule enforcement process is collective, on the other hand, the apparent shared responsibility may mean in practice that no one is responsible: Procedural delays and substantive outcomes can also be attributed to someone else's demands or preferences. When responsibility is assigned to an agency, the agency should be given adequate authority to execute that responsibility effectively. In this regard, Congress may wish to review the Gramm-Leach-Bliley Act and other statutes to ensure that authorities and responsibilities are clearly defined for both primary and consolidated supervisors of financial firms and their affiliates. Some measure of regulatory overlap may be useful in some circumstances--a kind of constructive redundancy--so long as both supervisors have adequate incentives for balancing various policy objectives. But if, for example, access to information is restricted or one supervisor must rely on the judgments of the other, the risk of misaligned responsibility and authority recurs.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. Your questions highlight a very real and important issue--how best to ensure that financial supervisors exercise the tools at their disposal to address identified risk management weaknesses at an institution or within an industry even when the firm, the industry, and the economy are experiencing growth and appear in sound condition. In such circumstances, there is a danger that complacency or a belief that a ``rising tide will lift all boats'' may weaken supervisory resolve to forcefully address issues. In addition, the supervisor may well face pressure from external sources--including the supervised institutions, industry or consumer groups, or elected officials--to act cautiously so as not to change conditions perceived as supporting growth. For example, in 2006, the Federal Reserve, working in conjunction with the other federal banking agencies, developed guidance highlighting the risks presented by concentrations in commercial real estate. This guidance drew criticism from many quarters, but is particularly relevant today given the substantial declines in many regional and local commercial real estate markets. Although these dangers and pressures are to some degree inherent in any regulatory framework, there are ways these forces can be mitigated. For example, sound and effective leadership at any supervisory agency is critical to the consistent achievement of that agency's mission. Moreover, supervisory agencies should be structured and funded in a manner that provides the agency appropriate independence. Any financial supervisory agency also should have the resources, including the ability to attract and retain skilled staff, necessary to properly monitor, analyze and--when necessary--challenge the models, assumptions and other risk management practices and internal controls of the firms it supervises, regardless of how large or complex they may be. Ultimately, however, supervisors must show greater resolve in demanding that institutions remain in sound financial condition, with strong capital and liquidity buffers, and that they have strong risk management. While these may sound like obvious statements in the current environment, supervisors will be challenged when good times return to the banking industry and bankers claim that they have learned their lessons. At precisely those times, when bankers and other financial market actors are particularly confident, when the industry and others are especially vocal about the costs of regulatory burden and international competitiveness, and when supervisors cannot yet cite recognized losses or writedowns, regulators must be firm in insisting upon prudent risk management. Once again, regulatory restructuring can he helpful, but will not be a panacea. Financial regulators should speak with one, strong voice in demanding that institutions maintain good risk management practices and sound financial condition. We must be particularly attentive to cases where different agencies could be sending conflicting messages. Improvements to the U.S. regulatory structure could provide added benefit by ensuring that there are no regulatory gaps in the U.S. financial system, and that entities cannot migrate to a different regulator or, in some cases, beyond the boundary of any regulation, so as to place additional pressure on those supervisors who try to maintain firm safety and soundness policies.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. My expectation is that, when the history of this financial crisis and its origins is ultimately written, culpability will be shared by essentially every part of the government responsible for constructing and implementing financial regulation, as well as many financial institutions themselves. Since just about all financial institutions have been adversely affected by the financial crisis, all supervisors have lessons to learn from this crisis. The Federal Reserve is already implementing a number of changes, such as enhancing risk identification processes to more quickly detect emerging risks, not just at individual institutions but across the banking system. This latter point is particularly important, related as it is to the emerging consensus that more attention must be paid to risks created across institutions. The Board is also improving the processes to issue supervisory guidance and policies to make them more timely and effective. In 2008 the Board issued supervisory guidance on consolidated supervision to clarify the Federal Reserve's role as consolidated supervisor and to assist examination staff as they carry out supervision of banking institutions, particularly large, complex firms with multiple legal entities. With respect to hedge funds, although their performance was particularly poor in 2008, and several large hedge funds have failed over the past 2 years, to date none has been a meaningful source of systemic risk or resulted in significant losses to their dealer bank counterparties. Indirectly, the failure of two hedge funds in 2007 operated by Bear Stearns might be viewed as contributing to the ultimate demise of that investment bank 9 months later, given the poor quality of assets the firm had to absorb when it decided to support the funds. However, these failures in and of themselves were not the sole cause of Bear Stearns' problems. Of course, the experience with Long Term Capital Management in 1998 stands as a reminder that systemic risk can be associated with the activities of large, highly leveraged hedge funds. On-site examiners of the federal banking regulators did identify a number of issues prior to the current crisis, and in some cases developed policies and guidance for emerging risks and issues that warranted the industry's attention--such as in the areas of nontraditional mortgages, home equity lending, and complex structured financial transactions. But it is clear that examiners should have been more forceful in demanding that bankers adhere to policies and guidance, especially to improve their own risk management capacities. Going forward, changes have been made in internal procedures to ensure appropriate supervisory follow-through on issues that examiners do identify, particularly during good times when responsiveness to supervisory policies and guidance may be lower.Q.4. While I think having a systemic risk regulator is important, I have concerns with handing additional authorities to the Federal Reserve after hearing GAO's testimony yesterday at my subcommittee hearing. Some of the Fed's supervision authority currently looks a lot like what it might conduct as a systemic risk regulator, and the record there is not strong from what I have seen. If the Federal Reserve were to be the new systemic risk regulator, has there been any discussion of forming a board, similar to the Federal Open Market Committee, that might include other regulators and meet quarterly to discuss and publicly report on systemic risks? If the Federal Reserve were the systemic risk regulator, would it conduct horizontal reviews that it conducts as the supervisor for bank holding companies, in which it looks at specific risks across a number of institutions? If so, and given what we heard March 18, 2009, at my subcommittee hearing from GAO about the weaknesses with some of the Fed's follow-up on reviews, what confidence can we have that the Federal Reserve would do a better job than it has so far?A.4. In thinking about reforming financial regulation, it may be useful to begin by identifying the desirable components of an agenda to contain systemic risk, rather than with the concept of a specific systemic risk regulator. In my testimony I suggested several such components--consolidated supervision of all systemically important financial institutions, analysis and monitoring of potential sources of systemic risk, special capital and other rules directed at systemic risk, and authority to resolve nonbank, systemically important financial institutions in an orderly fashion. As a matter of sound administrative structure and practice, there is no reason why all four of these tasks need be assigned to the same agency. Indeed, there may be good reasons to separate some of these functions--for example, conflicts may arise if the same agency were to be both a supervisor of an institution and the resolution authority for that institution if it should fail. Similarly, there is no inherent reason why an agency charged with enacting and enforcing special rules addressed to systemic risk would have to be the consolidated supervisor of all systemically important institutions. If another agency had requisite expertise and experience to conduct prudential supervision of such institutions, and so long as the systemic risk regulator would have necessary access to information through examination and other processes and appropriate authority to address potential systemic risks, the roles could be separated. For example, were Congress to create a federal insurance regulator with a safety and soundness mission, that regulator might be the most appropriate consolidated supervisor for nonbank holding company firms whose major activities are in the insurance area. With respect to analysis and monitoring, it would seem useful to incorporate an interagency process into the framework for systemic risk regulation. Identification of inchoate or incipient systemic risks will in some respects be a difficult exercise, with a premium on identifying risk correlations among firms and markets. Accordingly, the best way to incorporate more expertise and perspectives into the process is through a collective process, perhaps a designated sub-group of the President's Working Group on Financial Markets. Because the aim, of this exercise would be analytic, rather than regulatory, there would be no problem in having both executive departments and independent agencies cooperating. Moreover, as suggested in your question, it may be useful to formalize this process by having it produce periodic public reports. An additional benefit of such a process would be that to allow nongovernmental analysts to assess and, where appropriate, critique these reports. As to potential rule-making, on the other hand, experience suggests that a single agency should have both authority and responsibility. While it may be helpful for a rule-maker to consult with other agencies, having a collective process would seem a prescription for delay and for obscuring accountability. Regardless of whether the Federal Reserve is given additional responsibilities, we will continue to conduct horizontal reviews. Horizontal reviews of risks, risk management practices and other issues across multiple financial firms are very effective vehicles for identifying both common trends and institution-specific weaknesses. The recently completed Supervisory Capital Assessment Program (SCAP) demonstrates the effectiveness of such reviews and marked an important evolutionary step in the ability of such reviews to enhance consolidated supervision. This exercise was significantly more comprehensive and complex than horizontal supervisory reviews conducted in the past. Through these reviews, the Federal Reserve obtained critical perspective on the capital adequacy and risk management capabilities of the 19 largest U.S. bank holding companies in light of the financial turmoil of the last year. While the SCAP process was an unprecedented supervisory exercise in an unprecedented situation, it does hold important lessons for more routine supervisory practice. The review covered a wide range of potential risk exposures and available firm resources. Prior supervisory reviews have tended to focus on fewer firms, specific risks and/or individual business lines, which likely resulted in more, ``siloed'' supervisory views. A particularly innovative and effective element of the SCAP review was the assessment of individual institutions using a uniform set of supervisory devised stress parameters, enabling better supervisory targeting of institution-specific strengths and weaknesses. Follow-up from these assessments was rapid, and detailed capital plans for the institutions will follow shortly. As already noted, we expect to incorporate lessons from this exercise into our consolidated supervision of bank holding companies. In addition, though, the SCAP process suggests some starting points for using horizontal reviews in systemic risk assessment. Regarding your concerns about the Federal Reserve's performance in the run-up to the financial crisis, we are in the midst of a comprehensive review of all aspects of our supervisory practices. Since last year, Vice Chairman Kohn has led an effort to develop recommendations for improvements in our conduct of both prudential supervision and consumer protection. We are including advice from the Government Accountability Office, the Congress, the Treasury, and others as we look to improve our own supervisory practices. Among other things, our analysis reaffirms that capital adequacy, effective liquidity planning, and strong risk management are essential for safe and sound banking; the crisis revealed serious deficiencies on the part of some financial institutions in one or more of the areas. The crisis has likewise underscored the need for more coordinated, simultaneous evaluations of the exposures and practices of financial institutions, particularly large, complex firms.Q.5. Mr. Tarullo, the Federal Reserve has been at the forefront of encouraging countries to adopt Basel II risk-based capital requirements. This model requires, under Pillar I of Basel II, that risk-based models calculate required minimum capital. It appears that there were major problems with these risk management systems, as I heard in GAO testimony at my subcommittee hearing on March l8th, 2009, so what gave the Fed the impression that the models were ready enough to be the primary measure for bank capital? Moreover, how can the regulators know what ``adequately capitalized'' means if regulators rely on models that we now know had material problems?A.5. The current status of Basel II implementation is defined by the November 2007 rule that was jointly issued by the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and Federal Reserve Board. Banks will not be permitted to operate under the advanced approaches until supervisors are confident the underlying models are functioning in a manner that supports using them as basis for determining inputs to the risk-based capital calculation. The rule imposes specific model validation, stress testing, and internal control requirements that a bank must meet in order to use the Basel II advanced approaches. In addition, a bank must demonstrate that its internal processes meet all of the relevant qualification requirements for a period of at least 1 year (the parallel run) before it may be permitted by its supervisor to begin using those processes to provide inputs for its risk-based capital requirements. During the first 3 years of applying Basel II, a bank's regulatory capital requirement would not be permitted to fall below floors established by reference to current capital rules. Moreover, banks will not be allowed to exit this transitional period if supervisors conclude that there are material deficiencies in the operation of the Basel II approach during these transitional years. Finally, supervisors have the continued authority to require capital beyond the minimum requirements, commensurate with a bank's credit, market, operational, or other risks. Quite apart from these safeguards that U.S. regulators will apply to our financial institutions, the Basel Committee has undertaken initiatives to strengthen capital requirements--both those directly related to Basel II and other areas such as the quality of capital and the treatment of market risk. Staff of the Federal Reserve and other U.S. regulatory agencies are participating fully in these reviews. Furthermore, we have initiated an internal review on the pace and nature of Basel II implementation, with particular attention to how the long-standing debate over the merits and limitations of Basel II has been reshaped by experience in the current financial crisis. While Basel II was not the operative capital requirement for U.S. banks in the prelude to the crisis, or during the crisis itself, regulators must understand how it would have made things better or worse before permitting firms to use it as the basis for regulatory capital requirements. ------ CHRG-111shrg54789--6 Mr. Barr," Certainly. Thank you very much, Chairman Dodd, thank you very much, Ranking Member Shelby. It is a pleasure to be back here to talk with you about the Administration's proposal for a Consumer Financial Protection Agency, a strong financial regulatory agency charged with just one job: looking out for consumers across the financial services landscape. The need could not be clearer. Today's consumer protection system is fundamentally broken. It has just experienced a massive failure. This failure cost millions of responsible consumers their homes, their savings, and their dignity. And it contributed to the near collapse of our financial system. There are voices today saying that the status quo is fine or good enough, that we should just keep the bank regulators in charge of protecting consumers, that we just need some patches to our broken system. They even claim consumers are better off with the current approach. It is not surprising that we are hearing these voices. As Secretary Geithner observed last week, the President's proposals would reduce the ability of financial institutions to choose their own regulator and to continue financial practices that were lucrative for a time, but that ultimately proved so damaging to households and our economy. Entrenched interests resist change always. Major reform always brings out fear mongering. But responsible financial institutions and providers have nothing to fear. We all aspire to the same objectives for consumer protection regulation: independence, accountability, effectiveness, and balance. The question is how to achieve them. A successful regulatory structure for consumer protection requires a focused mission, marketwide coverage, and consolidated authority. Today's system has none of these qualities. It fragments jurisdiction for consumer protection over many regulators, most of which have higher priorities than protecting consumers. Nonbanks avoid Federal supervision; no Federal consumer compliance examiner lands at their doorsteps. Banks can choose the least restrictive supervisor among several different banking agencies with respect to consumer protection. Fragmentation of rule writing, supervision, and enforcement leads to finger-pointing in place of action and makes the action that is taken less effective. The President's proposal for one agency, for one marketplace with one mission--to protect consumers--will change that. The Consumer Financial Protection Agency will create a level playing field for all providers, regardless of their charter or corporate form. It will ensure high and uniform standards across the financial services marketplace. It will end profits based on misleading sales pitches and hidden fee traps, along the lines of those that Senator Shelby and Chairman Dodd worked together to end in the credit card market. But there will be plenty of profits made on a level playing field where banks and nonbanks can compete fairly on the basis of price and quality. If we create one Federal regulator with consolidated authority, we will be able to leave behind regulatory arbitrage and interagency finger-pointing. And we will be assured of accountability. Our proposal ensures, not limits, consumer choice; it preserves, not stifles, innovation; it strengthens, not weakens, depository institutions; it will reduce, not increase, regulatory costs; and it will increase, not reduce, national regulatory uniformity. Successful consumer protection regulation requires mission focus, marketwide coverage, and it requires expertise and effectiveness through a consolidated supervisory entity. Consumer protection requires a mission focus for accountability, expertise, and effectiveness. A new supervisor must have marketwide jurisdiction to ensure consistent and high standards for everyone. And an effective regulator requires authority for regulation, supervision, and enforcement to be consolidated. A regulator without the full kit of tools is frequently forced to choose between acting with minimal effect and not acting at all. We need to end the finger-pointing. The rule writer that does not supervise providers lacks information it needs to determine when to write or revise rules and how best to do so. The supervisor that does not write rules lacks a marketwide perspective or adequate incentives to act. Splitting authorities is a recipe for inertia, inefficiency, and lack of accountability. The present system of consumer protection is not designed to be independent or accountable, effective, or balanced. It is designed to fail. It is simply incapable of earning and keeping the trust of the American people. Today's system does not meet a single one of the requirements I just laid out. The system fragments jurisdiction and authority for consumer protection over many agencies, most of which have higher priorities than protecting consumers. Nonbanks avoid Federal supervision; banks can choose the least restrictive supervisor; and fragmentation of rule writing, supervision, and enforcement leads to finger-pointing in place of action. This structure is a welcome mat for bad actors and irresponsible practices. Responsible banks and credit unions are forced to choose between keeping market share and treating consumers fairly. The least common denominator sets the standard, standards inevitably erode, and consumers pay the price. Mr. Chairman, if you look at the range of problems that have been occurring in the marketplace through this fragmented jurisdiction, I think that it is clear that the American public cannot afford more of the same. The problems that we had in the mortgage market--exploding ARMs, rising loan balances, credit card tricks such as double-cycle billing and late fee traps, the extent of failures in the past--are just unacceptable for us in the future, and the system we have had that led to this is structurally flawed. It is not capable of being fixed through tinkering around the edges. The problem is the structure itself. That problem has only one effective solution: the creation of one agency for one marketplace with one mission--to protect consumers of financial products and services, and the authority to achieve that mission. It is time for a level playing field for financial services competition based on strong rules, not based on exploiting consumer confusion. It is time for an agency that consumers--and their elected representatives--can hold fully accountable. The Administration's legislation fulfills these needs. Thank you for this opportunity to discuss our proposal, and I would be happy to answer any questions. " CHRG-111hhrg52406--147 Mr. Manzullo," No, it won't. It will just add to it. The Federal Reserve had the authority to do two things that could have stopped this collapse in America. Number one, they could have required to have written proof of a person's income before that person could have bought a home. And number two, they could have eliminated the outrageous 3/27 and the 2/28 mortgages with the teaser rates upfront. One agency had the authority to do it. They didn't do anything, and the Nation collapsed economically because of that. So why should we create another agency to come in, create brand new products, oversee what these other people already are not doing. How do we know the new agency would do its job? " fcic_final_report_full--64 One reason for the rapid growth of the derivatives market was the capital require- ments advantage that many financial institutions could obtain through hedging with derivatives. As discussed above, financial firms may use derivatives to hedge their risks. Such use of derivatives can lower a firm’s Value at Risk as determined by com- puter models. In addition to gaining this advantage in risk management, such hedges can lower the amount of capital that banks are required to hold, thanks to a  amendment to the regulatory regime known as the Basel International Capital Ac- cord, or “Basel I.” Meeting in Basel, Switzerland, in , the world’s central banks and bank super- visors adopted principles for banks’ capital standards, and U.S. banking regulators made adjustments to implement them. Among the most important was the require- ment that banks hold more capital against riskier assets. Fatefully, the Basel rules made capital requirements for mortgages and mortgage-backed securities looser than for all other assets related to corporate and consumer loans.  Indeed, capital re- quirements for banks’ holdings of Fannie’s and Freddie’s securities were less than for all other assets except those explicitly backed by the U.S. government.  These international capital standards accommodated the shift to increased lever- age. In , large banks sought more favorable capital treatment for their trading, and the Basel Committee on Banking Supervision adopted the Market Risk Amend- ment to Basel I. This provided that if banks hedged their credit or market risks using derivatives, they could hold less capital against their exposures from trading and other activities.  OTC derivatives let derivatives traders—including the large banks and investment banks—increase their leverage. For example, entering into an equity swap that mim- icked the returns of someone who owned the actual stock may have had some up- front costs, but the amount of collateral posted was much smaller than the upfront cost of purchasing the stock directly. Often no collateral was required at all. Traders could use derivatives to receive the same gains—or losses—as if they had bought the actual security, and with only a fraction of a buyer’s initial financial outlay.  Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., testified to the FCIC about the unique characteristics of the derivatives market, saying, “they accentuated enormously, in my view, the leverage in the system.” He went on to call derivatives “very dangerous stuff,” difficult for market participants, regulators, audi- tors, and investors to understand—indeed, he concluded, “I don’t think I could man- age” a complex derivatives book.  CHRG-111hhrg48867--205 Mr. Ryan," Just as to the role, as we see the role here, it is really early and prompt warning, prompt corrective action. The systemic regulator needs a total picture of all of the interconnected risks. As I have said, this regulator needs to be empowered with information to look over the horizon. We do not do that job well as regulators right now. And it also needs the power to be the tiebreaker, because there are differences of opinion between primary regulators, and if there is a systemic issue, we need someone to make that determination. Just one last comment here. We were talking about failure of institutions. As Ed Yingling said, we already have a system set up for banks in this country under the FDIC. We had no such system for securities firms, we have no such system for large insurance companies, and we have no such system for other, what I would call, potentially systemically important entities. And we need to address that. Thank you. " fcic_final_report_full--295 That summer, the SEC felt Bear’s liquidity was adequate for the immediate future, but supervisors “were suitably skeptical,” Eichner insisted. After the August  meet- ing, the SEC required that Bear Stearns report daily on Bear’s liquidity. However, Eichner admitted that he and his agency had grossly underestimated the possibility of a liquidity crisis down the road.  Every weeknight Upton updated the SEC on Bear’s  billion balance sheet, with specifics on repo and commercial paper. On September , Bear Stearns raised approximately . billion in unsecured -year bonds. The reports slowed to once a week.  The SEC’s inspector general later criticized the regulators, writing that they did not push Bear to reduce leverage or “make any efforts to limit Bear Stearns’ mort- gage securities concentration,” despite “aware[ness] that risk management of mort- gages at Bear Stearns had numerous shortcomings, including lack of expertise by risk managers in mortgage backed securities” and “persistent understaffing; a proximity of risk managers to traders suggesting a lack of independence; turnover of key per- sonnel during times of crisis; and the inability or unwillingness to update models to reflect changing circumstances.”  Michael Halloran, a senior adviser to SEC Chairman Christopher Cox, told the FCIC the SEC had ample information and authority to require Bear Stearns to de- crease leverage and sell mortgage-backed securities, as other financial institutions were doing. Halloran said that as early as the first quarter of , he had asked Erik Sirri, in charge of the SEC’s Consolidated Supervised Entities program, about Bear Stearns (and Lehman Brothers), “Why can’t we make them reduce risk?” According to Halloran, Sirri said the SEC’s job was not to tell the banks how to run their compa- nies but to protect their customers’ assets.  “TURN INTO A DEATH SPIRAL” In August, after the rating agencies revised their outlook on Bear, Cayne tried to ob- tain lines of credit from Citigroup and JP Morgan. Both banks acknowledged Bear had always been a very good customer and maintained they were interested in help- ing.  “We wanted to try to be belts-and-suspenders,” said CFO Samuel Molinaro, as Bear attempted both to obtain lines of credit with banks and to reinforce traditional sources of short-term liquidity such as money market funds. But, Cayne told the FCIC, nothing happened. “Why the [large] banks were not more willing to partici- pate and provide lines during that period of time, I can’t tell you,” Molinaro said.  A major money market fund manager, Federated Investors, had decided on Octo- ber  to drop Bear Stearns from its list of approved counterparties for unsecured commercial paper,  illustrating why unsecured commercial paper was traditionally seen as a riskier lifeline than repo. Throughout , Bear Stearns reduced its unse- cured commercial paper (from . billion at the end of  to only . billion at the end of ) and replaced it with secured repo borrowing (which rose from  billion to  billion). But Bear Stearns’s growing dependence on overnight repo would create a different set of problems. The tri-party repo market used two clearing banks, JP Morgan and BNY Mellon. CHRG-111hhrg52400--82 Mr. McRaith," And, Congressman, if I could also just--Mr. Chairman, if I might add just very briefly? That is, of course, a very serious concern for State insurance regulators. The regulation of the insurance industry is significantly different from the bank industry. So we do--as the regulators now have expertise that can be integrated with systemic risk regulation, but should not be displaced. So, one of the priorities for any systemic regulator is to recognize and value the expertise of the functional regulator, facilitate communication among those regulators, and prevent the systemic disruption that we have experienced. " fcic_final_report_full--113 In its public order approving the merger, the Federal Reserve mentioned the com- mitment but then went on to state that “an applicant must demonstrate a satisfactory record of performance under the CRA without reliance on plans or commitments for future action. . . . The Board believes that the CRA plan—whether made as a plan or as an enforceable commitment—has no relevance in this case without the demon- strated record of performance of the companies involved.”  So were these commitments a meaningful step, or only a gesture? Lloyd Brown, a managing director at Citigroup, told the FCIC that most of the commitments would have been fulfilled in the normal course of business.  Speaking of the  merger with Countrywide, Andrew Plepler, head of Global Corporate Social Responsibility at Bank of America, told the FCIC: “At a time of mergers, there is a lot of concern, sometimes, that one plus one will not equal two in the eyes of communities where the acquired bank has been investing. . . . So, what we do is reaffirm our intention to con- tinue to lend and invest so that the communities where we live and work will con- tinue to economically thrive.” He explained further that the pledge amount was arrived at by working “closely with our business partners” who project current levels of business activity that qualifies toward community lending goals into the future to assure the community that past lending and investing practices will continue.  In essence, banks promised to keep doing what they had been doing, and commu- nity groups had the assurance that they would. BANK CAPITAL STANDARDS:  “ARBITRAGE ” Although the Federal Reserve had decided against stronger protections for con- sumers, it internalized the lessons of  and , when the first generation of sub- prime lenders put themselves at serious risk; some, such as Keystone Bank and Superior Bank, collapsed when the values of the subprime securitized assets they held proved to be inflated. In response, the Federal Reserve and other regulators re- worked the capital requirements on securitization by banks and thrifts. In October , they introduced the “Recourse Rule” governing how much capi- tal a bank needed to hold against securitized assets. If a bank retained an interest in a residual tranche of a mortgage security, as Keystone, Superior, and others had done, it would have to keep a dollar in capital for every dollar of residual interest. That seemed to make sense, since the bank, in this instance, would be the first to take losses on the loans in the pool. Under the old rules, banks held only  in capital to protect against losses on residual interests and any other exposures they retained in securitizations; Keystone and others had been allowed to seriously understate their risks and to not hold sufficient capital. Ironically, because the new rule made the cap- ital charge on residual interests , it increased banks’ incentive to sell the residual interests in securitizations—so that they were no longer the first to lose when the loans went bad. CHRG-110shrg50417--79 Mr. Eakes," I wanted to put in a word of caution. I think until we fix the problems that we have with asset-backed securities, we should be careful about trying to promote its regrowth. So the ratings agencies were a problem in rating AAA paper. We are basically talking about setting up a Government-owned structured investment vehicle, SIV, that got Citibank into trouble. We need to think about the regulatory structure. We need to make sure that the loans that are made cannot be passed into a structure without responsibility or liability passed back to the people who originated it. And, finally, I think that by putting $250 billion of equity into the banking system, normally that should leverage $10 to $12 for every dollar of equity, so we have basically enhanced the balance sheet capacity of the banks in America by $2.5 to $3 trillion that they can add. The whole credit card market, the entire credit card market in America is about $1 trillion. So we have the ability to have, as the Wells representative mentioned, the ability to hold much of these assets on bank balance sheets because of the equity we have invested. So I just think we have some significant problems in the asset-backed market as we have heard the technical discussions about how do you modify loans once they are in there, what can you do; and we have in no way fixed those problems yet. Senator Crapo. Those are good cautions. Your answer to the question raises another point, though. You indicated that the injections of liquidity should have a 10 to 12 factor of leveraging in the marketplace. And I would just like to ask any of our witnesses: Has that, in fact, occurred? Have we seen that kind of---- " CHRG-111hhrg53021Oth--110 Secretary Geithner," Mr. Chairman, could I respond very, very briefly? Just want to say, I completely agree. And the approach we have taken is to apply more exacting standards to the largest institutions than we are to the 9,000 banks across the country that are in a somewhat different set of circumstances. And we are very committed to make sure that we have preserved that basic balance. A great strength of our financial system is that we are not a nation of three banks, or four banks, or five banks, or ten banks, which is true across many industrial economies. We are a nation of 8,000, 9,000 very diverse financial institutions. And that is a source of resilience and strength, and we want to preserve that. " CHRG-111hhrg53021--110 Secretary Geithner," Mr. Chairman, could I respond very, very briefly? Just want to say, I completely agree. And the approach we have taken is to apply more exacting standards to the largest institutions than we are to the 9,000 banks across the country that are in a somewhat different set of circumstances. And we are very committed to make sure that we have preserved that basic balance. A great strength of our financial system is that we are not a nation of three banks, or four banks, or five banks, or ten banks, which is true across many industrial economies. We are a nation of 8,000, 9,000 very diverse financial institutions. And that is a source of resilience and strength, and we want to preserve that. " CHRG-111shrg54533--10 Secretary Geithner," Mr. Chairman, I agree with you. These are some of the most important issues we are going to have to confront together, and I think that you and many others have expressed a number of thoughtful concerns about not just the role of the Fed going forward, but how to think about the right mix of accountability and authority in these areas. So let me just say a few things in response. I think you need to start--we need to start with the recognition that central banks everywhere around the world, in this country and everywhere else, were vested with the dual responsibility at the beginning for both monetary policy and some role in systemic financial stability. That is true here. It is true everywhere. And there is no, I believe, no necessary conflict between those two roles. For example, the Fed has got an exemplary record of keeping inflation low and stable over the last 30 years, even though it had the set of responsibilities you outlined that take it into the areas of financial stability. So I see no conflict. The second point I would make is the following. If you look at the experience of countries in this financial crisis who have taken away from their central bank, from their equivalent of our Federal Reserve, and given those responsibilities for financial stability, for supervision, for looking across the system to other agencies, I think they found themselves in a substantially worse position than we did as a country, with in many ways a worse crisis, with more leverage in their banking systems, with less capacity to act when the crisis unfolded, for a simple basic reason, I think. If you require a committee to act, if the people that have to act in the crisis, if the fire department has no knowledge of the underlying institutions it may have to lend to in crisis, it is likely to make less good judgments in that context. It may be too tentative to act or it may act less with--too indiscriminately in a crisis in that context. So if we look at the experience of many countries in the docu-differ model, it is not encouraging. The model where you take those responsibilities away from the central bank and vest them somewhere is not an encouraging model, in our judgment. I think you see those countries, if you listen carefully, moving in the other direction. Just a few other quick things in response. Our proposals for the additional authority we are giving the Fed are actually quite modest and build on their existing authorities. So, for example, the Fed already is the holding company supervisor of the major firms in the United States that are banks, or built around banks, but it was not given in Gramm-Leach-Bliley clear accountability and authority. It was required to defer to the functional supervisors responsible for overseeing the banks and the broker dealers. That is a bad mix of responsibility without authority, but we are proposing just to tighten that up and clarify it so they feel perfectly accountable for exercising that authority. In the payments area, the Fed has a general responsibility for looking at payment systems, but very limited, weak authority in terms of capital, which is essential to our reform proposals and central to any effort to create a more stable system. The Fed has some role today in helping set capital requirements, but that role is very constrained by the requirements of consensus across a very complicated mix of other regulatory authorities. Those are the key areas where we propose giving the Fed modest additional authority and clarify accountability for responsibility. They are not a dramatic increase in powers. We are proposing to take away from the Fed responsibility for writing rules for consumer protection and enforcing those rules. That is a substantial diminishment of authority and preoccupation and distraction. We are also proposing to qualify their capacity to use their emergency powers to lend to an institution they do not supervise in the future and to require that to exercise that authority, they require the concurrence of the executive branch. So we proposed what we believe is a balanced package over this set of independent regulatory authorities for consumer protection, for market integrity, for resolution authority. We propose establishing a council that will play the necessary coordinating role. That will provide some checks and balances against the risk that those underlying agencies get things wrong. It provides the capacity to deal with gaps, adapt in the future. So those are some of the reasons. I want to just say one more thing to end. I don't think there is any regulator or any supervisor in our country, and I think this is true for all the other major economies, that can look at their record and not find things that they did not do well enough. That is certainly true of the Fed. On the other hand, if you look at where risks were most acute in our country, where underwriting standards were weakest, where consumer protections were least adequate, again, where systemic risk that threatened the system was most acute, those developed largely outside the direct and indirect purview of the Fed and the Fed was left with no responsibility and no ability to contain those basic risks, and that is an important thing for us to change if we are going to build a stronger system. " CHRG-111hhrg53234--171 Mr. Meyer," First, let me reiterate what I said before, and I agree with Vice Chairman Kohn here, that what the Treasury proposal does is very incremental and not very dramatic, not a vast expansion of powers--basically asking the Fed to do what it has been doing as bank holding company supervisor and extending that reach to a modest degree over systemically important financial institutions that don't have a bank. I think it is clear that the Federal Reserve didn't distinguish itself in carrying out its responsibilities as supervisor and regulator of banks and bank holding companies. This is an extraordinary period; it is the first financial crisis since the Great Depression, and I don't believe any other financial supervisor or regulator carried out its responsibilities to protect the safety and soundness of the banks and institutions under their control in this circumstance either. So I think what we need to do is not only ask the Fed to carry out its responsibilities, but to encourage it to do what I think it would otherwise do, to change capital standards that make them more onerous for systemically important institutions, carry out more macroprudential supervision than it has done before, although, let me say, the Treasury proposal separates that out and gives that responsibility mainly to Treasury--well, mainly to the risk council that is staffed by Treasury and chaired by the Secretary. " CHRG-111hhrg56776--268 Mr. Kashyap," Thank you, Chairman Watt, and members of the committee. Besides my affiliation at Chicago Booth, I want to mention I'm also a member of the Squam Lake Group, since I'm going to tout a couple of their recommendations. Today, I'm going to consider whether and how the Fed supervisory role should change by considering three specific questions. First, I want to ask how the most costly mistakes in the United States regarding individual institutions might have differed if the Fed had been stripped of its supervisory powers; second, I want to review the U.K. evidence where the Central Bank was not involved in bank supervision and ask if those outcomes were particularly good; and third, time permitting, I'll look at the overall financial system and ask what might have been done to protect the whole system better. I'm going to skip large parts of my written testimony, but I would be happy to take up questions about that. So let's look at the biggest individual supervisory failures. As has already been mentioned here today, by far the most expensive rescue was for Fannie and Freddie. CBO's latest estimates put the costs to the taxpayer at over $200 billion and the problems of these institutions were well known, and as Chairman Bernanke indicated, the Fed was testifying as early as 2004 about the risks that they posed. So it seems hard to put the blame for these two on the Fed. The next most expensive rescue was for AIG. The cost of this intervention was estimated at probably upwards of $30 billion. In this case, the Fed wrote the check for the rescue, and the Fed actions, particularly regarding the transparency around the transaction, have been legitimately and heavily criticized. AIG's primary regulator was the Office of Thrift Supervision, which had absolutely no experience in understanding what was happening inside AIG Financial Products. So when the decisions that had to be made about AIG were taken, the Fed was flying blind. Chairman Bernanke has said the AIG case causes him the most trouble of anything that happened in the crisis, and I think it also provides the best example of why stripping the Central Bank of its supervisory authority would likely make problems, such as AIG, more probable in the future. No one thinks it's possible to have a modern financial economy without a lender of last resort facility. So let me offer an analogy. As a lender of last resort, you're never sure who is going to come through the door and ask for a date. When your date shows up on Friday night and it's AIG, the question at hand is, would you like to know something about them or would you rather have to pay $85 billion to buy them dinner. If we mandate that the Fed is not involved in supervision, then we make hasty, uninformed decisions inevitable whenever the lender of last resort has to act. The third most expensive rescue is likely to turn out to be Bear Stearns. Here again the primary regulator, in this case the SEC, was clueless about what was going on as Bear's demise approached. The Fed crossed the rubicon in this rescue, but as with AIG, it was forced to act on short notice with very imperfect information about Bear's condition and with no supervisory authority to shape the outcome. Whatever the criticisms one wants to make about the Fed's actions regarding Bear Stearns, the problems didn't come because of incompetent Fed supervision of Bear. If anybody wants to ask about Citigroup, we could talk about that as well. That is a case where the Fed had direct responsibility. My point in reviewing these cases is not to absolve the Fed. As we say in this town, plenty of mistakes were made. But I think this quick summary shows that if another supervisor had taken over the Fed's responsibilities, the U.S. taxpayer still would be on the hook for billions of dollars. One obvious objection to the way I have been reasoning is that I took the rest of the environment as given in contemplating a supervisory system without the Central Bank. Perhaps if the Fed had been out of the picture, other supervisors would have stepped in and built a better system. Here the lessons of the United Kingdom are particularly informative. The U.K. has deep financial markets with many large financial institutions and London is a financial center. The U.K. separated the Central Bank from supervision in the 1990's and set up a separate organization--the Financial Services Agency--to focus on bank supervision. The agreement that was reached required the treasury, the Central Bank, and the FSA to agree on any rescues. The first real test of this system came when Northern Rock got into trouble. The management of Northern Rock notified the FSA of its problems on August 13, 2007; the Bank of England found out the next day. It took over a month of haggling between the Bank of England, the treasury, and the FSA to decide what to do before the Bank of England eventually announced its support for Northern Rock. Even that support was not enough to prevent a run, and the first failure related to a run in the U.K. since 1866. While the distribution of blame is debated, there is complete agreement that the situation was mismanaged and the lack of coordination was important. Besides Northern Rock, several other large British banks, including Lloyd's and Royal Bank of Scotland, required government assistance in the United Kingdom. The total taxpayer burden from these interventions is guesstimated as being about 20 to 50 billion pounds. I expect that if we formed a council to oversee the U.S. financial system, we would arrive at the same arrangement as in the U.K. In particular, it would rely on consensus, and information sharing amongst the different agencies would be poor. The events in the U.K. suggest when this system was actually adopted, it didn't work. And I see no reason to expect it would work in the United States. So, what should we do? Well, the problems with the existing regulatory structure go far beyond the question of which organizations do the supervision of individual institutions. The gaps in supervisory coverage were critical. The fact that institutions could change regulators if the regulator became too tough is appalling, and that let the risks in the system grow for no good reason. But the crisis has also shown us that while there were many sources of fragility, nobody was watching the whole financial system. And when individual regulators did see problems, they were often powerless to do anything about them. Thus, a critical step in reforming regulation must be the creation of a systemic risk regulator that is charged with monitoring the whole financial system. The regulator must have the authority and tools to intervene to preserve the stability of the system. I know Mr. Watt's subcommittee held some very nice hearings in July on exactly this issue, and the lack of progress on this front is disappointing. But even with a vigilant systemic risk regulator, it seems likely that most of the problems in the crisis would have appeared anyway. The Squam Lake Group has argued that the cost of the AIG rescue could have been substantially reduced if we had a package of reforms. And this package would have included: one, just designating the Fed as systemic risk regulator; two, increasing the use of centralized clearing of derivatives; three, creating mandatory living wills for financial institutions and bolstering resolution authority; four, changing capital rules for systemically important institutions; five, improving the disclosure of trading positions; and six, holding back pay at systemically relevant institutions. I would be glad to discuss this in the question-and-answer period. I just want to close with one last thought, which is I don't want to sound like I think that the Fed has a role or comparative advantage in all types of financial regulation, and I want to reiterate the Squam Lake Group's recommendation to get the Fed out of the business of consumer protection regulation. This is a case where there are very few synergies between the staffing requirements of consumer protection and other essential Central Bank duties. The Fed would be far better off handing off these duties to another regulator. Thank you. [The prepared statement of Professor Kashyap can be found on page 80 of the appendix.] " CHRG-110shrg50414--76 Secretary Paulson," The answer is yes, and it is very easy to rationalize it to the American people. Senator Shelby. I need your help here. " Secretary Paulson," OK. Here is how I want to--this is all about the American taxpayer. That is all we care about. And so any business, any banking operation in the United States that is doing business here and dealing with the American public is important. They are all important to keeping our markets open, keeping credit flowing. The American public, when they are dealing with the financial system, does not know who owns that bank. What they care about is how is the system working. And so we are doing this to protect the system, and it is about keeping credit flowing, protecting savings, making it possible to have car loans, student loans, mortgages. And, again, if you have operations in the United States and you are doing business with the American people, that is what we are focused on. But let me also say to you we have a global financial system, and when I was on the phone a number of times, and most recently Monday morning, talking with central bankers and finance ministers around the world, I urged them all to put in place where it is necessary similar programs with similar objectives. Senator Shelby. What do you say to people that ask us, or at least ask me--and I am sure others--how do you rationalize or justify bailing out banks and so forth that cause, are the root cause of a lot of this problem where they will be made whole with capital, at least it will strengthen them? And I understand that strengthens the economy, but they will profit dearly from this, more than likely. " CHRG-110hhrg46591--372 Mr. Klein," Is that a question of using the $250 billion that is out there and trying to have our community banks and others--I read Mr. Paulson's letter, which I am sure you saw, in terms of everybody has access to us, not just for large institutions. Are you comfortable that that strategy or what you are hearing so far of the application process will get that capital into the community bank system? " CHRG-111hhrg53244--125 Mr. Bernanke," In terms of having the same terms and conditions that they had before the crisis, maybe that will never come back, because credit is sort of permanently tightened up in that respect. I am hopeful that as banks stabilize--and we are seeing some improvements in the banking system--and as the economy stabilizes to give more confidence to lenders, that we will see better credit flows. " CHRG-111hhrg49968--61 Mr. Bernanke," Well, the point of the warrants was that if things turned around and got better, that the public would share in some of that gain. I would say that TARP has been pretty successful in terms of stabilizing the banks and helping to get them back on their feet and get our banking system back on its feet. And stock prices, although they are still relatively low on an historical basis, have done a lot better lately, and some of that gain should go to the public. " CHRG-111hhrg53021--7 Mr. Minnick," First we should merge the SEC and the Commodity Futures Trading Commission. Financial derivatives whether they originate in a commodity, a security, or neither, like weather futures are functionally identical and must be traded, cleared and settled subject to the same rules. Bifurcated responsibility might be made to work temporarily, but is a poor long-term solution which will discourage bold action when crises arise and will encourage regulatory arbitrage. Second, banking regulation should be removed from an already overburdened Federal Reserve and the remaining three Federal depository institution regulators, the OTS, the FDIC and the OCC should be combined into a single Federal bank regulator; which should also be given broad consumer protection responsibility and resolution authority for both banks and all other entities deemed systemically risky. Powerful global institutions like Citibank, Bank of America, or AIG should not be allowing to shop for the weakest Federal regulator. Finally, the proposed systemic risk oversight counsel should have the highest quality permanent staff if it is to respond appropriately as future dangers arise. Because the Federal Reserve is the more institutionally independent Executive Branch agency, and has increasing global responsibilities, that staff should be housed in the Fed and the counsel should be chaired by the Fed Chairman. I thank both chairs and yield back. " CHRG-111hhrg53021Oth--7 Mr. Minnick," First we should merge the SEC and the Commodity Futures Trading Commission. Financial derivatives whether they originate in a commodity, a security, or neither, like weather futures are functionally identical and must be traded, cleared and settled subject to the same rules. Bifurcated responsibility might be made to work temporarily, but is a poor long-term solution which will discourage bold action when crises arise and will encourage regulatory arbitrage. Second, banking regulation should be removed from an already overburdened Federal Reserve and the remaining three Federal depository institution regulators, the OTS, the FDIC and the OCC should be combined into a single Federal bank regulator; which should also be given broad consumer protection responsibility and resolution authority for both banks and all other entities deemed systemically risky. Powerful global institutions like Citibank, Bank of America, or AIG should not be allowing to shop for the weakest Federal regulator. Finally, the proposed systemic risk oversight counsel should have the highest quality permanent staff if it is to respond appropriately as future dangers arise. Because the Federal Reserve is the more institutionally independent Executive Branch agency, and has increasing global responsibilities, that staff should be housed in the Fed and the counsel should be chaired by the Fed Chairman. I thank both chairs and yield back. " CHRG-111shrg57320--392 Mr. Doerr," Same. That is a layered risk. Senator Levin. I guess one of the issues, obviously the big issue we will be looking at in the next two hearings is the dumping of high-risk loans into the financial system as a whole. We have been looking at the upstream. In one bank, a big bank, these mortgages ended up being a lot of toxic mortgages were created and put into the commercial stream. Next week we will be looking at credit rating agencies, how were those mortgages rated when they were securitized and the failures, the flaws, the shortcomings in that process, and then the week after we will be looking at the investment banks and the securitizing and the selling of those securities and what were the failures and inadequacies in that process that led to such horrific outcomes for our economy. But what role, if any, should the regulators have, what guidance should there be relative to a financial institution dumping these kind of toxic mortgages into a financial system? They can come back and bite the institution themselves, obviously, if they turn out to be flawed and there is a claim back on the institution. So that is one area why I would hope regulators would see that something needs to be done in that area. But, in general, I think you know exactly what I am driving at. What, if any, guidance should be given to institutions by regulators relative to that issue as to putting into the stream of commerce the mortgages which are bad mortgages? Let us just call them that. Mr. Corston. " CHRG-111hhrg53245--50 The Chairman," All right. The language frankly could have supported that. So you're not quoted in opposition to something--you are talking about strict capital-- What else would the Systemic Risk Council do--because you say here--and obviously I think this is an important possible area of some common ground--you say, ``The Systemic Risk Council would be authorized then to monitor the worldwide financial system, report to Congress and the public on the possible growth of systemic risk, or the factors that might produce a serious common shock.'' Would they have any more power than just to report it to us? Do they just drop it in our laps? Or would you give them any power to do anything other than limiting the capital limits on banks? " CHRG-111hhrg48674--146 Mr. Bernanke," Well, I think the main risk for stagflation would be if we don't fix the banking system. We saw in Japan, for example, or in the 1930's in the United States, that if the financial system is badly damaged and left to wither, that it is very difficult for entrepreneurs to get credit, for firms to invest, and that has a very negative effect on growth. So I think that it is absolutely essential that however difficult it may be, that we get the financial system running again. That will allow the economy to return to a more normal growth path. " CHRG-111hhrg52406--222 Mr. Manzullo," Let me flip the question. If you believe, as I do, that you do not need another agency, what would you do with the present structure to make sure this economic collapse did not occur again? " CHRG-111shrg55117--134 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KYL FROM BEN S. BERNANKEQ.1. As I recall at the Republican Policy Lunch a few weeks ago you acknowledged that some or the regional offices of Federal bank regulators may be too strict in their examinations and may have inadvertently discouraged some institutions from making certain loans that would otherwise be viable. Have you been able to make any progress in addressing this problem?A.1. In response to your concerns that actions of our examiners may be inadvertently discouraging bank lending, it is important to remember that the role of the examiner is to promote safety and soundness at financial institutions. To ensure a balanced approach in our supervisory activities, we have reminded our examiners not to discourage bank lending to creditworthy borrowers. In this environment, we are aware that lenders have been tightening credit standards and terms on many classes of loans. There are a number of factors involved in this, including the continued deterioration in residential and commercial real estate values and the current economic environment, as well as the desire of some depository institutions to strengthen their balance sheets. To ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers, the Federal Reserve has long-standing policies in place to support sound bank lending and the credit intermediation process. Guidance, which has been in place since 1991, specifically instructs examiners to ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers. \1\ The 1991 guidance also states that examiners are to ensure that supervisory personnel are reviewing loans in a consistent, prudent, and balanced fashion and emphasizes achieving an appropriate balance between credit availability and safety and soundness.--------------------------------------------------------------------------- \1\ ``Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans'', (November 1991); www.federalreserve.gov/boarddocs/srletters/1991/SR9124.htm.--------------------------------------------------------------------------- As part of our effort to help stimulate appropriate bank lending, the Federal Reserve and the other Federal banking agencies issued a statement in November 2008 reinforcing the longstanding guidance encouraging banks to meet the needs of creditworthy borrowers. \2\ The guidance was issued to encourage bank lending in a manner consistent with safety and soundness, specifically by taking a balanced approach in assessing borrowers' ability to repay and making realistic assessments of collateral valuations.--------------------------------------------------------------------------- \2\ ``Interagency Statement on Meeting the Needs of Creditworthy Borrowers'', (November 2008); www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm.Q.2. If so, how is the Federal Reserve facilitating coordination among the regional offices of our regulators to ensure standards are applied in a way that protects the safety and soundness of the banking system without discouraging viable ---------------------------------------------------------------------------lending?A.2. Federal Reserve Board staff has consistently reminded field examiners of the November guidance and the importance of ensuring access to loans by creditworthy borrowers. Across the Federal Reserve System, we have implemented training and outreach to underscore these intentions. We have prepared and delivered targeted Commercial Real Estate training across the System in 2008, and continue to emphasize achieving an appropriate balance between credit availability and safety and soundness during our weekly conference calls with examiners across the regional offices in the System. Weekly calls are also held among senior management in supervision to discuss issues on credit availability to help ensure examiners are not discouraging viable safe and sound lending. Additional outreach and discussions occur as specific cases arise and as we participate in conferences and meetings with various industry participants, examiners, and other regulators. Additional Material Supplied for the Record" CHRG-109hhrg22160--215 Mr. Greenspan," I did not use it yesterday in the Senate. I consider the problem a very serious one, one that has to be addressed, in my judgment, quite soon, and certainly to be in place well before the 2008 leading edge of the baby boom generation retiring. " CHRG-111shrg54789--62 Mr. Barr," Senator Tester, we have a very strong proposal in our report and will soon be sending up legislation with respect to consolidated supervision of very large financial firms, what are called under our proposal Tier 1 financial holding companies. They will be subject to stringent supervision on a consolidated basis. They will have higher capital standards. They will have higher requirements with respect to liquidity. And the basic goal of that system is to create large cushions in the system so that when failures happen, if failures happen, there is a lot more give---- Senator Tester. Are we doing the same thing to the community banks that you just talked about to the Wall Street banks? " CHRG-111shrg52619--85 Chairman Dodd," Thank you very much, and I totally agree with that. I think that is very, very important. Senator Reed. Senator Reed. Well, thank you, Mr. Chairman. I want to thank the witnesses. I have great respect for your efforts and your colleagues' efforts to enforce the laws and to provide the kind of stability and regulation necessary for a thriving financial system. I think I have seen Mr. Polakoff at least three times this week, so I know you put in a lot of hours in here as well as back in the office, so thank you for that. Yesterday, we had a hearing based on a GAO report about the risk assessment capacities and capabilities of financial institutions, but one of the things that struck me is that perhaps either inadvertently or advertently, we have given you conflicting tasks. One is to maintain confidence in the financial system of the United States, but at the same time giving you the responsibility to expose those faults in the financial system to the public, to the markets, and also to Congress. And I think in reflecting back over the last several years or months, what has seemed to trump a lot of decisions by all these agencies has been the need or the perceived need to maintain confidence in the system when, in fact, many regulators had grave doubts about the ability of the system to perform, the risks that were being assembled, the strategies that were being pursued. And I think if we don't at least confront that conflict or conundrum directly, we could reassign responsibilities without making a significant change in anything we do. And so in that respect, I wonder if you have any kind of thoughts about this tradeoff between your role as cheerleaders for the banking system and your role as referees for the banking system. Mr. Dugan? " CHRG-111shrg56415--244 PREPARED STATEMENT OF JOSEPH A. SMITH, JR. North Carolina Commissioner of Banks, on behalf of the Conference of State Bank Supervisors October 14, 2009INTRODUCTION Good afternoon, Chairman Johnson, Ranking Member Crapo, and distinguished members of the Subcommittee. My name is Joseph A. Smith, Jr. I am the North Carolina Commissioner of Banks and the Chairman of the Conference of State Bank Supervisors (CSBS). Thank you for the opportunity to testify today on the condition of the banking industry. In the midst of a great deal of discussion about reform and recovery, it is very important to pause to assess the health of the industry and the factors affecting it, for good and ill. My testimony today will present the views of state bank supervisors on the health of the banking industry generally and the banks we oversee in particular--the overwhelming majority of which are independent community banks. The states charter and regulate 73 percent of the nation's banks (Exhibit A). These banks not only compete with the nation's largest banks in the metropolitan areas, but many are the sole providers of credit to less populated and rural areas (Exhibit B). We must remember 91 percent of this country's banks have less than $1 billion in assets but share most of the same regulatory burdens and economic challenges of the largest banks which receive the greatest amount of attention from the Federal Government. Community and regional banks are a critical part of our economic fabric, providing an important channel for credit for consumers, farmers, and small businesses. I will address: the key challenges that state-chartered banks face, regulatory policies that we are pursuing to improve supervision and the health of the industry, and recommendations to improve the regulation of our banks and ultimately the health of the industry.CONDITION OF THE BANKING INDUSTRY While the economy has begun to show signs of improvement, there are still many areas of concern. Consumer confidence and spending remains low, deficit spending has soared, and unemployment rates continue to slowly tick upward. The capital markets crisis, distress in the residential and commercial real estate markets, and the ensuing recession have greatly weakened our nation's banking industry. And despite recent positive developments, the banking industry continues to operate under very difficult conditions. While there are pockets of strength in parts of the state bank system, the majority of my fellow state regulators have categorized general banking conditions in their states as ``gradually declining.'' Not surprisingly, the health of banks is directly affected by the economic conditions in which they operate. Times of economic growth will usually be fueled by a banking industry with sufficient levels of capital, a robust and increasing volume of performing loans, ample liquidity, and a number of new market entrants, in the form of de novo institutions. Conversely, this recession is characterized by a banking industry marred by evaporating capital levels, deteriorating and increasingly delinquent loans, liquidity crunches, and a steady stream of bank failures. The Federal Deposit Insurance Corporation (FDIC) reports in its most recent Quarterly Banking Profile that the banking industry suffered an aggregate net loss of $3.7 billion in the second quarter of 2009. These losses were largely caused by the increased contributions institutions made to their loan-loss provisions to counter the rising number of non-performing loans in their portfolios and realized losses. Further, additional writedowns in the asset-backed commercial paper portfolios and higher deposit insurance assessments impacted banks' earnings significantly.\1\--------------------------------------------------------------------------- \1\ FDIC Quarterly Banking Profile, Second Quarter 2009: http://www2.fdic.gov/qbp/2009jun/qbp.pdf.--------------------------------------------------------------------------- Across the country, my colleagues are experiencing deteriorating credit quality in their banks, which is straining earnings and putting extreme pressure on capital. Deterioration in credit quality is requiring greater examination resources as regulators evaluate a higher volume of loans. Concentrations in commercial real estate (CRE) loans in general, and acquisition, development, and construction (ADC) loans in particular, are posing the greatest challenge for a significant portion of the industry. This is an important line of business for community and regional banks. Banks with less than $10 billion in assets comprise 23 percent of total bank assets, but originate and hold 52 percent of CRE loans and 49 percent of ADC loans by volume. Reducing the concentrations that many of our institutions have in CRE lending is an important factor in restoring them to health; however, it is our view that this reduction needs to be done in a way that does not remove so much credit from the real estate market that it inhibits economic recovery. Striking an appropriate balance should be our goal. Deteriorating credit quality has a direct and destructive effect on bank capital. Reduction in capital, in turn, has a direct and destructive effect on a bank's liquidity, drying up its sources of funding from secondary sources, including capital markets, brokered deposits, home loan and bankers' banks and the Federal Reserve. This drying up of liquidity has been a significant challenge for a substantial number of the failures.CAPITAL IS KING As we entered the financial crisis, we touted the overall strong capital base of the industry, especially compared to previous periods of economic stress. While this was true, banks are highly leveraged operations, and when losses materialize, capital erodes quickly. While this is true for all institutions, it is more pronounced in our largest banks. According to the FDIC, as of December 31, 2007, banks over $10 billion in assets had an average leverage capital ratio of 7.41 percent. This was 200 basis points (b.p.) less than banks with assets between $1 billion and $10 billion; 256 b.p. less than banks with assets between $100 million and $1 billion; and an astonishing 610 b.p. less than banks with assets less than $100 million. As the financial crisis was unfolding and the serious economic recession began, these numbers show our largest institutions were poorly positioned, leading to the extraordinary assistance by the Federal Government to protect the financial system. Even with this assistance, this differential continues today with the largest institutions holding considerably less capital than the overwhelming majority of the industry. Last year, the Federal Government took unprecedented steps to protect the financial system by providing capital investments and liquidity facilities to our largest institutions. Financial holding company status was conferred on a number of major investment banks and other financial concerns with an alacrity that was jaw-dropping. We trust the officials responsible took the action they believed necessary at that critical time. However, Federal policy has not treated the rest of the industry with the same expediency, creativity, or fundamental fairness. Over the last year, we have seen nearly 300 community banks fail or be merged out of existence, while our largest institutions, largely considered too big to fail, have only gotten bigger. State officials expect this trend to continue, with an estimated 125 additional unassisted, privately negotiated mergers due to poor banking conditions. Additional capital, both public and private, must be the building block for success for community and regional banks. While TARP has provided a source of capital for some of these institutions, the process has been cumbersome and expensive for the community and regional banks, whether they actually received the investment of funds or not. There has been a lack of transparency associated with denial of a TARP application, which comes in the form of an institution being asked to withdraw. This should of deep concern to Congress. If TARP is to be an effective tool to strengthen community and regional banks, the Treasury must change the viability standard. We should provide capital to institutions which are viable after the TARP investment. Expanded and appropriate access to TARP capital will go a long way to saving the FDIC and the rest of the banking industry a lot of money. To date, this has been a lost opportunity for the Federal Government to support community and regional banks and provide economic stimulus. There are positive signs private capital may be flowing into the system. For the 6 months ending June 30, 2009, over 2,200 banks have injected $96 billion in capital. While capital injections were achieved for all sizes of institutions, banks with assets under $1 billion in assets had the smallest percentage of banks raising capital at 25 percent. There has been and, to our knowledge, there still is a concern among our Federal colleagues with regard to strategic investments in and acquisitions of banks, both through the FDIC resolution process and in negotiated transactions. While these concerns are understandable, we believe they must be measured against the consequence of denying our banks this source of capital. It is our view that Federal policy should not unnecessarily discourage private capital from coming off the sidelines to support this industry and in turn, the broader economy.SUPERVISION DURING THE CRISIS There are very serious challenges facing the industry and us as financial regulators. State regulators have increased their outreach with the industry to develop a common understanding of these challenges. Banks are a core financial intermediary, providing a safe haven for depositors' money while providing the necessary fuel for economic growth and opportunity. While some banks will create-and have created-their own problems by miscalculating their risks, it is no surprise that there are widespread problems in banks when the national economy goes through a serious economic recession. We will never be able, nor should we desire, to eliminate all problems in banks; that is, to have risk-free banking. While they are regulated and hold the public trust, financial firms are largely private enterprises. As such, they should be allowed to take risks, generate a return for shareholders, and suffer the consequences when they miscalculate. Over the last year, we have watched a steady stream of bank failures. While unfortunate and expensive, this does provide a dose of reality to the market and should increase the industry's self-discipline and the regulators' focus on key risk issues. In contrast to institutions deemed too big to fail, market discipline and enhanced supervisory oversight can result in community and regional banks that are restructured and strengthened.Recognizing the Challenges The current environment, while providing terrific challenges with credit quality and capital adequacy, has also brought an opportunity for us to reassess the financial regulatory process to best benefit our local and national economies. To achieve this objective, it is vital to step back and make an honest assessment of our regulated institutions, their lines of business, management ability, and capacity to deal with economic challenges. This assessment provides the basis for focusing resources to address the many challenges we face. With regard to financial institutions, as regulators we must do a horizontal review and engage in a process of ``triage'' that divides our supervised entities into three categories: I. Strong II. Tarnished III. Weak Strong institutions have the balance sheets and management capacity to survive, and even thrive, through the current crisis. These institutions will maintain stability and provide continued access to credit for consumers. Further, these institutions will be well-positioned to purchase failing institutions, which is an outcome that is better for all stakeholders than outright bank failure. We need to ensure these institutions maintain their positions of strength. Tarnished institutions are under stress, but are capable of surviving the current crisis. These institutions are where our efforts as regulators can make the biggest difference. Accordingly, these institutions will require the lion's share of regulatory resources. A regulator's primary objective with these institutions should be to fully and accurately identify their risks, require generous reserves for losses, and develop the management capacity to work through their problems. We have found that strong and early intervention by regulators, coupled with strong action by management, has resulted in the strengthening of our banks and the prevention of further decline or failure. By coordinating their efforts, state and Federal regulators can give these banks a good chance to survive by setting appropriate standards of performance and avoiding our understandable tendencies to over-regulate during a crisis. Weak institutions are likely headed for failure or sale. While this outcome may not be imminent, our experience has shown that the sooner we identify these institutions, the more options we will have to seek a resolution which does not involve closing the bank. It simply is not in our collective best interest to allow an institution to exhaust its capital and to be resolved through an FDIC receivership, if such an action can be avoided. Institutions we believe are headed toward almost certain failure deserve our immediate attention. This is not the same as bailing out, or propping up failing institutions with government subsidies. Instead, as regulators our goal is an early sale of the bank, or at least a ``soft landing'' with minimal economic disruption to the local communities they serve and minimal loss to the Deposit Insurance Fund.AREAS REQUIRING ATTENTION This is the time for us to be looking forward, not backwards. We need to be working to proactively resolve the problems in the banking industry. To do this, we need to ensure our supervisory approach is fair and balanced and gives those banks which deserve it the chance to improve their financial positions and results of operations. The industry and regulators must work together to fully identify the scope of the problems. However, I believe we need to consider the response which follows the identification. We should be tough and demanding, but the response does not need to send so many banks toward receivership. A responsive, yet reasonable approach, will take a great deal of time and effort, but it will result in less cost to the Deposit Insurance Fund and benefit communities and the broader economy in the long-run. I would like to highlight a few areas where I have concerns.Increase Access to Capital First, as discussed earlier, we need to allow capital to flow into the system. There is a significant amount of capital which is seeking opportunities in this market. We need to encourage this inflow through direct investments in existing institutions and the formation of new banks. To the extent that private investors do not themselves have bank operating experience or intend to dismantle institutions without consideration of the social and economic consequences, such shortcomings can and should be addressed by denial of holding company or bank applications or through operating restrictions in charters or regulatory orders. Where private equity groups have employed seasoned management teams and proposed acceptable business plans, such groups should be granted the necessary regulatory approvals to invest or acquire. While we cannot directly fix the capital problem, we should ensure the regulatory environment does not discourage private capital.Expedite Mergers Second, we need to allow for banks to merge, especially if it allows us to resolve a problem institution. Unfortunately, we have experienced too many roadblocks in the approval process. We need more transparency and certainty from the Federal Reserve on the process and parameters for approving mergers. To be clear, I am not talking about a merger of two failing institutions. Facilitating the timely merger of a weak institution with a stronger one is good for the system, good for local communities, and is absolutely the least cost resolution for the FDIC.Brokered Deposits Third, over the last several years the industry has explored more diversified funding, including the use of brokered deposits. Following the last banking crisis, there are restrictions for banks using brokered deposits when they fall below ``well capitalized.'' I appreciate the efforts of FDIC Chairman Bair in working to provide more consistency and clarity in the application of this rule. However, I am afraid the current approach is unnecessarily leading banks to fail. We allowed these banks to increase their reliance on this funding in the first place, and I believe we have a responsibility to assist them in gradually unwinding their dependency as they work to clean up their balance sheet. My colleagues have numerous institutions that could have benefited from a brokered deposit waiver granted by the FDIC. As noted above, many of the recent failures of community and regional banks have been the result of a sudden and precipitous loss of liquidity.Open Bank Assistance Fourth, the FDIC is seriously constrained in providing any institution with open bank assistance. We are concerned that this may be being too strictly interpreted. We believe there are opportunities to provide this assistance which do not benefit the existing shareholders and allows for the removal of bank management. This is a much less disruptive approach and I believe will prove to be much less costly for the FDIC. The approach we suggest was essentially provided to Citibank and Bank of America through loan guarantees without removing management or eliminating the stockholders. As discussed previously, we believe that the Capital Purchase Program under TARP can be a source of capital for transactions that restructure banks or assist in mergers to the same effect. We are not suggesting that such support be without conditions necessary to cause the banks to return to health.Prompt Corrective Action Finally, Congress should also investigate the effectiveness of the Prompt Corrective Action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act in dealing with problem banks. We believe there is sufficient evidence that the requirements of PCA have caused unnecessary failures and more costly resolutions and that allowing regulators some discretion in dealing with problem banks can assist an orderly restructuring of the industry.LOOKING FORWARD There will be numerous legacy items which will emerge from this crisis designed to address both real and perceived risks to the financial system. They deserve our deliberate thought to ensure a balanced and reasoned approach which provides a solid foundation for economic growth and stability. The discussions around regulatory reform are well underway. We would do well to remember the instability of certain firms a year ago which put the U.S. financial system and economy at the cliff's edge. We must not let the bank failures we are seeing today cloud the real and substantial risk facing our financial system--firms which are too big to fail, requiring extraordinary government assistance when they miscalculate their risk. We need to consider the optimal economic model for community banks, one that embraces their proximity to communities and their ability to engage in high-touch lending. However, we must ensure lower concentrations, better risk diversification, and improved risk management. We need to find a way to ensure banks are viable competitors for consumer finance and ensure they are positioned to lead in establishing high standards for consumer protection and financial literacy. We must develop better tools for offsite monitoring. The banking industry has a well established and robust system of quarterly data reporting through the Federal Financial Institutions Examination Council's Report of Condition and Income (Call Report). This provides excellent data for use by all regulators and the public. We need to explore greater standardization and enhanced technology to improve the timeliness of the data, especially during times of economic stress. Over the last several years, the industry has attracted more diversified sources of funding. This diversification has improved interest rate risk and liquidity management. Unfortunately, secured borrowings and brokered deposits increase the cost of resolution to the FDIC and create significant conflicts as an institution reaches a troubled condition. We need to encourage diversified sources of funding, but ensure it is compatible with a deposit insurance regime. We need to consider how the Deposit Insurance Fund can help to provide a countercyclical approach to supervision. We believe Congress should authorize the FDIC to assess premiums based on an institution's total assets, which is a more accurate measure of the total risk to the system. Congress should revisit the cap on the Fund and require the FDIC to build the Fund during strong economic times and reduce assessments during period of economic stress. This type of structure will help the entire industry when it is most needed.CONCLUSION The banking industry continues to face tremendous challenges caused by the poor economic conditions in the United States. To move through this crisis and achieve economic stability and growth, Members of Congress, state and Federal regulators, and members of the industry must coordinate efforts to maintain effective supervision, while exercising the flexibility and ingenuity necessary to guide our industry to recovery. Thank you for the opportunity to testify today, and I look forward to any questions you may have. ______ FOMC20080310confcall--51 49,CHAIRMAN BERNANKE.," I agree, President Fisher. We have deficiencies in our regulatory system. Even this change would take us short of what the ECB routinely already has because they don't have this division of commercial and investment banks, and they have essentially a much broader ability to take collateral. There is a problem, and it is a long-term issue. But the Treasury, for example, is looking at some of these regulatory structure issues going forward. Are there other questions? President Evans. " CHRG-111hhrg55814--185 Secretary Geithner," But again, this is taking a model that Congress designed for small banks and thrifts, and just adapting it to a system that has outgrown that framework. But that system exists today and I think it's the best way to do it. The alternative way, which is again, to create an ex-ante insurance fund that would create an expectation of explicit insurance, I think would create more moral hazard. " CHRG-109shrg24852--49 Chairman Greenspan," Well, Senator, actually all of these loans, properly used, are not bad instruments. In other words, they give the consumers, the mortgagors, indeed the mortgagees as well, a broader set of instruments which can be employed, so there is greater consumer choice. Our concern is that a number of these instruments are being used to enable people to purchase homes who would otherwise not have been able to do so. In other words, they are stretching to make the payments, and that is not good lending practice for banks or other purveyors of mortgages, and certainly it is not good practice on the part of pending homeowners. It is a concern to us. Fortunately, it is not a large enough part of the market to create serious systemic problems, but it is an issue, and we at the Federal Reserve and other banking supervisors are looking at that. We are examining these issues, and we are making decisions as to what, if any, guidance to the banking system we would endeavor to convey. Senator Allard. So just to follow up on that, you do not see any need for any kind of legislative remedy or anything at this point in time? " CHRG-111shrg54675--89 RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN JOHNSON FROM JACK HOPKINSQ.1. Mr. Hopkins and Mr. Johnson, both of your institutions are members of the Federal Home Loan Bank system. How do you use the Federal Home Loan Bank to support your bank's lending in your market? Has the current economic crisis and the liquidity crisis affected your use of the Federal Home Loan Banks? Last year, HERA expanded the number of community banks that can use collateral to borrow from the FHLBanks. Has your institution's ability to pledge this collateral been helpful?A.1. Answer not received by time of publication. ------ CHRG-110hhrg44900--129 Mr. Hensarling," Thank you, Mr. Chairman. I appreciate you calling this hearing and I appreciate the gentleman from New Jersey for his leadership in calling for this hearing as well. Chairman Bernanke, I believe the central question really before the committee is should the Federal Government really become the guarantor of last resort, or the lender of last resort to investment banks, not unlike they are commercial banks for the purpose of creating financial stability within our markets, obviously doing this with taxpayer dollars, given the recent intervention of the Fed by facilitating the Bear Stearns sale, which I am led to believe is the first time in 70 years that the Fed has opened up a discount window to a non-depository institution. My question is, have investment banks become so big and so interconnected that their bigness and interconnectedness alone now defines systemic risk? " FOMC20080430meeting--3 1,MR. DUDLEY.," 1 Certainly. Thank you, Mr. Chairman. The financial market environment has improved markedly since mid-March. However, concern about the circumstances that led to the demise of Bear Stearns may have provided added impetus to the ongoing deleveraging process. The result has been improvement in the broader equity and fixed-income markets but heightened term funding pressure within the financial system. Turning first to the broader markets, improvement is evident across most broad asset classes both in the United States and abroad. As shown in exhibit 1 of the handout in front of you, the broad U.S. equity indexes have recovered much of their earlier losses. Although the financial sector still lags behind, financial share prices have, in the aggregate, recovered more than 10 percent off their mid-March trough. Credit markets have also improved. As shown in exhibit 2, corporate credit spreads in both the investment-grade and the high-yield sectors have narrowed somewhat. Moreover, global credit default swap spreads--as shown in exhibit 3--have fallen significantly. As shown in exhibit 4, measures of implied volatility in the Treasury, equity, and foreign exchange markets have declined. Signs of a recovery in risk appetite can be seen very clearly in the subprime mortgage-backed securities market and the municipal securities market, both which 1 The materials used by Mr. Dudley are appended to this transcript (appendix 1). had earlier experienced significant distress. Exhibit 5 shows the price performance of the AAA-rated tranches of the last four ABX subprime vintages. As can be seen, the AAA-rated tranches have recovered even though housing activity and home prices have continued to decline at least as fast as anticipated. In the municipal market, crossover buyers have entered, attracted by municipal bond yields that exceed those available on Treasuries of comparable maturities. As seen in exhibit 6, although the ratios of tax-exempt to Treasury yields of comparable maturities remain elevated, there has been considerable improvement during the past two months. This improvement has occurred even though the outlook for the monoline financial guarantors remains poor. Ambac's announcement last week of a $1.7 billion loss in the first quarter made--thus far--barely a ripple in the broader market. The introduction of the primary dealer credit facility (PDCF) seems to have helped to stabilize the repo markets. That improvement, in turn, has caused the equity prices of the four remaining large investment banks to recover somewhat and their credit default swap spreads to fall sharply (exhibits 7 and 8). The PDCF backstop facility also appears to have helped break the negative dynamic of higher haircuts, forced asset sales, lower prices, higher volatility, and still higher haircuts that was in place in the weeks leading up to the Bear Stearns liquidity crisis. Although the collateral haircuts set by the major dealers for their hedge fund clients in our April 9 survey--shown in exhibit 9--are considerably higher than in the previous month, our contacts indicate that this rise occurred mostly around the time of Bear Stearns's demise. Over the past few weeks, haircuts have stabilized. Despite the improvement in the broad market indexes and in the equity prices and credit default swap spreads of most major financial firms, term funding pressures have intensified rather than subsided. As shown in exhibits 10 and 11, the pressures have been evident at both the one-month and the three-month tenures in the United States, the euro area, and the United Kingdom. The additional deleveraging by the investment banks following the demise of Bear Stearns may have intensified the pressure on commercial bank balance sheets or the urge for banks to delever. The LIBOR indexes took a jump upward following a Wall Street Journal article that alleged that some of the 16 LIBOR panelists were understating the rates at which they could obtain funding. The British Bankers Association reacted by threatening to throw out any panelist that was not wholly honest in its daily posting of its costs of obtaining funds at different maturity horizons. The BBA announcement appears to have provoked an outbreak of veracity among at least some of the panelists. As shown in exhibit 12, the LIBOR fixing rose nearly 20 basis points in the few days immediately after the article. The dispersion in offered rates between the highest and lowest posting banks also increased. There is considerable evidence that the official LIBOR fixing understates the rates paid by many banks for funding. For example, as shown in exhibit 13, the all-in cost of FX swap financing into dollars out of euros has recently climbed to more than 30 basis points above the cost of LIBOR funding. The term funding pressures appear to be mainly the consequence of the deleveraging process that is still firmly under way. Balance sheet capacity has become strained in three ways. First, pressures to carry more assets on the balance sheet have increased in a number of ways. For example, some types of assets can no longer be securitized, and balance sheet assets are created when lines of credit are drawn upon. Second, loan-loss provisions and mark-to-market losses have cut into capital, at least until recently, faster than banks have been able to raise new capital. Third, desired capital ratios have undoubtedly risen as financial markets have become more volatile and the macroeconomic outlook has worsened. These pressures have sharply pushed up the shadow price of balance sheet capacity, and term funding spreads undoubtedly reflect that pressure. As evidence, note how the spread between jumbo and conforming fixed-rate mortgage yields in exhibit 14 has mostly tracked the trajectory of term funding spreads shown in exhibit 13. Because banks can securitize conforming mortgages but not jumbo mortgages, this widening spread likely reflects the rise in the shadow price of balance sheet capacity. The term funding pressures have also been evident in the strong demand exhibited in our biweekly TAF auctions. As shown in exhibit 15, the spread between the stop-out rate and the minimum bid rate has risen sharply since late January, despite the large rise in the size of the TAF auctions over this period. In contrast, the demand by primary dealers to borrow Treasury securities in our term securities lending facility (TSLF) has been less intense. It is unclear whether this reflects the large and immediate scale of these auctions ($175 billion offered over four weeks) or less need by primary dealers, who rely heavily on secured repo borrowing for their short-term funding needs. As shown in exhibit 16, two of the five auctions have not been fully covered. Besides providing liquidity to the primary dealers, the TSLF auctions have helped to generate a dramatic improvement in Treasury market function. As shown in exhibit 17, before the first TSLF auction, overnight Treasury repo rates were unusually low, and the Treasury market was distorted by a growing number of security failures (that is, dealers were unable to deliver promised securities) and a large number of securities trading special (that is, with a repo rate below the rate on general Treasury collateral). So have the TAF and TSLF auctions been helpful in improving market function? Although it is impossible to know what the counterfactual would have been without the auctions, most evidence suggests that these auctions have improved market function. Although a recent study by John Taylor and John Williams found no statistical evidence that the TAF auctions have had an effect on term funding, the choices in terms of econometric design made it very difficult for this study to have found an effect. Interestingly, minor changes in the specification used by Taylor and Williams produce statistically significant results with the expected sign--in other words, the TAF auctions reduced the spread. They say that a picture is worth a thousand words. Exhibit 18 documents the Federal Reserve's major initiatives over the past eight months relative to the LIBOR� OIS spread. Note that virtually all the Federal Reserve initiatives aimed at improving market function have been associated with a decline in the LIBOR�OIS spread. Perhaps this just represents an announcement or placebo effect. More study is obviously needed. However, it is interesting that those market participants who are the patients have been clamoring for more medicine in the form of both an increase in the size of the TAF auctions and auctions with longer maturities. As the equity and credit markets have improved, market participants have reduced their expectations of the magnitude of further monetary policy easing. As shown in exhibit 19, the federal funds rate futures curve has shifted upward and is virtually flat around 2 percent from May though September--implying that market participants expect that tomorrow will likely be the last easing in this cycle. The Eurodollar futures curve, which is shown in exhibit 20, has shifted up even more sharply since the last FOMC meeting. In part, this reflects the rise in term funding spreads and, most important, the view that these spreads are likely to remain elevated relative to the target federal funds rate for the foreseeable future. Our Survey of Primary Dealers undertaken about ten days before each FOMC meeting shows more stability in dealer expectations (exhibits 21 and 22). Note that the dealer forecasts now anticipate somewhat greater easing than implied by the federal funds rate futures market and the Eurodollar futures market. This is quite different from the pattern in previous months. The average of the dealer modal forecasts has a trough in yields of about 1.50 percent, about � percentage point below the market forecast. In terms of this week's meeting, there is little disagreement between the dealer survey and market participants. All 18 of the primary dealers that responded to our survey anticipate a rate cut at this meeting, with nearly all in the 25 basis point rate cut camp. As shown in exhibit 23, this is slightly more aggressive than the expectations embodied in federal funds rate options, which are pricing in a probability of a 25 basis point easing of almost 80 percent. The shift in interest rate expectations cannot be explained easily by developments on the inflation front. Although the continued surge in crude oil prices has pushed aggregate commodity indexes, such as the GSCI, higher, agricultural and industrial metal prices have been much more stable in recent weeks (exhibit 24). Despite the rise in energy prices, market-based measures of long-term inflation compensation have fallen in recent weeks. For example, as shown in exhibit 25, both the Board's and Barclays' fiveyear, five-year-forward measures have declined about 40 basis points from the peak reached in early March. Turning to the Desk's operations, we get mixed grades over the intermeeting period. On the one hand, we have done a pretty good job of hitting the target on average (through yesterday, the daily effective rate since the last FOMC meeting was a miraculous 2.25 percent). On the other hand, this average conceals considerable intraday and day-to-day volatility. This can be seen in exhibit 26, which charts the daily federal funds rate range and the daily average effective rate. Notice how wide the daily range of trading has been. This reflects three factors: (1) the demand by European banks for federal funds, which has often caused the federal funds rate to be elevated early in the day before Europe closes; (2) stigma associated with primary credit facility (PCF) borrowing--the PCF rate is not a firm cap on federal funds rate trading; and (3) large unanticipated shifts in the autonomous factors that affect the level of reserves in the banking system--especially shifts in the level of PCF and PDCF borrowing. Note the big rise in PCF and PDCF borrowing since mid-March and the large daily shifts in the level of this borrowing shown in exhibit 27. We have little ability to forecast these daily shifts in borrowing. Thus, these shifts are mostly unexpected and do increase the volatility of the federal funds rate. Finally, let me briefly outline a number of policy recommendations for which we seek your approval. First, I will need approval for domestic operations. There were no foreign operations. Second, as noted in the memo that was circulated to you last week, we are recommending that the outstanding swap lines with Canada and Mexico be renewed for another year. Third, the staff is recommending approval of an increase in the size of the foreign exchange swap facilities with the European Central Bank and the Swiss National Bank. This recommendation is discussed in more detail in a memo that was distributed to the FOMC last Friday. For the ECB, the recommendation is to increase the size of the swap line to $50 billion from $30 billion, and for the SNB, to $12 billion from $6 billion, with maximum draws on these facilities of $25 billion and $6 billion, respectively. We also recommend extending the term of these swap facilities to January 30, 2009, from September 30, 2008. As before, these swap lines will be used in conjunction with our TAF auctions to increase the amount of 28-day term dollar funding available to banks with operations in the euro area and in Switzerland. At the same time, we understand that Chairman Bernanke intends to use his delegated authority from the Board to increase the size of the TAF to $150 billion from $100 billion. Fourth, we recommend that eligible collateral for the TSLF be broadened to include AAA-rated asset-backed securities (ABS). Currently, as you know, this facility accepts only AAA-rated residential-mortgage-backed securities and commercial-mortgage-backed securities. We believe that broadening the eligibility to AAA-rated ABS will help support the availability of consumer credit, including credit card, auto, and student loan credit. Spreads in AAA-rated ABS backed by auto loans and credit card receivables have risen sharply over the past six months even though the deterioration in the underlying performance of the assets in terms of delinquency and loss has been well within the bounds of past cycles. We do not recommend increasing the collateral eligibility by greater breadth than this. As we noted in last Friday's memo, including additional classes of securities could increase operational costs to an extent that is not likely to be warranted by the marginal benefits. It could also expose the System to the risks associated with a range of complex structured finance products and, in the case of AAA-rated corporate securities, would not provide much benefit because the amounts of such securities outstanding are relatively small. Under this proposal, the maximum size of the TSLF would remain unchanged--at $200 billion--as would the other terms of the facility. I also want to inform the Committee of a small technical change that the staff plans to make in the TSLF program. We plan to eliminate the requirement that eligible AAA-rated securities not be on watch for downgrade. We plan to make this change because we have found that enforcing this rule has been very difficult operationally because the two clearing banks that manage the triparty repo system have a limited ability to perform this monitoring function on our behalf. In addition, I would point out that the added risks from this change are very small. If securities were downgraded, the primary dealer would have to substitute new eligible collateral. Also, it should be pointed out that the PDCF accepts most investment-grade securities--thus, we already have a broader collateral regime in place for our other primary dealer facility. " CHRG-111hhrg53245--201 Mr. Sherman," Ms. Rivlin, I wonder--you seem to have a comment? Ms. Rivlin. No, I agree with that, and I was glad to get a chance to counteract the absent Mr. Wallison who thinks we only need to worry about banks. I think the lesson of this crisis is we need to worry about the whole financial sector and a lot of the trouble came from outside the banking system. " CHRG-111hhrg53240--42 Mr. Sherman," Can you identify any harm there would be if we had, as Presidential appointees, all the members of the Board of Governors of all of the regional banks? Ms. Duke. I think that the system that we have with the separate Reserve Banks who are--who have separate boards of directors are important for our independence and monetary policy, that they perform a critical role in monetary policy. " FinancialCrisisInquiry--112 I’m here to represent my own views. I’ve submitted almost 200 pages of supporting material. I hope you received that. Two decades ago, I worked down the street at the Federal Reserve. At the time, we were helping banks recover from crisis. We took great meaning from our work. I hope the commission’s efforts lead to a banking system that we don’t have to revisit every two decades to save. This is important. I’ve been covering an industry on steroids. Performance was artificially enhanced, and we’re now paying the price with the biggest bailout of U.S. banks in history. And it’s also resulting in the biggest wealth transfer from future generations to the current generation. My children, 9, 7, and 4, and their generation will have to pay the price. I’m shocked and amazed more changes have not taken place. There seems an unwritten premise that Wall Street, exactly how it exists today, is necessary for the economy to work. That’s not true. The economy worked fine before Wall Street got this large and this complex. Wall Street has done an incredible job at pulling the wool over the eyes of the American people. This may relate to the clout of the banks. The four banks that testified this morning have annual revenues of $300 billion. That’s equal to the GDP of Argentina. My perspective? I’ve analyzed banks since the late 1980’s. I value the independent reputation of COSA. And I’ve been negative on banks since 1999, and I’ve published over 10,000 pages of research to back up my view. I’ve identified 10 causes of the crisis. If you can turn to Slide 3 -- and I’ll go through each cause. Cause One: excessive loan growth. We could not accept the reality that we’re in a slower-growing economy, a more mature market. Loans grew twice as fast as they should have grown, twice as fast as GDP. Cause Two: higher yielding assets. The U.S. banking industry acted like a leverage bond fund. More borrowings with the proceeds invested in more risky assets. Look at Treasury securities. As a percentage of securities, they went down from 32 percent down to 2 percent. That’s the least risky asset. Instead, banks took more risky securities and more risky loans whether it’s home equity or construction loans. Look at construction loans. The percentage of construction loans to total is double the level where it was even in the early ‘90’s. CHRG-111hhrg54869--101 Mr. Volcker," Well, let me just make a general kind of philosophic question, and then credit default swaps. My general position is you make a distinction between banks and others. Banks are going to be protected. They are protected in other countries. They have been protected here for a century. That is not going to change, shouldn't change, I don't think. But let's not extend that protection to the whole world. Now we get the credit default swaps which are out there in the market and arguably serve a legitimate function in a trading operation of protecting the holding of a bond against the default on the bond. But it became a big kind of speculative market, trading market, so you had many more credit default swaps outstanding than there were credits, which raises some questions about the functioning of the market, and how the basic purpose it was serving was underlying and had a purpose. But the market was developed in a way that it was vulnerable to collapse--if that is the right word--if it came under great strain. And it came under great strain because AIG was so central to the market. Now, that had been of concern, frankly, before. Some people understood this before the crisis, and, on a voluntary basis, began introducing measures-- Mr. Miller of North Carolina. You do need to eat your microphone. I am having a really hard time hearing you. Sorry. " CHRG-111shrg50564--168 Chairman Dodd," Right. " Mr. Dodaro,"----but that is done by the financial institutions in the system and not supported by taxpayer funds. I mean, that was something that was modernized during the savings and loan and banking crisis we had in the 1990s. " CHRG-110shrg50409--64 Mr. Bernanke," And I agree with you on that. As far as powers are concerned, as I mentioned earlier, I think we ought to review the payment system issue which is something that other central banks have. But I have not asked for any other powers. Thank you. " CHRG-111shrg51303--5 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. The collapse of the American International Group is the largest corporate failure in American history. Once a premier global insurance and financial services company, with more than $1 trillion in assets, AIG lost nearly $100 billion last year. Over the past 5 months, it has been the recipient of four bailouts. To date, the Federal Government has committed to provide approximately $170 billion in loans and equity. Given the taxpayers' dollars at stake and the impact on our financial system, this Committee has an obligation to thoroughly examine the reasons for AIG's collapse and how Federal regulators have responded. I also hope that today's hearing will shed new light on the origins of our financial crisis as well as inform our upcoming discussions on financial regulatory reform. In reviewing our witnesses' testimony here today and AIG's public filings, it appears that the origins of AIG's demise were twofold: First, as has been widely reported, AIG suffered huge losses on credit default swaps written by its Financial Products subsidiary on collateralized debt obligations. AIG's problems, however, were not isolated to its credit default swap business. Significant losses in AIG's State-regulated life insurance companies also contributed to the company's collapse. Approximately a dozen of AIG's life insurance subsidiaries operated a securities lending program whereby they loaned out securities for short periods in exchange for cash collateral. Typically, an insurance company or bank will lend securities and reinvest the cash collateral in very safe short-term instruments. AIG's insurance companies, however, invested their collateral in riskier long-term mortgage-backed securities. And although they were highly rated at the time, approximately half of them were backed by subprime and Alternate-A mortgage loans. When the prices for mortgage-backed securities declined sharply last year, the value of AIG's collateral plummeted. The company was rapidly becoming unable to meet the demands of borrowers returning securities to AIG. By September, it became clear that AIG's life insurance companies would not be able to repay collateral to their borrowers. Market participants quickly discovered these problems and rushed to return borrowed securities and get back their collateral. Because AIG was unable to cover its obligations to both its securities lending and derivatives operations, it ultimately had to seek Federal assistance. In total, AIG's life insurance companies suffered approximately $21 billion in losses related to securities lending in 2008. More than $17 billion in Federal assistance has been used to recapitalize the State-regulated insurance companies to ensure that they are able to pay their policy holders' claims. In addition, the Federal Reserve had to establish a special facility to help unwind AIG's securities lending program. The causes of AIG's collapse raise profound questions about the adequacy of our existing State and Federal financial regulatory regimes. With respect to AIG's derivatives operations, the Office of Thrift Supervision was AIG's holding company regulator. It appears, however, that the OTS was not adequately aware of the risks presented by the companies credit default swap positions. Since AIG's Financial Products subsidiary had operations in London and Hong Kong, as well as in the U.S., it is unclear whether the OTS even had the authority to oversee all of AIG's operations. It is also unclear whether OTS had the expertise necessary to properly supervise what was primarily an insurance company. Additionally, did AIG life insurance companies obtain the approval of their State regulators before they participated in securities lending? If so, why did the State insurance regulators allow AIG to invest such a high percentage of the collateral from its securities lending program in longer-term mortgage-backed securities? Also, did the insurance regulators coordinate their oversight of AIG's securities lending since it involved life insurance regulated by at least five different States? While I hope we can get some answers to these and many other questions today, I believe we are just beginning to scratch the surface of what is an incredibly complex and, on many levels, a very disturbing story of malfeasance, incompetence, and greed. Thank you, Mr. Chairman. " CHRG-111shrg55278--113 PREPARED STATEMENT OF ALLAN H. MELTZER Professor of Political Economy, Tepper School of Business, Carnegie Mellon University July 23, 2009Regulatory Reform and the Federal Reserve Thank you for the opportunity to present my appraisal of the Administration's proposal for regulatory changes. I will confine most of my comments to the role of the Federal Reserve as a systemic regulator and will offer an alternative proposal. I share the belief that change is needed and long delayed, but appropriate change must protect the public, not bankers. And I believe that effective regulation should await evidence and conclusions about the causes of the recent crisis. There are many assertions about causes. The Congress should want to avoid a rush to regulate before the relevant facts are established. If we are to avoid repeating this crisis, make sure you know what caused it. During much of the past 15 years, I have written three volumes entitled ``A History of the Federal Reserve.'' Working with two assistants we have read virtually all of the minutes of the Board of Governors, the Federal Open Market Committee, and the Directors of the Federal Reserve Bank of New York. We have also read many of the staff papers and internal memos supporting decisions. I speak from that perspective. I speak also from experience in Japan. During the 1990s, the years of the Japanese banking and financial crisis, I served as Honorary Adviser to the Bank. Their policies included preventing bank failures. This did not restore lending and economic growth. Two findings are very relevant to the role of the Federal Reserve. First, I do not know of any clear examples in which the Federal Reserve acted in advance to head off a crisis or a series of banking or financial failures. We know that the Federal Reserve did nothing about thrift industry failures in the 1980s. Thrift failures cost taxpayers $150 billion. AIG, Fannie, and Freddie will be much more costly. Of course, the Fed did not have responsibility for the thrift industry, but many thrift failures posed a threat to the financial system that the Fed should have tried to mitigate. The disastrous outcome was not a mystery that appeared without warning. Peter Wallison, Alan Greenspan, Bill Poole, Senator Shelby, and others warned about the excessive risks taken by Fannie and Freddie, but Congress failed to legislate. Why should anyone expect a systemic risk regulator to get requisite Congressional action under similar circumstances? Can you expect the Federal Reserve as systemic risk regulator to close Fannie and Freddie after Congress declines to act? Conflicts of this kind, and others, suggest that that the Administration's proposal is incomplete. Defining ``systemic risk'' is an essential, but missing part of the proposal. Trying to define the authority of the regulatory authority when Congress has expressed an interest points up a major conflict. During the Latin American debt crisis, the Federal Reserve acted to hide the failures and losses at money center banks by arranging with the IMF to pay the interest on Latin debt to those banks. This served to increase the debt that the Governments owed, but it kept the banks from reporting portfolio losses and prolonged the debt crisis. The crisis ended after one of the New York banks decided to write off the debt and take the loss. Others followed. Later, the Treasury offered the Brady plans. The Federal Reserve did nothing. In the dot-com crisis of the late 1990s, we know the Federal Reserve was aware of the growing problem, but it did not act until after the crisis occurred. Later, Chairman Greenspan recognized that it was difficult to detect systemic failures in advance. He explained that the Federal Reserve believed it should act after the crisis, not before. Intervention to control soaring asset prices would impose large social costs of unemployment, so the Federal Reserve, as systemic risk regulator would be unwise to act. The dot-com problem brings out that there are crises for which the Federal Reserve cannot be effective. Asset market exuberance and supply shocks, like oil price increases, are nonmonetary so cannot be prevented by even the most astute, far-seeing central bank. We all know that the Federal Reserve did nothing to prevent the current credit crisis. Before the crisis it kept interest rates low during part of the period and did not police the use that financial markets made of the reserves it supplied. The Board has admitted that it did not do enough to prevent the crisis. It has not recognized that its actions promoted moral hazard and encouraged incentives to take risk. Many bankers talked openly about a ``Greenspan put,'' their belief that the Federal Reserve would prevent or absorb major losses. It was the Reconstruction Finance Corporation, not the Fed, that restructured banks in the 1930s. The Fed did not act promptly to prevent market failure during the 1970 Penn Central failure, the Lockheed and Chrysler problems, or on other occasions. In 2008, the Fed assisted in salvaging Bear Stearns. This continued the ``too-big-to-fail'' (TBTF) policy and increased moral hazard. Then without warning, the Fed departed from the course it had followed for at least 30 years and allowed Lehman to fail in the midst of widespread financial uncertainty. This was a major error. It deepened and lengthened the current deep recession. Much of the recent improvement results from the unwinding of this terrible mistake. In 1990-91, the Fed kept the spread between short- and long-term interest rates large enough to assist many banks to rebuild their capital and surplus. This is a rare possible exception, a case in which Federal Reserve action to delay an increase in the short-term rate may have prevented banking failures. Second, in its 96-year history, the Federal Reserve has never announced a lender-of-last-resort policy. It has discussed internally the content of such policy several times, but it rarely announced what it would do. And the appropriate announcements it made, as in 1987, were limited to the circumstances of the time. Announcing and following a policy would alert financial institutions to the Fed's expected actions and might reduce pressures on Congress to aid failing entities. Following the rule in a crisis would change bankers' incentives and reduce moral hazard. A crisis policy rule is long overdue. The Administration proposal recognizes this need. A lender-of-last-resort rule is the right way to implement policy in a crisis. We know from monetary history that in the 19th century the Bank of England followed Bagehot's rule for a half-century or more. The rule committed the Bank to lend on ``good'' collateral at a penalty rate during periods of market disturbance. Prudent bankers borrowed from the Bank of England and held collateral to be used in a panic. Banks that lacked collateral failed. Financial panics occurred. The result of following Bagehot's rule in crises was that the crises did not spread and did not last long. There were bank failures, but no systemic failures. Prudent bankers borrowed and paid depositors cash or gold. Bank deposits were not insured until much later, so bank runs could cause systemic failures. Knowing the Bank's policy rule made most bankers prudent, they held more capital and reserves in relation to their size than banks currently do, and they held more collateral to use in a crisis also. These experiences suggest three main lessons. First, we cannot avoid banking failures but we can keep them from spreading and creating crises. Second, neither the Federal Reserve nor any other agency has succeeded in predicting crises or anticipating systemic failure. It is hard to do, in part because systemic risk is not well-defined. Reasonable people will differ, and since much is often at stake, some will fight hard to deny that there is a systemic risk. One of the main reasons that Congress in 1991 passed FDICIA (Federal Deposit Insurance Corporation Improvement Act) was to prevent the Federal Reserve from delaying closure of failing banks, increasing losses and weakening the FDIC fund. The Federal Reserve and the FDIC have not used FDICIA against large banks in this crisis. That should change. The third lesson is that a successful policy will alter bankers' incentives and avoid moral hazard. Bankers must know that risk taking brings both rewards and costs, including failure, loss of managerial position and equity followed by sale of continuing operations.An Alternative Proposal Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Members of Congress should ask themselves and each other: Is the banker or the regulator more likely to know about the risks on a bank's balance sheet? Of course it is the banker, and especially so if the banker is taking large risks that he wants to hide. To me that means that reform should start by increasing a banker's responsibility for losses. The Administration's proposal does the opposite by making the Federal Reserve responsible for systemic risk. Systemic risk is a term of art. I doubt that it can be defined in a way that satisfies the many parties involved in regulation. Members of Congress will properly urge that any large failure in their district or State is systemic. Administrations and regulators will have other objectives. Without a clear definition, the proposal will bring frequent controversy. And without a clear definition, the proposal is incomplete and open to abuse. Resolving the conflicting interests is unlikely to protect the general public. More likely, regulators will claim that they protect the public by protecting the banks. That's what they do now. The Administration's proposal sacrifices much of the remaining independence of the Federal Reserve. Congress, the Administration, and failing banks or firms will want to influence decisions about what is to be bailed out. I believe that is a mistake. If we use our capital to avoid failures instead of promoting growth we not only reduce growth in living standards we also sacrifice a socially valuable arrangement--central bank independence. We encourage excessive risk taking and moral hazard. I believe there are better alternatives than the Administration's proposal. First step: End TBTF. Require all financial institutions to increase capital more than in proportion to their increase in size of assets. TBTF gives perverse incentives. It allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur. My proposal reduces the profits from giant size, increases incentives for prudent banker behavior by putting losses back to managements and stockholders where they belong. Benefits of size come from economies of scale and scope. These benefits to society are more than offset by the losses society takes in periods of crisis. Congress should find it hard to defend a system that distributes profits and losses as TBTF does. I believe that the public will not choose to maintain that system forever. Permitting losses does not eliminate services; failure means that management loses its position and stockholders take the losses. Profitable operations continue and are sold at the earliest opportunity. Second step: Require the Federal Reserve to announce a rule for lender-of-last-resort. Congress should adopt the rule that they are willing to sustain. The rule should give banks an incentive to hold collateral to be used in a crisis period. Bagehot's rule is a great place to start. Third step: Recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate but markets circumvent burdensome regulation. The Basel Accord is an example. Banks everywhere had to increase capital when they increased balance sheet risk. The banks responded by creating entities that were not on their balance sheet. Later, banks had to absorb the losses, but that was after the crisis. There are many other examples of circumvention from Federal Reserve history. The reason we have money market funds was that Fed regulation Q restricted the interest that the public could earn. Money market funds bought unregulated, large certificates of deposit. For a small fee they shared the higher interest rate with the public. Much later Congress agreed to end interest rate regulation. The money funds remained. Fourth step: Recognize that regulators do not allow for the incentives induced by their regulations. In the dynamic, financial markets it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating them. The lesson is to focus on incentives, not prohibitions. Shifting losses back to the bankers is the most powerful incentive because it changes the risk-return tradeoff that bankers and stockholders see. Fifth step: Either extend FDICIA to include holding companies or subject financial holding companies to bankruptcy law. Make the holding company subject to early intervention either under FDICIA or under bankruptcy law. That not only reduces or eliminates taxpayer losses, but it also encourages prudential behavior. Other important changes should be made. Congress should close Fannie Mae and Freddie Mac and put any subsidy for low-income housing on the budget. The same should be done to other credit market subsidies. The budget is the proper place for subsidies. Congress, the regulators, and the Administration should encourage financial firms to change their compensation systems to tie compensation to sustained average earnings. Compensation decisions are too complex for regulation and too easy to circumvent. Decisions should be management's responsibility. Part of the change should reward due diligence by traders. We know that rating agencies contributed to failures. The rating problem would be lessened if users practiced diligence of their own. Three principles should be borne in mind. First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the cost of failures to society. Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior. Third, those that rely on regulation to reduce risk should recall that this is the age of Madoff and Stanford. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy and the public. Incentives for fraud, evasion, and circumvention of regulation often have been far more powerful than incentives to enforce regulation that protects the public. CHRG-110hhrg45625--189 Mr. Bernanke," I don't know, but I know the system is quite fragile and therefore very vulnerable when shocks occur. I think we need to stabilize it and make it stronger so that it can support the economy to recover. Going back to your previous question, the idea about FIDICIA, that only applies to failing banks. And again we are not dealing with the Japanese situation where banks are either insolvent or practically insolvent. We are dealing with one where there is insufficient capital lending capacity, they are bringing back credit, and that is hurting our economy. Ms. Brown-Waite. Well, if you actually read the 1991 statute, it says it does grant an exception for when there is a risk to the entire financial system. So maybe if the banks had been dealt with using the 1991 law, we wouldn't--if it had been done earlier, maybe we wouldn't be here with a $700 billion bailout. My next question is, does it have to be $700 billion? Could we do this in installments, see how it goes, how it works? " CHRG-111shrg56376--220 Mr. Ludwig," Two points, Senator. One is that these systemic problems are really, by and large, governmental problems. They are not institutional problems. So when you say who is going to be looking out, one of the reasons you want to have somebody with a systemic responsibility for looking for systemic problems--i.e., bubbles--that is independent is because if you look historically, it has really been governmental problems into which institutions are dragged, by and large. The second thing is the point you made and the point that Rick made about a single consolidated regulator being less given to arbitrage and, therefore, more likely to be conservative. To some degree, the proof of the pudding is in Canada and Australia. In both those systems, they are both English-speaking countries with consolidated prudential supervisors, and that is all they did. And in both systems, they were quite conservative as regulators in terms of their institutions. Now, I just came back from Canada. I was up a couple weeks ago and spent some time with their finance minister and their head of the central bank and their bankers. And they will all say that their supervisor was a restraining force on them getting into a lot of the problems that our institutions got into. Senator Reed [presiding]. Senator Warner. Senator Warner. Mr. Chairman, I will not ask a question. I would just like to make a request to the panel, because it is clear that the panel has got a lot of ideas here. As I think I said earlier, I would love to see more specificity about how we can ensure community banks, smaller banks, are inside a single end-to-end regulator, from assessments to less regulatory, less paperwork. What are the protections we could give beyond division, number one? Number two, Senator Corker and I believe that there needs to be expanded resolution authority at least to bank holding companies, with the FDIC, and the FDIC has raised--and I know you have addressed today, but has raised the concern that if they were--if we took away their prudential supervision, would back-up supervision be enough to have them have their pulse on the status of all of the institutions that they might cover in this expanded jurisdiction. So I would love to have some specific suggestions on how we could address that concern. And then, third, obviously, you know, the Federal Reserve will make the point that, as lender of last resort, they still need to keep their hands in this pie in terms of at least with these larger institutions on the bank holding companies. And I think you have made some very--the whole panel has made a number of valid points about the bank holding companies, but I would love--and, again, Martin, you made the comment about the fact that FDIC and the Fed would be on the board. But what are other ways that we could ensure that the Fed, as lender of last resort, would not lose the expertise that they have? Thank you, Mr. Chairman. Senator Reed. Thank you very much, gentlemen. I just have one or two quick questions since I have got the opportunity with this panel, which is rare. Going back to the landscape after we adopt a single regulator, at least hypothetically, should the Federal Reserve continue to have any regulatory authority with respect to State member banks if that is all they are doing in the regulatory sphere? Mr. Ludwig. " CHRG-111shrg53822--89 PREPARED STATEMENT OF MARTIN NEIL BAILY Senior Fellow, Economic Studies Program, the Brookings Institution, and former Chairman of the Council of Economic Advisers Under President Clinton, and Robert E. Litan \1\ May 6, 2009 Thank you Mr. Chairman and members of the Committee for asking us to discuss with you the appropriate policy response to what has come to be widely known as the ``too big to fail'' (TBTF) problem. We will first outline some threshold thoughts on this question and then answer the questions that you posed in requesting this testimony.--------------------------------------------------------------------------- \1\ Robert E. Litan is Vice President, Research and Policy, The Kauffman Foundation and Senior Fellow, Economic Studies and Global Economy Programs, The Brookings Institution. This testimony draws on several of the authors' recent essays on the financial crisis on the Brookings website, www.brookings.edu, the work of Douglas Elliott of Brookings and the papers of the Squam Lake Working Group on Financial Regulation http://squamlakeworkinggroup.org/.---------------------------------------------------------------------------The Key PointsToo Big to Fail and the Current Financial Crisis The U.S. economy has been in free fall. Hopefully the pace of decline is now easing, but the transition to sustained growth will not be possible without a restoration of the financial sector to health. The largest U.S. financial institutions hold most of the financial assets and liabilities of the sector as a whole and, despite encouraging signs, many of them remain very fragile. Many banks in the UK, Ireland, Switzerland, Austria, Germany, Spain and Greece are troubled and there is no European counterpart to the U.S. Treasury to stand behind them. The global financial sector is in a very precarious state. In this situation policymakers must deal with ``too big to fail'' institutions because we cannot afford to see the disorderly failure of another major financial institution, which would exacerbate systemic risk and threaten economic recovery. The stress tests are being completed and some banks will be told to raise or take additional capital. There is a lot more to be done after this, however, as large volumes of troubled or toxic assets remain on the books and more such assets are being created as the recession continues. It is possible that one or two of the very large banks will become irretrievably insolvent and must be taken over by the authorities and, if so, they will have to deal with that problem even though the cost to taxpayers will be high. But pre-emptive nationalization of the large banks is a terrible idea on policy grounds and is clouded by thicket of legal problems.\2\--------------------------------------------------------------------------- \2\ See the papers by Doug Elliott on the Brookings website. Getting the U.S. financial sector up and running again is essential, but will be very expensive and is deeply unpopular. If Americans want a growing economy next year with an improving labor market, Congress will have to bite the bullet and provide more Treasury TARP funds, maybe on a large scale. The costs to taxpayers and the country will be lower than nationalizing the --------------------------------------------------------------------------- banks. Congress recently removed from the President's budget the funds to expand the TARP, a move that can only deepen the recession and delay the recovery.\3\--------------------------------------------------------------------------- \3\ If it is any consolation, between 72 and 80 percent of Federal income taxes are paid by the top 10 percent of taxpayers. Average working families will not be paying much for the bailout.---------------------------------------------------------------------------Too Big to Fail: Answering the Four Key Questions (Plus One More) Should regulation prevent financial institutions from becoming ``too big to fail''? We need very large financial institutions given the scale of the global capital markets and, of necessity, some of these may be ``too big to fail'' (TBTF) because of systemic risks. For U.S. institutions to operate in global capital markets, they will need to be large. Congress should not punish or prevent organic growth that may result in an institution having TBTF status. At the same time, however, TBTF institutions can be regulated in a way that at least partially offsets the risks they pose to the rest of the financial system by virtue of their potential TBTF status. Capital standards for large banks should be raised progressively as they increase in size, for example. In addition, financial regulators should have the ability to prevent a financial merger on the grounds that it would unduly increase systemic risk (this judgment would be separate from the traditional competition analysis that is conducted by the Department of Justice's Antitrust Division). Should Existing Institutions be Broken Up? Organic growth should not be discouraged since it is a vital part of improving efficiency. If, however, the FDIC (or another resolution authority) assumes control of a weakened TBTF financial institution and later returns it to the private sector, the agency should operate under a presumption that it break the institution into pieces that are not considered TBTF. And it should also avoid selling any one of the pieces to an acquirer that will create a new TBTF institution. The presumption could be overcome, however, if the agency determines that the costs of breakup would be large or the immediate need to avoid systemic consequences requires an immediate sale to another large institution. What Requirements Should be Imposed on Too Big to Fail Institutions? TBTF or systemically important financial institutions (SIFIs) can and should be specially regulated, ideally by a single systemic risk regulator. This is a challenging task, as we discuss further below, but we believe it is both one that can be met and is clearly necessary in light of recent events. Too big to fail institutions have an advantage in that their cost of capital is lower than that of small institutions. At a recent Brookings meeting, Alan Greenspan estimated informally that TBTF banks can borrow at lower cost than other banks, a cost advantage of 50 basis points. This means that some degree of additional regulatory costs (in the form of higher capital requirements, for example) can be imposed on large financial institutions without rendering them uncompetitive.\4\--------------------------------------------------------------------------- \4\ However it is important that international negotiation be used to keep a level playing field globally. Improved Resolution Procedures for Systemically Important Banks. This is an important issue that should be addressed soon. When large financial firms become distressed, it is difficult to restructure them as ongoing institutions and governments end up spending large amounts to support the financial sector, just as is happening now. The Squam Lake Working group has proposed one solution to this problem: that systemically important banks (and other financial institutions) be required to issue a long-term debt instrument that converts to equity under specific conditions. Institutions would issue these bonds before a crisis and, if triggered, the automatic conversion of debt into equity would transform an undercapitalized or insolvent institution, at least in principle, into a well capitalized one at no cost to taxpayers.\5\--------------------------------------------------------------------------- \5\ http://squamlakeworkinggroup.org/. Where the losses are so severe that they deplete even the newly converted capital, there should be a bank-like process for orderly resolving the institution by placing it in receivership. Treasury Secretary Geithner has outlined a process for doing this, which we generally support. There are other important resolution-related issues that must be --------------------------------------------------------------------------- addressed and we discuss them below. The Origin of the Crisis and the Structure of the Solution. The financial crisis was the result of market failure and regulatory failure. Market failure occurred because wealth- holders in many cases failed to take the most rudimentary precautions to protect their own interests. Compensation structures were established in companies that rewarded excessive risk taking. Banks bought mortgages knowing that lending standards had become lax.\6\--------------------------------------------------------------------------- \6\ See ``The Origins of the Financial Crisis'' and ``Fixing Finance'' available on the Brookings website. At the same time, there were thousands of regulators who were supposed to be watching the store, literally rooms full of regulators policing the large institutions. Warnings were given to regulators of impending crisis but they chose to ignore --------------------------------------------------------------------------- them, believing instead that the market could regulate itself. In the future we must seek a system that takes advantage of market incentives and makes use of well-paid highly qualified regulators. Creating such a system will take time and commitment, but it is clearly necessary.Expanding on the Issues As the Committee is well aware, TBTF actually is somewhat of a misnomer, since no company is actually ``too big to fail.'' More accurately, as we have seen in the various bailouts during this crisis, even when the government comes to the rescue, it does not prevent shareholders from being wiped out or having the value of their shares significantly diminished. The beneficiaries of the rescues instead are typically short-term creditors, and in some cases, longer term creditors. The rescues are mounted to prevent systemic risk, which can arise in two ways: if creditors at one institution suffer loss or have to wait for their money, their losses will cascade throughout the financial system and threaten the failure of other firms and/or creditors in similar institutions will ``run'' and thereby trigger a wider crisis. In what follows we refer to financial institutions whose failure poses systemic risk as ``systemically important financial institutions'' or ``SIFIs'' for short. Clearly, large banks can be SIFIs because they are funded largely by deposits that can be withdrawn on demand. But, as has been painfully learned during this crisis, policymakers have feared that certain non-banks--the formerly independent investment banks and AIG--can be SIFIs because they, too, are or were funded largely by short-term creditors. By similar reasoning, other financial institutions--if sufficiently large, leveraged, or interconnected with the rest of the financial system--also can be systemically important, especially during a time of general economic stress: --Our entire financial system, for example, depends on the ability of the major stock and futures exchanges to price financial instruments, and on the major financial clearinghouses to pay those who are owed funds at the end of each day. --The harrowing experience with the near failure of LTCM in 1998 demonstrates that large, leveraged hedge funds can expose the financial system to real dangers if counter-parties are not paid on a timely basis. --Large troubled life insurers can also generate systemic risks if policyholders run to cash out their life insurance policies, or if the millions of retirees who rely on annuities suddenly learn that their contracts may not be honored sharply curtail their spending as a result. --It is an open question whether the large monoline bond insurers, which have been hit hard by losses on subprime securities they have guaranteed, are systemically important. On the one hand, these losses for a time appeared to threaten the ability of these insurers to continue underwriting municipal bond issues (their core business), which could have had major negative ripple effects throughout the economy. On the other hand, as the recent entry of Berkshire Hathaway into this business has demonstrated, other entrants eventually can take up the slack in the market if one or more of the existing bond insurers were to fail. Nonetheless, because the entry process takes time, it is possible that one or more of the existing bond insurers could be deemed too big (or important) to fail in a time of broad economic distress, such as the present time. --One or more large property-casualty insurers could be deemed to be systemically important if they each were hit suddenly by a massive volume of claims--for example, following one or a series of catastrophic hurricanes--which, among other things, could trigger a large amount of securities sales in a short period of time. A large volume of CAT claims could also imperil the solvency of one or more large insurers (and/or possibly state backup insurance pools, like the one in Florida) and leave millions of policy holders without coverage, an outcome that Federal policymakers may deem unacceptable. One question we are certain you have been asked by your constituents and the media is why the auto companies have been treated differently, at least so far, from large financial firms. To be sure, in each case, it now appears that the Federal Government will end up owning some or, in the case of GM, most of the equity. But the creditors of the auto companies are not being protected, unlike those of the large financial firms that have been labeled ``too big to fail.'' Why the difference? There is an economic answer to this question which admittedly may be politically less than persuasive to some. Essentially by definition, systemically important financial institutions are funded largely if not primarily by short-term borrowings--deposits, repurchase agreements, commercial paper--which if not fully repaid when due or ``rolled over'' will cause not only the firm to fail, but threaten the failure of many other firms throughout the economy in one or both of the ways we have already described. In contrast, non-financial firms are typically not funded primarily by short-term borrowing, but instead by a combination of longer-term debt and equity. To be sure, their failure can lead to the failure of other firms, such as suppliers, and also trigger a wider loss of confidence among consumers, but most economists believe the damage to the entire economy is not likely to be as substantial as it would be if depositors at one or more of the largest banks or the short-term counter-parties of a large hedge fund or insurance company are not paid on time. We are nonetheless confident that the various financial firm bailouts do not please you or your constituents, which presumably is why you've convened this hearing. We are all highly uncomfortable with having the government bail out some or all possibly all of the creditors of large systemically important financial institutions. In particular, there are three reasons for this discomfort. First, if creditors of some institutions know that they will be fully protected regardless of how the managers of those firms act, the creditors will have no incentive to monitor the firms' risks and to discourage the taking of excessive risk. Economists call this the ``moral hazard'' effect, and over time, if left unchecked it will lead to too much risk-taking by too many institutions, putting the economy at risk of future bubbles and the potentially huge costs when they pop. Second, bailouts of creditors of failed firms are fundamentally inconsistent with capitalism, which rewards and thus provides incentives for success, but punishes failure. Socializing the risks of failure is not how the game is played, and not only introduces too much risk-taking into the economy, but is also rightfully perceived as unfair by those firms whose creditors who are not given this protection. Third, we are learning that bailouts undermine the public's trust in government, which can make it harder for elected officials to do the public's business. Thus, for example, the unpopularity of the bailouts thus far may slow down the much needed cleanup of the financial system, which will slow the recovery. Likewise, if the public gets the impression that much of what Washington does is bail out mistakes, voters may be much more reluctant to support and fund worthy, cost-effective endeavors by government to ensure more universal health care, fix education, and address climate change, among other important objectives. For all these reasons, policymakers must take reasonable steps now to prevent institutions from becoming TBTF, or if that is the outcome of market forces, then to prevent these institutions from taking excessive risks that expose taxpayers to paying for their mistakes. These are essentially the options on which you have requested comment, and to which we now turn.Desirability and Feasibility of Preventing Institutions from Becoming CHRG-111shrg61651--14 Mr. Johnson," Thank you, Senator. I strongly support the Volcker Rules, as everybody is starting to call them, in terms of the principles they put forward. I think there are two main principles. The first is that we should redesign the size cap that does already exist for U.S. banks, the size cap from the 1994 Riegle-Neal Act. We should redesign it to reflect current realities. And second, we should address the issue that has arisen, in particular over the past few years, of U.S. Government backing for very large financial enterprises that have basically an unlimited ability to take risk around the world. I do not, however, think that the exact formulation of the Volcker Rules as put forward is the right way to go. I think, actually, you should consider tightening the restrictions on the largest banks and reducing the size cap, and I would emphasize that our banks are now already much larger as a percent of the--our largest banks as a percent of the economy, a percent of total financial assets, than we have ever seen before in the United States. Our largest six banks have assets worth over 60 percent of GDP. This reflects, in addition to what has happened in the financial crisis and the bailout and the rescue, it reflects the underlying concentration of these financial markets. So the big four banks now have more than half of the mortgage market in this country and two-thirds of the market for credit cards. This is unfair competition. Because these banks are too big to fail, they have lower funding costs, they are able to attract more capital, they make more money over the cycle, and they continue to get larger. And I do not think that we have seen the end of this. If you look at the European situation today, for example, it is much worse than what we have in this country with regard to the size of the largest banks. Just as one example, the Royal Bank of Scotland peaked with total assets at 125 percent of U.K. GDP. That is a seriously troubled bank that is now the responsibility of the U.K. taxpayer. If we allow our biggest banks to continue to build on these unfair market advantages and the lower funding costs, we will head in the same direction. I think I would suggest to you that you consider imposing a size cap on banks relative not to total normal assets or liabilities, which is the Volcker proposal, because that is not bubble-proof. If you have a massive increase in house prices, real estate prices, such as happened in Japan in the 1980s, you will have a big increase in the normal size of bank balance sheets. And when the bubble bursts, you are going to have a big problem. I think the size cap should be redefined as a percent of GDP. And I think that while the science on bank size is, to be sure, incomplete and inexact, there is no evidence that I can find of any kind, and I have spent a lot of time talking to technical people from they financial sector and people at central banks, people in the banking system themselves have impressed various points on me. I cannot find anything--I put this in the written testimony--that supports the idea that societies such as ours should have banks with total assets larger than around $100 billion in today's money. Now, if you were to impose a size cap of, say, 3 or 5 percent of GDP, no bank can be larger than that size, that would return our biggest banks roughly to the position that they had in the early 1990s. Now, our financial system worked very well in the early 1990s. Goldman Sachs, as one example, was one of the world's top investment banks. I don't think anyone questioned the competitive sector. But since the early 1990s, we have developed a lot more system risk focused on the existence of these very big banks. So, as Mr. Corrigan said, the essence of this crisis was lending, but it was lending that at the heart of it was based on the idea you could make nonrecourse loans to people who can walk away from their homes when the house value falls, leaving the bank with huge losses. How do people think this was a good idea? Why did they think that this would survive as a business model? Well, I think it was very much about the size of these banks and very much about the support they expected to receive when they are under duress. So in conclusion, I think the Volcker principles are exactly right. I think they are long overdue. I think you should--I hope that you will take them up and develop them further. I think the degree of unfair market competition, the degree to which the community banks are disadvantaged by the current situation, because they have to pay a lot more money--they pay higher interest for funds, their cost of capital is higher--this is unfair. This dynamic will continue unless you put an effective cap on it. The biggest banks will become even larger and even more dangerous. Thank you very much. " CHRG-111hhrg55809--251 Mr. Bernanke," Well, you know, it is not a single smoking gun, but there are lots of different problems where, again, there were gaps that arose because we didn't take enough of a systemic viewpoint. I talked about consumer protection and the problem of subprime, those things that you talked about. I think that is important. But if you look across the whole range of financial institutions, not just banks but investment banks and others, it seems clear that the strength and consistency of the oversight was not adequate; that there were many individual financial instruments, like the CDS and others, where again the oversight was fragmented and not sufficiently consistent and powerful. So it would take me some time frankly--I am sure you appreciate how complex the whole crisis has been. It would take me some time to go through all the different elements. But I think what we learned is that the system which seemed to be working fine as long as the economy and financial stresses were not too great; when things got much worse, then the system wasn't able to stand up to it. We learned a great deal from this crisis. I very much hope that this Congress and the agencies together will make use of those lessons. " fcic_final_report_full--426 These facts tell us that our explanation for the credit bubble should focus on fac- tors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. Furthermore, any explanation that relies too heavily on a unique element of the U.S. regulatory or supervisory system is likely to be insufficient to explain why the same thing happened in parts of Europe. This moves inadequate international capital and liquidity standards up our list of causes, and it moves the differences between the regulation of U.S. commercial and invest- ment banks down that list. Applying these international comparisons directly to the majority’s conclusions provokes these questions: • If the political influence of the financial sector in Washington was an essential cause of the crisis, how does that explain similar financial institution failures in the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark? • How can the “runaway mortgage securitization train” detailed in the majority’s report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States? • How can the corporate and regulatory structures of investment banks explain the decisions of many U.S. commercial banks, several large American univer- sity endowments, and some state public employee pension funds, not to men- tion a number of large and midsize German banks, to take on too much U.S. housing risk? • How did former Fed Chairman Alan Greenspan’s “deregulatory ideology” also precipitate bank regulatory failures across Europe? Not all of these factors identified by the majority were irrelevant; they were just not essential. The Commission’s statutory mission is “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” By fo- cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna- tional parallels, emphasizing only arguments for greater regulation, failing to prioritize the causes, and failing to distinguish sufficiently between causes and ef- fects, the majority’s report is unbalanced and leads to incorrect conclusions about what caused the crisis. We begin our explanation by briefly describing the stages of the crisis. CHRG-111shrg52619--188 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM SHEILA C. BAIRQ.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 activities that caused distress for AIG were primarily those related to its credit default swap (CDS) and securities lending businesses. The issue of lack of regulation of the credit derivatives market had been debated extensively in policy circles since the late 1990s. The recommendations contained in the 1999 study by the President's Working Group on Financial Markets, ``Over-the-Counter Derivatives Markets and the Commodity Exchange Act,'' were largely adopted in the Commodity Futures Modernization Act of 2000, where credit derivatives contracts were exempted from CFTC and SEC regulations other than those related to SEC antifraud provisions. As a consequence of the exclusions and environment created by these legislative changes, there were no major coordinated U.S. regulatory efforts undertaken to monitor CDS trading and exposure concentrations outside of the safety and soundness monitoring that was undertaken on an intuitional level by the primary or holding company supervisory authorities. AIG chartered AIG Federal Savings Bank in 1999, an OTS supervised institution. In order to meet European Union (EU) Directives that require all financial institutions operating in the EU to be subject to consolidated supervision, the OTS became AIG's consolidated supervisor and was recognized as such by the Bank of France on February 23, 2007 (the Bank of France is the EU supervisor with oversight responsibility for AIG's EU operations). In its capacity as consolidated supervisor of AIG, the OTS had the authority and responsibility to evaluate AIG's CDS and securities lending businesses. Even though the OTS had supervisory responsibility for AIG's consolidated operations, the OTS was not organized or staffed in a manner that provided the resources necessary to evaluate the risks underwritten by AIG. The supervision of AIG demonstrates that 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 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.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. 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, the supervisory 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. Effective institution specific supervision is needed by functional regulators focused on safety and soundness as well as consumer protection. Finally, there should be a legal mechanism for quick and orderly resolution of these institutions similar to what we use for FDIC insured banks. Whatever the approach to regulation and supervision, any system must be designed to facilitate coordination and communication among supervisory agencies and the relevant safety-net participants. In response to your question: Single Consolidated Regulator. This approach regulates and supervises a total financial organization. It designates a single supervisor to examine all of an organization's operations. Ideally, it must appreciate how the integrated organization works and bring a unified regulatory focus to the financial organization. The supervisor can evaluate risk across product lines and assess the adequacy of capital and operational systems that support the organization as a whole. Integrated supervisory and enforcement actions can be taken, which will allow supervisors to address problems affecting several different product lines. If there is a single consolidated regulator, the potential for overlap and duplication of supervision and regulation is reduced with fewer burdens for the organization and less opportunity for regulatory arbitrage. By centralizing supervisory authority over all subsidiaries and affiliates that comprise a financial organization, the single consolidated regulator model should increase regulatory and supervisory efficiency (for example through economies of scale) and accountability. With regard to disadvantages, 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. Another disadvantage is the potential for an unwieldy structure and a very cumbersome and bureaucratic organization. It may work best in financial systems with few financial organizations. Especially in larger systems, it may create the risk of a single point of regulatory failure. The U.S. has consolidated supervision, but individual components of financial conglomerates are supervised by more than one supervisor. For example, the Federal Reserve functions as the consolidated supervisor for bank holding companies, but in most cases it does not supervise the activities of the primary depository institutions. Similarly, the Securities and Exchange was the consolidated supervisor for many internationally active investment banking groups, but these institutions often included depository institutions that were regulated by a banking supervisor. Functional Regulation. Functional regulation and supervision applies a common set of rules to a line of business or product irrespective of the type of institution involved. It is designed to level the playing field among financial firms by eliminating the problem of having different regulators govern equivalent products and services. It may, however, artificially divide a firm's operations into departments by type of financial activity or product. By separating the regulation of the products and services and assigning different regulators to supervise them, absent a consolidated supervisor, no functional supervisor has an overall picture of the firm's operations and how those operations may affect the safety and soundness of the individual pieces. To be successful, this approach requires close coordination among the relevant supervisors. Even then, it is unclear how these alternative functional supervisors can be organized to efficiently focus on the overall safety and soundness of the enterprise. Functional regulation may be the most effective means of supervising highly sophisticated and emerging aspects of finance that are best reviewed by teams of examiners specializing in such technical areas Objectives-Based Regulation. This approach attempts to gamer the benefits of the single consolidated regulator approach, but with a realization that the efficacy of safety-and-soundness regulation and supervision may benefit if it is separated from consumer protection supervision and regulation. This regulatory model maintains a system of multiple supervisors, each specializing in the regulation of a particular objective-typically safety and soundness and consumer protection (there can be other objectives as well). The model is designed to bring uniform regulation to firms engaged in the same activities by regulating the entire entity. Arguments have been put forth that this model may be more adaptable to innovation and technological advance than functional regulation because it does not focus on a particular product or service. It also may not be as unwieldy as the consolidated regulator model in large financial systems. It may, however, produce a certain amount of duplication and overlap or could lead to regulatory voids since multiple regulators are involved. Another approach 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 also should have the authority to demand better information from systemically important entities and to ensure that information is shared more readily. The creation of 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 resolutions of these entities if they fail while protecting taxpayers from exposure.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. At present, the federal banking regulatory agencies likely have the best information regarding which large, complex, financial organizations (LCFO) would be ``systemically significant'' institutions if they were in danger of failing. Whether an institution is systemically important, however, would depend on a number of factors, including economic conditions. For example, if markets are functioning normally, a large institution could fail without systemic repercussions. Alternatively, in times of severe financial sector distress, much smaller institutions might well be judged to be systemic. Ultimately, identification of what is systemic will have to be decided within the structure created for systemic risk regulation. Even if we could identify the ``too big to fail'' (TBTF) institutions, it is unclear that it would be prudent to publicly identify the institutions or fully disclose the characteristics that identify an institution as systemic. Designating a specific firm as TBTF would have a number of undesirable consequences: market discipline would be fully suppressed and the firm would have a competitive advantage in raising capital and funds. Absent some form of regulatory cost associated with systemic status, the advantages conveyed by such status create incentives for other firms to seek TBTF status--a result that would be counterproductive. Identifying TBTF institutions, therefore, must be accompanied by legislative and regulatory initiatives that are designed to force TBTF firms to internalize the costs of government safety-net benefits and other potential costs to society. TBTF 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.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. ``Too-Big-To-Fail'' implies that an organization is of such importance to the financial system that its failure will impose widespread costs on the economy and the financial system either by causing the failure of other linked financial institutions or by seriously disrupting intermediation in banking and financial markets. In such cases, the failure of the organization has potential spillover effects that could lead to widespread depositor runs, impair public confidence in the broader financial system, or cause serious disruptions in domestic and international payment and settlement systems that would in turn have negative and long lasting implications for economic growth. Although TBTF is generally associated with the absolute size of an organization, it is not just a function of size, but also of the complexity of the organization and its position in national and international markets (market share). Systemic risk may also arise when organizations pose a significant amount of counterparty risk (for example, through derivative market exposures of direct guarantees) or when there is risk of important contagion effects when the failure of one institution is interpreted as a negative signal to the market about the condition of many other institutions. As described above, 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. There are three key elements to addressing the problem of 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.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. A firm fails when it becomes insolvent; the value of its assets is less than the value of its liabilities or when its regulatory capital falls below required regulatory minimum values. Alternatively, a firm can fail when it has insufficient liquidity to meet its payment obligations which may include required payments on liabilities or required transfers of cash-equivalent instruments to meet collateral obligations. According to the above definition, AIG's initial liquidity crisis qualifies it as a failure. AIG's need for cash arose as a result of increases in required collateral obligations triggered by a ratings downgrade, increases in the market value of the CDS protection AIG sold, and by mass redemptions by counterparties in securities lending agreements where borrowers returned securities and demand their cash collateral. At the same time, AIG was unable to raise capital or renew commercial paper financing to meet increased need for cash. Subsequent events suggest that AIG's problems extended beyond a liquidity crisis to insolvency. Large losses AIG has experienced depleted much of its capital. For instance, AIG reported a net loss in the fourth quarter 2008 of $61.7 billion bringing its net loss for the full year (2008) to $99.3 billion. Without government support, which is in excess of $180 billion, AIG would be insolvent and a bankruptcy filing would have been unavoidable. ------ CHRG-110shrg46629--44 Chairman Bernanke," The Federal Reserve does not have any specific powers or responsibilities regarding the rating agencies themselves. What we are doing is working with our banks that we supervise to ensure that they are safe and sound and that they are doing due diligence in the types of assets that they purchase or the types of assets they themselves securitize and resell. So our perspective is protecting the safety of the banking system. We do not have broader authority to dictate how these assets are created. Senator Reed. Should someone have the broader authority to do that? I mean if we assume, as I think you perhaps might, that the market will not evaluate these assets accurately because they are so thinly traded, difficult to understand, it falls upon a rating agency. And if the rating agency, if there is no supervision, is there a gap? " CHRG-111hhrg54867--251 Secretary Geithner," Oh, I am sorry. We are proposing, again, for the large, complex institutions that those requirements are set and enforced by the Federal Reserve, which is quite close to the system today, now that investment banks are bank holding companies. But we want to make sure that is absolutely clear, so there is more accountability. But the rules need to be more conservative and better designed to reduce that run risk. " FOMC20080916meeting--68 66,MR. DUDLEY.," I think a lot of the programs that we have are actually open ended. The discount window is open ended in the sense that it's limited only by the amount of collateral that the banks post there. The Primary Dealer Credit Facility is open ended in that it is limited only by the size of the tri-party repo system. My point here is that, if foreign banks worry about capacity limits, even having a large program could in principle not be sufficient in extremis. But if the program is open ended, the rollover risk problem goes away. If I lend you more dollars today, I don't have to worry about getting those dollars back because I always know that the facility is there. So it's really the elimination of the ability to flatten out your position if you need to in terms of your dollar exposures. " CHRG-111hhrg48875--54 Secretary Geithner," We did not propose to establish capital requirements for hedge funds. What we are saying, though, is that the large institutions, principally the banks and the major large complex regulated financial institutions, are held to a set of requirements on capital liquidity reserves risk management, which are commensurate with the risks they pose. And because their risks are greater, and because the consequences of their failure is greater, they need to be subject to a higher set of standards and greater constraints on leverage. But we're not proposing to establish capital requirements for the broad universe of hedge funds and private pools of capital that exist in our markets. We want them to register with the SEC if they reach a certain scale, and in the future, if some of them individually reach a size where they may be systemic, then at that point, we believe they should be brought within a regulatory framework that's similar to that which exists for banks. " CHRG-111hhrg55809--11 Mr. Garrett," I thank the chairman for holding this hearing, and I welcome Chairman Bernanke back again to the committee. I note in the Chairman's testimony you continue to advocate that the Federal Reserve should be given authority for consolidated oversight for all ``systemically important financial institutions.'' And, quite candidly, I do have a number of concerns about this proposal, many that I have expressed before. Among them, first of all, specifically designating institutions as systemically critical leads to unfair competitive agendas, disadvantages, increased moral hazard, and makes it more likely such institutions will be considered ``too-big-to-fail.'' Secondly, the Federal Reserve already has consolidated supervision over many of the large bank holding companies, including Citi and Bank of America, which the Federal Government has pumped billions of dollars into due to the fact that such consolidated supervision apparently failed in the past. Furthermore, Fed policy itself--that is, keeping interest rates too low for too long, primarily before you were here--was one of the major factors leading to this crisis. I am not alone in my concerns about the Fed as a systemic regulator. There seems to be a universal distaste for the Fed in such a role on the Senate Banking Committee. Such a political reality would seem to make it less likely that the House would confer such new powers on the Fed either. And as has been stated previously, rather than give the Fed additional powers, Republicans on the committee have proposed as part of a reform plan that the powers of the Fed be focused primarily on monetary policy and others be reduced. So preventing future taxpayer-funded bailouts is a primary aim of the GOP plan and is also the primary aim of a piece of legislation I plan to introduce later today that will call for raising the minimum downpayment for the FHA loans as well as a study to examine what is an appropriate leverage ratio for the FHA. There have been increasing reports of a likely necessity of a taxpayer-funded bailout for the FHA, and this legislation aims to implement-- " CHRG-111shrg56376--15 Chairman Dodd," Thank you very much, Mr. Bowman. Let me ask the clerk to put the clock on here for about 6 minutes per Member, and I have two questions I want to raise with you, if time permits, and then I will turn to Senator Shelby. First of all, for decades--and I have been on this Committee for a number of years, and we have had commissions and think tanks and regulators, presidents, Banking Committee Chairs. John, you will remember sitting behind us back here at that table with parties recommending the consolidation of Federal banking supervision. Bill Proxmire, who sat in this chair for a number of years, proclaimed the U.S. system of regulation to be, and I quote, ``the most bizarre and tangled financial regulatory system in the world.'' Former FDIC Chairman, Sheila, Chairman William Seidman, called it ``complex, inefficient, outmoded, and archaic.'' In the wake of the last bank and thrift crisis, when hundreds of institutions failed, the Clinton administration urged Congress to consolidate the Federal banking regulators into a single prudential regulator. So here we have seen Administrations, Chairs of this Committee, and others over the years, all at various times, in the wake of previous crises, call for consolidation, and yet we did not act after those crises. We sat back and basically left pretty much the system we have today intact. And as a result, we have had some real costs ranging from inefficiencies and redundancies to the lack of accountability and regulatory laxity. We are now paying a very high price for those shortcomings. So my first question is--the Administration, as you all know and you have commented on, has proposed the consolidation of the OCC and OTS, but leaves in place the three Federal bank regulators. My question is simply: Putting the safety and soundness of the banking system first, is the Administration proposal really enough? Or should we not be listening to the admonition of previous Administrations? And people have sat in this chair who have recommended greater consolidation that ought to be the step taken. Sheila, we will begin with you. Ms. Bair. As I indicated in my opening statement, we do not think that the ability to choose between the Federal and State charter was any kind of a significant driver or had any kind of an impact at all on the activities that led to this current crisis. The key problems were arbitrage between more heavily regulated banks and nonbanks, and then the OTC derivatives sector, which was pretty much completely unregulated. I do support merging OCC and OTS. That is reflective of market conditions, but that doesn't need to be about whether there is a weak regulator or strong regulator. I think that is just a reflection of the market and the lack of current market interest in a specialty charter to do just mortgage lending or heavily concentrate on mortgage lending. In fact, some of the restrictions on the thrift charter perhaps have impeded the ability of those thrifts to undertake additional diversification. So, Mr. Chairman, I would have to respectfully disagree in terms of drivers of what went on this time around. I really do not see that as a symptom of the fact that you have four different regulators overseeing different charters for FDIC-insured institutions. And I do think that the banks held up pretty well compared to the other sectors. They did have higher capital standards and more extensive regulation. " FOMC20080916meeting--133 131,CHAIRMAN BERNANKE.," President Lacker, I have a question. I really would like your advice on this. Historically, if we look at situations like Japan and Scandinavia, ultimately there comes a point at which the banking system is decapitalized and dysfunctional and the government intervenes on a large scale. Those interventions have been very expensive, but in those cases I mentioned, they have generally restored the banking system to health and have helped the economy recover. What's your view on the right sequencing? Do you think that we should remain very tough until such time as it becomes inevitable that fiscal intervention is needed? Do you think that we should avoid fiscal intervention at all stages? I'm seriously interested in knowing what you, or anyone else who would like to comment, think is the appropriate stage, if any, at which fiscal intervention becomes necessary. " CHRG-111shrg52966--71 PREPARED STATEMENT OF ROGER T. COLE Director, Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System March 18, 2009 Chairman Reed, Ranking Member Bunning and members of the Subcommittee, it is my pleasure to appear today to discuss the state of risk management in the banking industry and steps taken by Federal Reserve supervisors to address risk management shortcomings at banking organizations. In my testimony, I will describe the vigorous and concerted steps the Federal Reserve has taken and is taking to rectify the risk management weaknesses revealed by the current financial crisis. I will also describe actions we are taking internally to improve supervisory practices and apply supervisory lessons learned. This includes a process spearheaded by Federal Reserve Vice Chairman Donald Kohn to systematically identify key lessons revealed by recent events and to implement corresponding recommendations. Because this crisis is ongoing, our review is ongoing.Background The Federal Reserve has supervisory and regulatory authority over a range of financial institutions and activities. It works with other Federal and State supervisory authorities to ensure the safety and soundness of the banking industry, foster the stability of the financial system, and provide for fair and equitable treatment of consumers in their financial transactions. The Federal Reserve is not the primary Federal supervisor for the majority of commercial bank assets. Rather, it is the consolidated supervisor of bank holding companies, including financial holding companies, and conducts inspections of all of those institutions. As I describe below, we have recently enhanced our supervisory processes on consolidated supervision to make them more effective and efficient. The primary purpose of inspections is to ensure that the holding company and its nonbank subsidiaries do not pose a threat to the soundness of the company's depository institutions. In fulfilling this role, the Federal Reserve is required to rely to the fullest extent possible on information and analysis provided by the appropriate supervisory authority of the company's bank, securities, or insurance subsidiaries. The Federal Reserve is also the primary Federal supervisor of State-member banks, sharing supervisory responsibilities with State supervisory agencies. In this role, Federal Reserve supervisory staff regularly conduct onsite examinations and offsite monitoring to ensure the soundness of supervised State member banks. The Federal Reserve is involved in both regulation--establishing the rules within which banking organizations must operate--and supervision--ensuring that banking organizations abide by those rules and remain, overall, in safe and sound condition. A key aspect of the supervisory process is evaluating risk management practices, in addition to assessing the financial condition of supervised institutions. Since rules and regulations in many cases cannot reasonably prescribe the exact practices each individual bank should use for risk management, supervisors design policies and guidance that expand upon requirements set in rules and regulations and establish expectations for the range of acceptable practices. Supervisors rely extensively on these policies and guidance as they conduct examinations and to assign supervisory ratings. We are all aware that the U.S. financial system is experiencing unprecedented disruptions that have emerged with unusual speed. The principal cause of the current financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn. In the period leading up to the crisis, the Federal Reserve and other U.S. banking supervisors took several important steps to improve the safety and soundness of banking organizations and the resilience of the financial system. For example, following the September 11, 2001, terrorist attacks, we took steps to improve clearing and settlement processes, business continuity for critical financial market activities, and compliance with Bank Secrecy Act, anti-money laundering, and sanctions requirements. Other areas of focus pertained to credit card subprime lending, the growth in leveraged lending, credit risk management practices for home equity lending, counterparty credit risk related to hedge funds, and effective accounting controls after the fall of Enron. These are examples in which the Federal Reserve took aggressive action with a number of financial institutions, demonstrating that effective supervision can bring about material improvements in risk management and compliance practices at supervised institutions. In addition, the Federal Reserve, working with the other U.S. banking agencies, issued several pieces of supervisory guidance before the onset of the recent crisis--taking action on nontraditional mortgages, commercial real estate, home equity lending, complex structured financial transactions, and subprime lending--to highlight emerging risks and point bankers to prudential risk management practices they should follow. Moreover, we identified a number of potential issues and concerns and communicated those concerns to the industry through the guidance and through our supervisory activities.Supervisory Actions to Improve Risk Management Practices In testimony last June, Vice Chairman Kohn outlined the immediate supervisory actions taken by the Federal Reserve to identify risk management deficiencies at supervised firms related to the current crisis and bring about the necessary corrective steps. We are continuing and expanding those actions. While additional work is necessary, we are seeing progress at supervised institutions toward rectifying issues identified amid the ongoing turmoil in the financial markets. We are also devoting considerable effort to requiring bankers to look not just at risks from the past but also to have a good understanding of their risks going forward. The Federal Reserve has been actively engaged in a number of efforts to understand and document the risk management lapses and shortcomings at major financial institutions revealed during the current crisis. In fact, the Federal Reserve Bank of New York organized and leads the Senior Supervisors Group (SSG), which published a report last March on risk management practices at major international firms.\1\ I do not plan to summarize the findings of the SSG report and similar public reports, since others from the Federal Reserve have already done so.\2\ But I would like to describe some of the next steps being taken by the SSG.--------------------------------------------------------------------------- \1\ Senior Supervisors Group (2008). ``Observations on Risk Management Practices during the Recent Market Turbulence'' March 6, www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf. \2\ President's Working Group on Financial Markets (2008), ``Policy Statement on Financial Market Developments,'' March 13, www.treas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf. Financial Stability Forum (2008), ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 7, www.fsforum.org/publications/FSF_Report_to_G7_11_April.pdf.--------------------------------------------------------------------------- A key initiative of the Federal Reserve and other supervisors since the issuance of the March 2008 SSG report has been to assess the response of the industry to the observations and recommendations on the need to enhance key risk management practices. The work of the SSG has been helpful, both in complementing our evaluation of risk management practices at individual firms and in our discussions with bankers and their directors. It is also providing perspective on how each individual firm's risk management performance compares with that of a broad cross-section of global financial services firms. The continuation of the SSG process requires key firms to conduct self-assessments that are to be shared with the organization's board of directors and serve to highlight progress in addressing gaps in risk management practices and identify areas where additional efforts are still needed. Our supervisory staff is currently in the process of reviewing the firms' self assessments, but we note thus far that in many areas progress has been made to improve risk management practices. We plan to incorporate the results of these reviews into our future examination work to validate management assertions. The next portion of my remarks describes the supervisory actions we have been taking in the areas of liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit risk, and commercial real estate. In all of these areas we are moving vigorously to address the weaknesses at financial institutions that have been revealed by the crisis.Liquidity risk management Since the beginning of the crisis, we have been working diligently to bring about needed improvements in institutions' liquidity risk management practices. One lesson learned in this crisis is that several key sources of liquidity may not be available in a crisis. For example, Bear Stearns collapsed in part because it could not obtain liquidity even on a basis fully secured by high-quality collateral, such as U.S. Government securities. Others have found that back-up lines of credit are not made available for use when most needed by the borrower. These lessons have heightened our concern about liquidity and improved our approach to evaluating liquidity plans of banking organizations. Along with our U.S. supervisory colleagues, we are monitoring the major firms' liquidity positions on a daily basis, and are discussing key market developments and our supervisory views with the firms' senior management. We also are conducting additional analysis of firms' liquidity positions to examine the impact various scenarios may have on their liquidity and funding profiles. We use this ongoing analysis along with findings from examinations to ensure that liquidity and funding risk management and contingency funding plans are sufficiently robust and that the institutions are prepared to address various stress scenarios. We are aggressively challenging those assumptions in firms' contingency funding plans that may be unrealistic. Our supervisory efforts require firms to consider the potential impact of both disruptions in the overall funding markets and idiosyncratic funding difficulties. We are also requiring more rigor in the assessment of all expected and unexpected funding uses and needs. Firms are also being required to consider the respective risks of reliance on wholesale funding and retail funding, as well as the risks associated with off-balance sheet contingencies. These efforts include steps to require banks to consider the potential impact on liquidity that arises from firms' actions to protect their reputation, such as an unplanned increase in assets requiring funding that would arise with support given to money market funds and other financial vehicles where no contractual obligation exists. These efforts also pertain to steps banks must take to prepare for situations in which even collateralized funding may not be readily available because of market disruptions or concern about the health of a borrowing institution. As a result of these efforts, supervised institutions have significantly improved their liquidity risk management practices, and have taken steps to stabilize and improve their funding sources as market conditions permit. In conducting work on liquidity risk management, we have used established supervisory guidance on liquidity risk management as well as updated guidelines on liquidity risk management issued by the Basel Committee on Banking Supervision last September--a process in which the Federal Reserve played a lead role. So that supervisory expectations for U.S. depository institutions are aligned with these international principles, the U.S. banking agencies plan to update their own interagency guidance on liquidity risk management practices in the near future. The new guidance will emphasize the need for institutions of all sizes to conduct meaningful cash-flow forecasts of their funding needs in both normal and stressed conditions and to ensure that they have an adequately diversified funding base and a cushion of liquid assets to mitigate stressful market conditions. Our supervisory efforts at individual institutions and the issuance of new liquidity risk management guidance come on top of broader Federal Reserve efforts outside of the supervision function to improve liquidity in financial markets, such as introduction of the Term Auction Facility and the Term Asset-Backed Securities Loan Facility.Capital planning and capital adequacy Our supervisory activities for capital planning and capital adequacy are similar to those for liquidity. We have been closely monitoring firms' capital levels relative to their risk exposures, in conjunction with reviewing projections for earnings and asset quality and discussing our evaluations with senior management. We have been engaged in our own analysis of loss scenarios to anticipate institutions' future capital needs, analysis that includes the potential for losses from a range of sources as well as assumption of assets currently held off balance sheet. We have been discussing our analysis with bankers and requiring their own internal analyses to reflect a broad range of scenarios and to capture stress environments that could impair solvency. As a result, banking organizations have taken a number of steps to strengthen their capital positions, including raising substantial amounts of capital from private sources in 2007 and 2008. We have stepped up our efforts to evaluate firms' capital planning and to bring about improvements where they are needed. For instance, we recently issued guidance to our examination staff--which was also distributed to supervised institutions--on the declaration and payment of dividends, capital repurchases, and capital redemptions in the context of capital planning processes. We are forcefully requiring institutions to retain strong capital buffers-above the levels prescribed by minimum regulatory requirements--not only to weather the immediate environment but also to remain viable over the medium and long term. Our efforts related to capital planning and capital adequacy are embodied in the interagency supervisory capital assessment process, which began in February. We are conducting assessments of selected banking institutions' capital adequacy, based on certain macroeconomic scenarios. For this assessment, we are carefully evaluating the forecasts submitted by each financial institution to ensure they are appropriate, consistent with the firm's underlying portfolio performance, and reflective of each entity's particular business activities and risk profile. The assessment of capital under the two macroeconomic scenarios being used in the capital assessment program will permit supervisors to ascertain whether institutions' capital buffers over the regulatory capital minimum are appropriate under more severe but plausible scenarios. Federal Reserve supervisors have been engaged over the past few years in evaluating firms' internal processes to assess overall capital adequacy as set forth in existing Federal Reserve supervisory guidance. A portion of that work has focused on how firms use economic capital practices to assess overall capital needs. We have communicated our findings to firms individually, which included their need to improve some key practices, and demanded corrective actions. We also presented our overall findings to a broad portion of the financial industry at a System-sponsored outreach meeting last fall that served to underscore the importance of our message.Firm-wide risk identification and compliance risk management One of the most important aspects of good risk management is risk identification. This is a particularly challenging exercise because some practices, each of which appears to present low risk on its own, may combine to create unexpectedly high risk. For example, in the current crisis, practices in mortgage lending--which historically has been seen as a very low-risk activity--have become distorted and, consequently riskier, as they have been fueled by another activity that was designed to reduce risk to lenders--the sale of mortgage assets to investors outside the financial industry. Since the onset of the crisis, we have been working with supervised institutions to improve their risk identification practices where needed, such as by helping identify interconnected risks. These improvements include a better understanding of risks facing the entire organization, such as interdependencies among risks and concentrations of exposures. One of the key lessons learned has been the need for timely and effective communication about risks, and many of our previously mentioned efforts pertaining to capital and liquidity are designed to ensure that management and boards of directors understand the linkages within the firm and how various events might impact the balance sheet and funding of an organization. We have demanded that institutions address more serious risk management deficiencies so that risk management is appropriately independent, that incentives are properly aligned, and that management information systems (MIS) produce comprehensive, accurate, and timely information. In our 2006 guidance on nontraditional mortgage products, we recognized that poor risk management practices related to retail products and services could have serious effects on the profitability of financial institutions and the economy; in other words, there could be a relationship between consumer protection and financial soundness. For example, consumer abuses in the subprime mortgage lending market were a contributing cause to the current mortgage market problems. Here, too, we are requiring improvements. The Federal Reserve issued guidance on compliance risk management programs to emphasize the need for effective firm-wide compliance risk management and oversight at large, complex banking organizations. This guidance is particularly applicable to compliance risks, including its application to consumer protection, that transcend business lines, legal entities, and jurisdictions of operation.Residential lending Financial institutions are still facing significant challenges in the residential mortgage market, particularly given the rising level of defaults and foreclosures and the lack of liquidity for private label mortgage-backed securities. Therefore, we will continue to focus on the adequacy of institutions' risk management practices, including their underwriting standards, and re-emphasize the importance of a lender's assessment of a borrower's ability to repay the loan. Toward that end, we are requiring institutions to maintain risk management practices that more effectively identify, monitor, and control the risks associated with their mortgage lending activity and that more adequately address lessons learned from recent events. In addition to efforts on the safety and soundness front, last year we finalized amendments to the rules under the Home Ownership and Equity Protection Act (HOEPA). These amendments establish sweeping new regulatory protections for consumers in the residential mortgage market. Our goal throughout this process has been to protect borrowers from practices that are unfair or deceptive and to preserve the availability of credit from responsible mortgage lenders. The Board believes that these regulations, which apply to all mortgage lenders, not just banks, will better protect consumers from a range of unfair or deceptive mortgage lending and advertising practices that have been the source of considerable concern and criticism. Given escalating mortgage foreclosures, we have urged regulated institutions to establish systematic, proactive, and streamlined mortgage loan modification protocols and to review troubled loans using these protocols. We expect an institution (acting either in the role of lender or servicer) to determine, before proceeding to foreclosure, whether a loan modification will enhance the net present value of the loan, and whether loans currently in foreclosure have been subject to such analysis. Such practices are not only consistent with sound risk management but are also in the long-term interests of borrowers, lenders, investors, and servicers. We are encouraging regulated institutions, through government programs, to pursue modifications that result in mortgages that borrowers will be able to sustain over the remaining maturity of their loan. In this regard, just recently the Federal Reserve joined with other financial supervisors to encourage all of the institutions we supervise to participate in the Treasury Department's Home Affordable loan modification program, which was established under the Troubled Assets Relief Program.\3\ Our examiners are closely monitoring loan modification efforts of institutions we supervise.--------------------------------------------------------------------------- \3\ See http://www.Federalreserve.gov/newsevents/press/bcreg/20090304a.htm.---------------------------------------------------------------------------Counterparty credit risk The Federal Reserve has been concerned about counterparty credit risk for some time, and has focused on requiring the industry to have effective risk management practices in place to deal with risks associated with transacting with hedge funds, for example, and other key counterparties. This focus includes assessing the overall quality of MIS for counterparty credit risk and ensuring that limits are complied with and exceptions appropriately reviewed. As the crisis has unfolded, we have intensified our monitoring of counterparty credit risk. Supervisors are analyzing management reports and, in some cases, are having daily conversations with management about ongoing issues and important developments. This process has allowed us to understand key linkages and exposures across the financial system as specific counterparties experience stress during the current market environment. Federal Reserve supervisors now collect information on the counterparty credit exposures of major institutions on a weekly and monthly basis, and have enhanced their methods of assessing this exposure. Within counterparty credit risk, issues surrounding the credit default swap (CDS) market have been particularly pertinent. As various Federal Reserve officials have noted in past testimony to congressional committees and in other public statements, regulators have, for several years, been addressing issues surrounding the over-the-counter (OTC) derivatives market in general and the CDS market in particular. Since September 2005, an international group of supervisors, under the leadership of the Federal Reserve Bank of New York, has been working with dealers and other market participants to strengthen arrangements for processing, clearing, and settling OTC derivatives. An early focus of this process was on CDS. This emphasis includes promoting such steps as greater use of electronic-confirmation platforms, adoption of a protocol that requires participants to request counterparty consent before assigning trades to a third party, and creation of a contract repository that maintains an electronic record of CDS trades. More recently, and in response to the recommendations of the President's Working Group on Financial Markets and the Financial Stability Forum, supervisors are working to bring about further improvements to the OTC derivatives market infrastructure. With respect to credit derivatives, this agenda includes: (1) further increasing standardization and automation; (2) incorporating an auction-based cash settlement mechanism into standard documentation; (3) reducing the volume of outstanding CDS contracts; and (4) developing well-designed central counterparty services to reduce systemic risks. The most important potential change in the infrastructure for credit derivatives is the creation of one or more central counterparties (CCPs) for CDS. The Federal Reserve supports CCP clearing of CDS because, if properly designed and managed, CCPs can reduce risks to market participants and to the financial system. In addition to clearing CDS through CCPs, the Federal Reserve believes that exchange trading of sufficiently standardized contracts by banks and other market participants can increase market liquidity and transparency, and thus should be encouraged. In a major step toward achieving that goal, the Federal Reserve Board, on March 4, 2009, approved the application by ICE US Trust LLC (ICE Trust) to become a member of the Federal Reserve System. ICE Trust intends to provide central counterparty services for certain credit default swap contracts.Commercial real estate For some time, the Federal Reserve has been focused on commercial real estate (CRE) exposures. For background, as part of our onsite supervision of banking organizations in the early 2000s, we began to observe rising CRE concentrations. Given the central role that CRE lending played in the banking problems of the late 1980s and early 1990s, we led an interagency effort to issue supervisory guidance on CRE concentrations. In the 2006 guidance on CRE, we emphasized our concern that some institutions' strategic- and capital-planning processes did not adequately acknowledge the risks from their CRE concentrations. We stated that stress testing and similar exercises were necessary for institutions to identify the impact of potential CRE shocks on earnings and capital, especially the impact from credit concentrations. Because weaker housing markets and deteriorating economic conditions have clearly impaired the quality of CRE loans at supervised banking organizations, we have redoubled our supervisory efforts in regard to this segment. These efforts include monitoring carefully the impact that declining collateral values may have on CRE exposures as well as assessing the extent to which banks have been complying with the interagency CRE guidance. We found, through horizontal reviews and other examinations, that some institutions would benefit from additional and better stress testing and could improve their understanding of how concentrations--both single-name and sectoral/geographical concentrations--can impact capital levels during shocks. We have also implemented additional examiner training so that our supervisory staff is equipped to deal with more serious CRE problems at banking organizations as they arise, and have enhanced our outreach to key real estate market participants and obtained additional market data sources to help support our supervisory activities. As a result of our supervisory work, risk management practices related to CRE are improving, including risk identification and measurement. To sum up our efforts to improve banks' risk management, we are looking at all of the areas mentioned above--both on an individual and collective basis--as well as other areas to ensure that all institutions have their risk management practices at satisfactory levels. More generally, where we have not seen appropriate progress, we are aggressively downgrading supervisory ratings and using our enforcement tools.Supervisory Lessons Learned Having just described many of the steps being taken by Federal Reserve supervisors to address risk management deficiencies in the banking industry, I would now like to turn briefly to our internal efforts to improve our own supervisory practices. The current crisis has helped us to recognize areas in which we, like the banking industry, can improve. Since last year, Vice Chairman Kohn has led a System-wide effort to identify lessons learned and to develop recommendations for potential improvements to supervisory practices. To benefit from multiple perspectives in these efforts, this internal process is drawing on staff from around the System. For example, we have formed System-wide groups, led by Board members and Reserve Bank Presidents, to address the identified issues in areas such as policies and guidance, the execution of supervisory responsibilities, and structure and governance. Each group is reviewing identified lessons learned, assessing the effectiveness of recent initiatives to rectify issues, and developing additional recommendations. We will leverage these group recommendations to arrive at an overall set of enhancements that will be implemented in concert. As you know, we are also meeting with Members of the Congress and other government bodies, including the Government Accountability Office, to consult on lessons learned and to hear additional suggestions for improving our practices. One immediate example of enhancements relates to System-wide efforts for forward-looking risk identification efforts. Building on previous System-wide efforts to provide perspectives on existing and emerging risks, the Federal Reserve has recently augmented its process to disseminate risk information to all the Reserve Banks. That process is one way we are ensuring that risks are identified in a consistent manner across the System by leveraging the collective insights of Federal Reserve supervisory staff. We are also using our internal risk reporting to help establish supervisory priorities, contribute to examination planning and scoping, and track issues for proper correction. Additionally, we are reviewing staffing levels and expertise so that we have the appropriate resources, including for proper risk identification, to address not just the challenges of the current environment but also those over the longer term. We have concluded that there is opportunity to improve our communication of supervisory and regulatory policies, guidance, and expectations to those we regulate. This includes more frequently updating our rules and regulations and more quickly issuing guidance as new risks and concerns are identified. For instance, we are reviewing the area of capital adequacy, including treatment of market risk exposures as well as exposures related to securitizations and counterparty credit risk. We are taking extra steps to ensure that as potential areas of risk are identified or new issues emerge, policies and guidance address those areas in an appropriate and timely manner. And we will increase our efforts to ensure that, for global banks, our policy and guidance responses are coordinated, to the extent possible, with those developed in other countries. One of the Federal Reserve's latest enhancements related to guidance, a project begun before the onset of the crisis, was the issuance of supervisory guidance on consolidated supervision. This guidance is intended to assist our examination staff as they carry out supervision of banking institutions, particularly large, complex firms with multiple legal entities, and to provide some clarity to bankers about our areas of supervisory focus. Importantly, the guidance is designed to calibrate supervisory objectives and activities to the systemic significance of the institutions and the complexity of their regulatory structures. The guidance provides more explicit expectations for supervisory staff on the importance of understanding and validating the effectiveness of the banking organization's corporate governance, risk management, and internal controls that are in place to oversee and manage risks across the organization. Our assessment of nonbank activities is an important part of our supervisory process to understand the linkages between depository and nondepository subsidiaries, and their effects on the overall risks of the organization. In addition to issues related to general risk management at nonbank subsidiaries, the consolidated supervision guidance addresses potential issues related to consumer compliance. In this regard, in 2007 and 2008 the Board collaborated with other U.S. and State government agencies to launch a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. This interagency initiative has clarified jurisdictional issues and improved information-sharing among the participating agencies, along with furthering its overarching goal of preventing abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. As stated earlier, there were numerous cases in which the U.S. banking agencies developed policies and guidance for emerging risks and issues that warranted the industry's attention, such as in the areas of nontraditional mortgages, home equity lending, and complex structured financial transactions. It is important that regulatory policies and guidance continue to be applied to firms in ways that allow for different business models and that do not squelch innovation. However, when bankers are particularly confident, when the industry and others are especially vocal about the costs of regulatory burden and international competitiveness, and when supervisors cannot yet cite recognized losses or writedowns, we must have even firmer resolve to hold firms accountable for prudent risk management practices. It is particularly important, in such cases, that our supervisory communications are very forceful and clear, directed at senior management and boards of directors so that matters are given proper attention and resolved to our satisfaction. With respect to consumer protection matters, we have an even greater understanding that reviews of consumer compliance records of nonbank subsidiaries of bank holding companies can aid in confirming the level of risk that these entities assume, and that they assist in identifying appropriate supervisory action. Our consumer compliance division is currently developing a program to further the work that was begun in the interagency pilot discussed earlier. In addition to these points, it is important to note that we have learned lessons and taken action on important aspects of our consumer protection program, which I believe others from the Federal Reserve have discussed with the Congress. In addition, we must further enhance our ability to develop clear and timely analysis of the interconnections among both regulated and unregulated institutions, and among institutions and markets, and the potential for these linkages and interrelationships to adversely affect banking organizations and the financial system. In many ways, the Federal Reserve is well positioned to meet this challenge. In this regard, the current crisis has, in our view, demonstrated the ways in which the Federal Reserve's consolidated supervision role closely complements our other central bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. The information, expertise, and powers derived from our supervisory authority enhance the Federal Reserve's ability to help reduce the likelihood of financial crises, and to work with the Treasury Department and other U.S. and foreign authorities to manage such crises should they occur. Indeed, the enhanced consolidated supervision guidance that the Federal Reserve issued in 2008 explicitly outlines the process by which we will use information obtained in the course of supervising financial institutions--as well as information and analysis obtained through relationships with other supervisors and other sources--to identify potential vulnerabilities across financial institutions. It will also help us identify areas of supervisory focus that might further the Federal Reserve's knowledge of markets and counterparties and their linkages to banking organizations and the potential implications for financial stability. A final supervisory lesson applies to the structure of the U.S. regulatory system, an issue that the Congress, the Federal Reserve, and others have already raised. While we have strong, cooperative relationships with other relevant bank supervisors and functional regulators, there are obvious gaps and operational challenges in the regulation and supervision of the overall U.S. financial system. This is an issue that the Federal Reserve has been studying for some time, and we look forward to providing support to the Congress and the Administration as they consider regulatory reform. In a recent speech, Chairman Bernanke introduced some ideas to improve the oversight of the U.S. financial system, including the oversight of nonbank entities. He stated that no matter what the future regulatory structure in the United States, there should be strong consolidated supervision of all systemically important banking and nonbanking financial institutions. Finally, Mr. Chairman, I would like to thank you and the Subcommittee for holding this second hearing on risk management--a crucially important issue in understanding the failures that have contributed to the current crisis. Our actions, with the support of the Congress, will help strengthen institutions' risk management practices and the supervisory and regulatory process itself--which should, in turn, greatly strengthen the banking system and the broader economy as we recover from the current difficulties. I look forward to answering your questions. ______ CHRG-111shrg54533--94 RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED FROM TIMOTHY GEITHNERQ.1. If the Federal Reserve is given more regulatory responsibilities, how can we ensure that Congress can fully exercise its oversight role while also maintaining the Federal Reserve's independence over monetary policy?A.1. Congress has exercised vigorous oversight over Federal Reserve regulation and supervision for decades and we are not aware of any evidence that this oversight has infringed on the independence of monetary policy. Congress can and does call hearings on supervision and regulation where the Federal Reserve and other agencies are called to testify. Moreover, all of the Federal Reserve's supervisory and regulatory functions are subject to review by the GAO. Recent GAO reports on the Federal Reserve and other banking regulators have included assessments of capital rules, http://www.gao.gov/new.items/d08953.pdf; consolidated supervision, http://www.gao.gov/new.items/d07154.pdf; and oversight of risk management systems at major banking organizations, http://www.gao.gov/ncw.items/d09499t.pdf. We believe that this oversight can and should continue and we do not perceive a threat to the independence of monetary policy.Q.2. We have spoken about concerns I have about private equity acquisitions of banks. As you know I feel strongly that there should be a consistent and carefully thought out policy that allows us to take advantage of the capital that private equity has to offer, while at the same time include strong protections to ensure that commercial interests of private equity and other firms do not threaten the safety and soundness of institutions or the overall stability of our Nation's financial system. What is the status of efforts to develop a consistent policy among regulators in this area?A.2. The staff of the Department of the Treasury (Treasury) has consulted with staff of the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS), respectively, regarding the standards used to assess proposals by private equity investors (Investors) for controlling investments in banking organizations. Even though these standards have common features, each agency supervises different types of banking organizations and must administer separate laws with distinct mandates. As these agencies continue to develop standards, as summarized below, Treasury is mindful of the need to establish consistent policies for promoting access to capital, ensuring appropriate supervisory oversight over banking firms, aligning the incentives of investors with the long-term health of banking organizations, and strengthening the wall between banking and commerce. We will be working through the President's Working Group on financial markets (and in the future through the Financial Services Oversight Council if Congress creates one as part of regulatory reform) on these matters.The Federal Banking Agencies Continue To Develop Policies for InvestorsThe Board In September 2008, the Board adopted a policy statement regarding noncontrolling investments in banks and bank holding companies under the requirements of the Bank Holding Company Act (BHCA). As individual transactions may present unique structures, the Board addresses controlling investments in banks and bank holding companies on a case-by-case basis. The Board staff has advised Treasury that, in general, various proposals by Investors to establish a fund to acquire control of a banking organization have not appeared to satisfy the requirements of the BCHA because the Investors also control funds that make commercial investments. Although the Board has permitted a few groups of investors to establish bank holding companies notwithstanding their control of other funds with commercial investments, the Board has not recently approved such a transaction. According to the Board staff, in each of those prior cases, the decision to permit the bank holding company to be affiliated with a commercial firm was limited to the particular circumstances surrounding the investment and the Investors, such as ownership and control of the bank holding company by individuals, as opposed to private equity organizations.The OTS The OTS has approved private equity investments in thrifts under the Home Owners' Loan Act (HOLA). In considering these investments and new proposals, OTS staff has advised that the agency is focused on balancing the needs to allow investments in thrifts and thrift holding companies, as permitted by the HOLA, with prudential measures designed to assure the safety and soundness of those institutions. For example, OTS indicated that in January 2009 the OTS approved the acquisition of Flagstar Bank, FSB by eight newly formed private equity funds and, among other measures, obtained commitments by the Investors barring the Investors from exercising control over the management, policies, or business operations of the thrift organization and restricting transactions between their affiliates and the thrift organization. In this regard, the commitments obtained by the OTS were similar to commitments obtained by the Board in other transactions by Investors approved by the Board. Staff of the OTS has advised Treasury that, subject to appropriate prudential measures, certain controlling investments in thrifts and thrift holding companies by Investors, including Investors that also maintain controlling commercial investments, may satisfy the requirements of the HOLA.The FDIC The FDIC issued final guidance in August establishing principles that would apply to certain applications to acquire failed banks (FDIC Policy Statement) by Investors. Under the FDIC Policy Statement, certain Investors will have to satisfy requirements regarding: capital commitments; cross guarantees; transactions with affiliates; limits on entities based in secrecy law jurisdictions; continuity of ownership; special bid limits on insiders; and disclosure. In particular, Investors will be required to ensure that the acquired depository institution has a minimum Tier 1 leverage ratio of 10 percent for at least 3 years, and thereafter is ``well capitalized'' during the remaining period of their ownership, and generally will be prohibited from selling or otherwise transferring the securities of the holding company or depository institution for a 3-year period. In addition, the FDIC Policy Statement makes Investors holding 10 percent or more of the equity of a bank or thrift in receivership ineligible to be a bidder on that failed depository institution. Finally, the FDIC Policy Statement states that structure for owning depository institutions where the beneficial ownership is not easily ascertained--so-called ``silo'' structures--will not be approved.Treasury Is Working To Promote Consistent Policies Private equity investments in banking organizations raise potentially competing considerations. These investments can strengthen our banking system by providing an important component of private capital and spurring the timely resolution of failed depository institutions. On the other hand, these investments can entail risks and raise important policy issues relating to the supervisory oversight necessary to protect the safety and soundness of banks, such as aligning the incentives of investors with the long-term health of banks and strengthening the policy of separating banking from commerce. Treasury is currently reviewing developments in this area, and will continue to work through the President's Working Group on Financial Markets (and in the future through the Financial Services Oversight Council if Congress creates one as part of regulatory reform) to engage independent banking agencies to develop consistent policies regarding private equity investments in insured depository institutions.Q.3. Are there legislative changes that are required to adequately address this issue?A.3. The Administration has recommended the closing of certain statutory loopholes that historically have permitted the mixing of banking and commerce and evasion of supervision under the Bank Holding Company Act. The banking agencies have authority under current law to balance the Deed for capital in the system with the need for appropriate safety and soundness supervision with respect to private equity investments. We would be happy to discuss the issue with you, including possible legislative changes.Q.4. As you know, I have urged Treasury to use its leverage to sell, exercise, or hold warrants after financial institutions repay TARP funds to ensure the best return for taxpayers. What are Treasury's plans with respect to handling the warrants of institutions that repay their TARP funds? Will there be a clear written set of policies and procedures on this?A.4. In December 2009, Treasury conducted public auctions for its warrants in Capital One Financial Corporation, JPMorgan Chase & Co., and TCF Financial Corporation. Each of these banks had fully repurchased Treasury's preferred stock investment. The auctions were conducted as modified ``Dutch'' auctions registered under the Securities Act of 1933, in a format where qualified bidders may submit one or more independent bids at different price-quantity combinations and the warrants will be sold at a uniform price that clears the market. Proceeds to Treasury from the auction of its warrants in Capital One Financial Corporation, JPMorgan Chase & Co., and TCF Financial Corporation, were approximately $148.73 million, $950.32 million, and $9.59 million, respectively, with net receipts to Treasury after underwriting fees and selling expenses of approximately $146.50 million, $936.06 million and $9.45 million, respectively. Treasury expects to conduct similar auctions in the future. ------ CHRG-111shrg55278--8 INSURANCE CORPORATION Ms. Bair. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate you holding this hearing. The issues under discussion today approach in importance those before the Congress in the wake of the Great Depression. We are emerging from a credit crisis that has wreaked havoc on our economy. Homes have been lost; jobs have been lost. Retirement and investment accounts have plummeted in value. The proposals put forth by the Administration to address the causes of this crisis are thoughtful and comprehensive. However, these are very complex issues that can be addressed in a number of different ways. It is clear that one of the causes of our current economic crisis is significant regulatory gaps within the financial system. Differences in the regulation of capital, leverage, complex financial instruments, and consumer protection provided an environment in which regulatory arbitrage became rampant. Reforms are urgently needed to close these regulatory gaps. At the same time, we must recognize that much of the risk in the system involved financial firms that were already subject to extensive regulation. One of the lessons of the past several years is that regulation alone is not sufficient to control risk taking within a dynamic and complex financial system. Robust and credible mechanisms to ensure that market participants will actively monitor and control risk taking must be in place. We must find ways to impose greater market discipline on systemically important institutions. In a properly functioning market economy, there will be winners and losers, and when firms--through their own mismanagement and excessive risk taking--are no longer viable, they should fail. Actions that prevent firms from failing ultimately distort market mechanisms, including the incentive to monitor the actions of similarly situated firms and allocate resources to the most efficient providers. Unfortunately, the actions taken during the past year have reinforced the idea that some financial organizations are too-big-to-fail. The notion of ``too-big-to-fail'' creates a vicious circle that needs to be broken. Large firms are able to raise huge amounts of debt and equity and are given access to the credit markets at favorable terms without sufficient consideration of the firms' risk profile. Investors and creditors believe their exposure is minimal since they also believe the Government will not allow these firms to fail. The large firms leverage these funds and become even larger, which makes investors and creditors more complacent and more likely to extend credit and funds without fear of losses. ``Too-big-to-fail'' must end. Today, shareholders and creditors of large financial firms rationally have every incentive to take excessive risk. They enjoy all the upside. But their downside is capped at their investment, and with ``too-big-to-fail,'' the Government even backstops that. For senior managers, the incentives are even more skewed. Paid in large part through stock options, senior managers have an even bigger economic stake in going for broke because their upside is so much bigger than any possible loss. And, once again, with ``too-big-to-fail'' the Government takes the downside. To end ``too-big-to-fail,'' we need a solution that uses a practical, effective, and highly credible mechanism for the orderly resolution of these institutions similar to that which exists for the FDIC-insured banks. When the FDIC closes a bank, shareholders and creditors take the first loss. When we call for a resolution mechanism, we are not talking about propping up the failed firm and its management. We are talking about a process where the failed bank is closed, where the shareholders and creditors typically suffer severe losses, and where management is replaced and the assets of the failed institution are sold off. This process is harsh, but it quickly reallocates assets back into the private sector and into the hands of better management. It also sends a strong message to the market that investors and creditors will face losses when an institution fails. So-called ``open bank assistance,'' which puts the interests of shareholders and creditors before that of the Government, should be prohibited. Make no mistake. I support the actions the regulators have collectively taken to stabilize the financial system. Lacking an effective resolution mechanism, we did what we had to do. But going forward, open bank assistance by any Government entity should be allowed only upon invoking the extraordinary systemic risk procedures, and even then, the standards should be tightened to prohibit assistance to prop up any individual firm. Moreover, whatever systemwide support is provided should be based on a specific finding that such support would be least costly to the Government as a whole. In addition, potentially systemic institutions should be subject to assessments that provide disincentives for complexity and high-risk behavior. I am very pleased that yesterday the President expressed support for the idea of an assessment. Funds raised through this assessment should be kept in reserve to provide working capital for the resolution of large financial organizations to further insulate taxpayers from loss. Without a new comprehensive resolution regime, we will be forced to repeat the costly ad hoc responses of the past year. In addition to a credible resolution process, there is a need to improve the structure for the supervision of systemically important institutions and create a framework that proactively identifies issues that pose risk to the financial system. The new structure, featuring a strong oversight council, should address such issues as the industry's excessive leverage, inadequate capital, and overreliance on short-term funding. A council of regulators will provide the necessary perspective and expertise to view our financial system holistically. A wide range of views makes it more likely we will capture the next problems before they happen. As with the FDIC Board, a systemic risk council can act quickly and efficiently in a crisis. The combination of the unequivocal prospect of an orderly closing, a stronger supervisory structure, and a council that anticipates and mitigates risks that are developing both within and outside the regulated financial sector will go a long way to assuring that the problems of the last several years are not repeated and that any problems that do arise can be handled without cost to the taxpayer. Thank you very much. " FOMC20070816confcall--6 4,MR. DUDLEY.," Yes, discount window loans will be an increase of reserves into the banking system. We would have to be making offsetting adjustments either to our portfolio or to our repurchase interventions. Absolutely." CHRG-111hhrg53248--141 Secretary Geithner," That doesn't worry me that much. In our system--because we will have a lot of banks competing for this business--that consumer will be able to go to another institution and say, I like the range of choice that institution offers. " CHRG-111hhrg48867--270 Mr. Grayson," I am wondering if there is any way to meet systemic risk threats that does not involve transferring hundreds of billions of dollars from the taxpayers to failed banks. Mr. Ryan? " CHRG-110hhrg46591--159 Mr. Johnson," Yes, I don't believe the mentality of deregulation was the cause, but if you are going to have a Federal safety net and protect deposits, then you have to regulate and supervise the banking system, and you have to do it very well. " fcic_final_report_full--537 Further investigation of this issue is necessary, including on the role of the bank regulators, in order to determine what effect, if any, the merger-related commitments to make CRA loans might have had on the number of NTMs in the U.S. financial system before the financial crisis. FOMC20070918meeting--234 232,MR. FISHER.," But again, for Paribas, for example, which can come to our discount window, the total sum would be 20 percent for any single credit across the System, even though it might be pieced out by Bank." CHRG-111hhrg53234--13 Mr. Kohn," Chairman Bernanke has made a useful distinction between microprudential regulation and macroprudential regulation. And microprudential regulation is looking at each individual institution and making sure they are robust and resilient and safe. In a macroprudential context, you want to look at not only the individual institutions, but how they relate to each other and how they relate to the system as a whole. And sometimes it is not so much the size of the institution, but its interconnectedness--whether it is at the center of a web of relationships which, if disrupted, would have knock-on domino effects. So I think the job of the systemic risk regulator would be to take account of those interrelationships--the markets and how they are developing, and the institutions and how they fit into the markets--and look at the overall risk to the system as well as the risk of the individual institution, how that fits in. And I think the Federal Reserve is well positioned to play a role in that. We have not only our supervisory authority over bank holding companies, which now include all the major investment banks, but we have staff who are familiar with markets, the macro economy, and have responsibility for financial stability of the system through our lender-of-last-resort facilities. So I think it requires a little bit of a different perspective than we are used to exercising. And I think the Fed's in good position to do that. " CHRG-111hhrg48674--84 Mr. Bernanke," Yes, sir. In the case of FDICIA, there is a systemic risk exception which requires majorities of the Federal Reserve Board, the FDIC and the Treasury Secretary in consultation with the President. So it is a very high bar. But if the systemic risk section is approved, that means the FDIC could take actions to resolve a bank, for example, that would be, not under normal circumstances, would be extraordinary actions-- " CHRG-111hhrg48867--257 Mr. Perlmutter," Thank you, Mr. Chairman. And I would note for the record that different regulators, such as yourself now in the chair, adhere to the 5-minute rule, whereas other regulators, some of the other Chairs didn't quite adhere to the 5-minute rule. So I just want to say to the panel, many of you have been here before. The information you are providing today and the way you have been thinking about this, the way this has been evolving, really for all of us, over the course of the last year, year and a half, I think we are really developing a lot of agreements. And now, Mr. Wallison, as much as I want to debate you on a lot of things, I do agree with you on your point about regulation can add to cost and potentially the loss of innovation. But I don't think that is the end of the question. Because, as we have been here and have had hearing after hearing on this subject, the banking system, the financial system, in my opinion, is a different animal that we have to look at in a different way. Because, as we relieved ourselves of regulations, whether it was Glass-Steagall or, you know, change mark-to-market or different kinds of things, people may have been able to make that last buck, but the bottom fell out, so that the taxpayers are paying a ton of money, because the system itself is so critical to how our economy runs and the world's economy runs. I mean, we are obviously seeing how interconnected everything is. So I agree with you. That is why there has to be reasonable regulation. And the pendulum always swings to too much, and we have seen too little, in my humble opinion, and it is costing us a ton of money. So, having said that--and it may be that I am just going to give a statement and not ask questions. I generally ask questions, but I want to say--is it Ms. ``Jorde?'' I think you had--you made a couple of points that, in my opinion, are critical to this whole discussion. That is, you know, the product mix, what do banks--what is their trade, what is their business, and has there been too much commerce and banking together so that we have products that get outside of a banking regulator's expertise, and then also the size of the institution. And Congressman Bartlett and I have had this conversation, about the size of the institution. In my opinion, things can get too big. But within the system--so I think we have to look at the product mix. The regulator has to look at the product mix, has to look at the size of the institutions, because they can get too big and outstrip whatever insurance we put out there. And then there is, sort of, the systemic peace of this, which is the group think, Mr. Plunkett, you talked about, where in Colorado in the 1980's, the savings and loans were not that big, but they all started thinking the same way, they all started doing the same things, and a lot of them got themselves in trouble. Now, if we had had mark-to-market back then, we would have lost every bank in Colorado. Thank goodness we still had at least half of them. So Mr. Yingling's dead on the mark on the mark-to-market stuff. Mr. Silvers, your points about the stock options and that you can go for the gusto because you have no downside, I really hadn't added that to the whole mix of this. And when it comes to financial institutions, we may have to look at that piece. I think that we do need a super-regulator because there are too many gaps within the system. So whether it is, you know, on top of Mount Olympus, Mr. Yingling, as you have described, or something, there are too many gaps within the system. We need to have somebody looking at this as a whole. And so all of you have brought a lot of information to us in a very cogent fashion, and I appreciate it. I mean, this is what it is going to take for us to develop this. Yes, Mr. Ryan? " CHRG-111shrg51290--28 Mr. Bartlett," No. We believe in the dual banking system in the sense that there should be State-chartered banks. But the power of actually insisting that the system be regarded as a system has to come from the Federal level, of which the States have a big role. But the system itself, it is an interstate system. It is a national system, so it should be thought of as a national system with uniform standards. Senator Merkley. Thank you. Ellen? Ms. Seidman. By steering payments, I assume among other things you mean yield spread premiums. I believe, having wrestled with the problem of yield spread premiums, that the right answer really is to get rid of them, that disclosure isn't sufficient. There have been proposals that say, well, you should just disclose it. The Fed actually tried that and then backed off because they came to the conclusion that no consumer could understand the disclosure. They, of course, then didn't take the next step, which would have been to ban them. An alternative which I think is a partial solution but probably not the full solution here, but a good solution in general, is that it is time to put a fiduciary responsibility on brokers. At the very least, that creates the legal responsibility to behave in the best interest of the consumer. I think Steve's point and the point we have all made about skin in the game with respect to compensation is also important. In terms of how this would work in the system that I proposed, the single regulator would face the issue and make a decision about whether these payments should be banned or should be disclosed or make the relevant decision, and then the enforcement would be in the case of the banks with their prudential supervisors, in the case of mortgage bankers in Massachusetts, who are subject to prudential supervision with the Massachusetts regulator, and otherwise the primary jurisdiction would be with the single Federal entity. Senator Merkley. Thank you. Ms. McCoy? Ms. McCoy. Senator, I have personal experience with this. Back in 2003, when I applied for a mortgage to buy my house in Connecticut, I walked in with complete copies of my pay stubs, tax returns, my new contract, my job contract, and the broker said, oh no, we will put you in a no-doc loan. So I walked out. But I later got the rate sheet from the lender which showed that the no-doc loan would have paid a higher YSP, yield spread premium, to that broker. So in my mind, this is a legalized kickback and we need to ban it. Probably broker compensation needs to be a percentage of loan principal and also the full payout of that commission should probably be linked and to urge appending good performances alone. I agree that a fiduciary duty should be placed on brokers and we need to seriously think about higher capital requirements for brokers because they have very, very little skin in the game today. Finally, the responsibility for administering this under my plan would be with the consumer credit regulator. Thank you. Senator Merkley. Thank you very much, Mr. Chairman. " CHRG-111hhrg53244--54 Mr. Bernanke," Many central banks around the world use what is called a corridor system, where they have an interest rate on reserves as the floor and then a lending rate like the discount window rate as the ceiling, and that keeps the market interest rate between those two levels. A lot of banks use that. So, yes, it is a very powerful tool; and we would not have been able to expand our balance sheet as we have if we had not had that tool to help us with the exit. " CHRG-111shrg56376--156 Mr. Carnell," Yes, three things. First, Secretary Bentsen's legislative proposal included a statutory requirement establishing a community banking division within the agency seeking to institutionalize a sensitivity to the ways community banks are different and the ways they should not be treated just the same as larger institutions. And I think--and this is my second point--that something like that, even though in a sense it is just an outline of an idea, it sends a signal that Congress cares about it, that it is something that needs to be done. I think that is a signal that the agency will clearly hear. And then, third, in any event the new agency would have every incentive to foster a healthy community banking system. The agency has no reason to favor large over small, and there are advantages to the agency when bankers come in, for example, to talk to Members of Congress, that people are having a positive experience with the new agency. So there is absolutely no reason for the regulator to hold back from doing the best job it can. There is no reason why a unified regulator would do any less of a good job than what we see now where an agency like the OCC regulates from the largest banks down to some of the smallest. Finally, you mentioned duality, and in case you were asking about a dual banking system, that is not something that you see abroad. That is, to my knowledge, a quirk of U.S. regulation having to do basically with some developments in the 1860s and 1870s. " CHRG-111hhrg52261--153 Mr. MacPhee," Yes, thank you. I am no expert on TARP. I do know that at the time that TARP was put into place and the institutions that were qualified for and took TARP, it was an important step in reassuring the public that the financial institution system in this country was going to go on. So I don't fault them for that. I think that being from a community bank, we are a $77 million bank and have 13.7 percent to capital and 29 percent liquidity. It is not a model that you see very often today. When the others were paying out 75 percent in dividends and retaining 25 percent, our model was the opposite. We were paying out 25 percent and retaining 75 percent. I am not saying that we are right and they are wrong. But there was a happy medium in there. I think both the unregulated and the systemically risky, which I would define as those banks over $100 billion could wreak havoc on society again, and did need TARP money to survive. The community banks today, I can tell you, are willing and ready to loan. I have money. Unfortunately for me, I live in a State where the unemployment is so high that I am not seeing the loan value that you might see in other areas. " CHRG-110hhrg41184--128 Mr. Bernanke," No, Congressman, I still think Basel II is the right way to go, because Basel II relates the amount of capital that banks have to hold to the riskiness of their portfolio. So, if done properly, risky assets require more capital, and that allows for better risk management and greater safety. Now, it is certainly true that some of the lessons we learned from this previous experience require us to go back and look at Basel II and see, for example, if there are changes that might need to be made. But that is one of the beauties of the system; it is a broad set of principles and can be adapted when circumstances change, as we have seen in the last couple of years. But we look at banks across the country and try to decide why some did well and some did poorly. The ones who did well had really strong risk management systems and good company-wide controls for managing and measuring risk. And that is the central idea behind Basel II. " CHRG-111shrg61651--85 Mr. Corrigan," Unfortunately, I would have to agree that there is. Senator Menendez. You know, I think part of that disconnect, when I look at that Goldman has set aside an astronomical sum of $16.2 billion in compensation for 2009, that is 50 percent more than in 2008, and that is happening in a year in which the financial system nearly collapsed and Goldman Sachs received at least $24 billion in taxpayer assistance, including $14 billion from the bailout of AIG. And so I look at that and I look at that in the juxtaposition of what Goldman is trying to do, which I think is laudable, but definitely underfunded in terms of your small business project, where you are basically going to put out maybe $500 million, which is about 3 percent of the amount Goldman has allotted to compensation about 2 percent of the amount Goldman has received in taxpayer assistance, and I say, how is that being responsive to these times? Sixteen-billion dollars in compensation, $500 million to lend to small businesses. " FOMC20060131meeting--54 52,CHAIRMAN GREENSPAN.," In other words, whether that bill passes or not, the pressures to fund these liabilities are going to increase, especially after the baby-boom generation starts to retire and fund managers look at the size of it." CHRG-111hhrg55809--40 Mr. Bernanke," There are tough questions there. I guess I would--it is not just a question of specialization. Unfortunately, financial crises, booms and busts are a long-standing problem of capitalism; and they have, I think, a special role in the broader-- " CHRG-111shrg51395--26 Mr. Bullard," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee for the opportunity to appear here today. I congratulate the Committee for its thorough and deliberate investigation into the causes of the current financial crisis. Recent events have provided useful lessons on the management of systemic risk, prudential regulation, and investor protection in the investment management industry. The performance of stock and bond mutual funds, for example, has demonstrated the remarkable resiliency of the investment company structure in times of stress. As equity values have plummeted, most shareholders and stock funds have stood their ground, notwithstanding that they have the right to redeem their shares at short notice at their NAVs. There is no scientific explanation for the stability of mutual funds during this crisis, but I believe it is related to this redemption right, as Paul was describing a moment ago. Mutual fund investors are confident that they will receive the net asset value of their holdings upon redemption and they appear to believe that the net asset value of those shares--the net asset value will be fair and accurate. This confidence in the valuation and redeemability of mutual fund shares reduces the likelihood of the kind of panic selling that creates systemic risk and may provide a useful lesson for the regulation of other financial intermediaries. The current crisis has exposed certain investor protection issues, however. Many investors in target date and short-term bond funds have experienced investment returns that are not consistent with returns typical of that asset class. If a fund uses the name Target Date 2010, for example, its equity allocation should fall within the generally expected range for someone on the brink of retirement. Similarly, a 529 plan option that is touted as appropriate for a 16-year-old should not lose 40 percent of its value 2 years before the money will be needed for college. Investors should be free to choose more aggressive asset allocations than those normally considered most appropriate for this situation. But funds that use a name that most investors will assume reflects a particular strategy should be required to invest consistent with that strategy. In contrast with other types of mutual funds, the performance of money market funds has raised systemic and prudential regulation concerns. Money market funds constitute a major linchpin in our payment system and therefore a run on these funds poses significant systemic risk. The management of this risk has been inadequate, as demonstrated by the recent run on money market funds following the failure of the reserve primary fund. There are important lessons to be learned from this experience, but not the lessons that some commentators have found. The Group of 30, for example, has recommended that the money market franchise be eliminated. Former Fed Chairman Volcker explained that if money market funds are going to talk like a bank and squawk like a bank, they ought to be regulated like a bank. The problem with this argument is that money market funds don't fail like banks. Since 1980, more than 3,000 U.S. banks have failed, costing taxpayers hundreds of billions of dollars. During the same period, two money market funds have failed, costing taxpayers zero dollars. I agree that a regulatory rearrangement is in order, but it is banks that should be regulated more like money market funds. Banks routinely fail because they invest in risky, long-term assets while money market funds invest in safe, short-term assets. Insuring bank accounts may be necessary to protect against the systemic risk that a run on banks poses to the payment system, but there is no good reason why banks should be permitted to invest insured deposits in anything other than the safest assets. And there is no good reason why money market funds that pose the same systemic risk to our payment system should be left uninsured. I note, Chairman Dodd, you may have picked up this morning on Chairman Bernanke's comments that some kind of interim insurance program may be an appropriate response to the crisis, and I have to disagree with Paul that the program will necessarily end in September. I posted an article on SSRN that deals with one thesis of how to approach money market fund insurance and I hope the Committee and staff will take a look at that. The current crisis has also exposed significant weaknesses in hedge fund and investment advisor regulation. For example, hedge funds are permitted to sell investments to any person with a net worth of at least $1 million, a minimum that has not been adjusted since 1982. This means that a hedge fund is free to sell interest to a recently retired couple that owns a $250,000 house and has $750,000 in investments, notwithstanding that their retirement income is likely to be around $35,000 a year before Social Security. Finally, the Madoff scandal has again reminded us of the risks of the SEC's expansive interpretation of the broker exclusion from the definition of investment advisor. It appears that Madoff did not register as an investment advisor in reliance on the SEC's position that managing discretionary accounts could somehow be viewed as solely incidental to related brokerage services. This over-broad exclusion left Madoff subject only to broker regulation, which failed to uncover this fraud. The SEC has since rescinded its ill-advised position on discretionary accounts, but it continues to read the ``solely incidental'' exception so broadly as to leave thousands of brokers who provide individualized investment advice subject only to a broker's suitability obligation. These brokers should be subject to the same fiduciary duties that other investment advisors are subject to, including the duty to disclose revenue sharing payments and other compensation that create a potential conflict with their clients' interests. And finally, I would just add to the comments on the question of systemic or prudential regulator. I agree with Professor Coffee's comments that there is something simply fundamentally inconsistent with the SEC's investor protection role and the prudential role that it has not served particularly well in recent times and that those roles should be separated. I agree that there should be a Federal Prudential Regulator, which is what I would call it, that oversees all of those similar characteristics, such as net capital rules, money market fund rules, banking regulations that share those prudential or systemic risk concerns. It is not clear to me, however, that the particular types of liabilities that insurance companies hold would be suitable for one common prudential regulator, but that is something we don't necessarily need to consider unless the Federalizing of insurance regulation begins to make additional progress. And I would also add that we need to keep in mind that there is a significant difference between customer protection and investor protection. I think when Paul was talking about a Capital Markets Regulator, the way I would think of capital markets as being a way of talking about a regulator as investor protection regulator, which would serve fundamentally different functions, especially in that it embraces risk and looks to the full disclosure of that risk as its principal objective as opposed to what might be viewed as customer protection, which is really to ensure that promised services are what are delivered in a fully disclosed and honest way. These and other issues are addressed in greater detail in my written submission. Thank you very much. " CHRG-111shrg61513--124 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System February 25, 2010 Chairman Dodd, Ranking Member Shelby, and other members of the Committee, I am pleased to present the Federal Reserve's semiannual Monetary Policy Report to the Congress. I will begin today with some comments on the outlook for the economy and for monetary policy, then touch briefly on several other important issues.The Economic Outlook Although the recession officially began more than 2 years ago, U.S. economic activity contracted particularly sharply following the intensification of the global financial crisis in the fall of 2008. Concerted efforts by the Federal Reserve, the Treasury Department, and other U.S. authorities to stabilize the financial system, together with highly stimulative monetary and fiscal policies, helped arrest the decline and are supporting a nascent economic recovery. Indeed, the U.S. economy expanded at about a 4 percent annual rate during the second half of last year. A significant portion of that growth, however, can be attributed to the progress firms made in working down unwanted inventories of unsold goods, which left them more willing to increase production. As the impetus provided by the inventory cycle is temporary, and as the fiscal support for economic growth likely will diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services. Private final demand does seem to be growing at a moderate pace, buoyed in part by a general improvement in financial conditions. In particular, consumer spending has recently picked up, reflecting gains in real disposable income and household wealth and tentative signs of stabilization in the labor market. Business investment in equipment and software has risen significantly. And international trade--supported by a recovery in the economies of many of our trading partners--is rebounding from its deep contraction of a year ago. However, starts of single-family homes, which rose noticeably this past spring, have recently been roughly flat, and commercial construction is declining sharply, reflecting poor fundamentals and continued difficulty in obtaining financing. The job market has been hit especially hard by the recession, as employers reacted to sharp sales declines and concerns about credit availability by deeply cutting their workforces in late 2008 and in 2009. Some recent indicators suggest the deterioration in the labor market is abating: Job losses have slowed considerably, and the number of full-time jobs in manufacturing rose modestly in January. Initial claims for unemployment insurance have continued to trend lower, and the temporary services industry, often considered a bellwether for the employment outlook, has been expanding steadily since October. Notwithstanding these positive signs, the job market remains quite weak, with the unemployment rate near 10 percent and job openings scarce. Of particular concern, because of its long-term implications for workers' skills and wages, is the increasing incidence of long-term unemployment; indeed, more than 40 percent of the unemployed have been out of work 6 months or more, nearly double the share of a year ago. Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable. The improvement in financial markets that began last spring continues. Conditions in short-term funding markets have returned to near pre-crisis levels. Many (mostly larger) firms have been able to issue corporate bonds or new equity and do not seem to be hampered by a lack of credit. In contrast, bank lending continues to contract, reflecting both tightened lending standards and weak demand for credit amid uncertain economic prospects. In conjunction with the January meeting of the Federal Open Market Committee (FOMC), Board members and Reserve Bank presidents prepared projections for economic growth, unemployment, and inflation for the years 2010 through 2012 and over the longer run. The contours of these forecasts are broadly similar to those I reported to the Congress last July. FOMC participants continue to anticipate a moderate pace of economic recovery, with economic growth of roughly 3 to 3 \1/2\ percent in 2010 and 3 \1/2\ to 4 \1/2\ percent in 2011. Consistent with moderate economic growth, participants expect the unemployment rate to decline only slowly, to a range of roughly 6 \1/2\ to 7 \1/2\ percent by the end of 2012, still well above their estimate of the long-run sustainable rate of about 5 percent. Inflation is expected to remain subdued, with consumer prices rising at rates between 1 and 2 percent in 2010 through 2012. In the longer term, inflation is expected to be between 1 \3/4\ and 2 percent, the range that most FOMC participants judge to be consistent with the Federal Reserve's dual mandate of price stability and maximum employment.Monetary Policy Over the past year, the Federal Reserve has employed a wide array of tools to promote economic recovery and preserve price stability. The target for the Federal funds rate has been maintained at a historically low range of 0 to \1/4\ percent since December 2008. The FOMC continues to anticipate that economic conditions--including low rates of resource utilization, subdued inflation trends, and stable inflation expectations--are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. We have been gradually slowing the pace of these purchases in order to promote a smooth transition in markets and anticipate that these transactions will be completed by the end of March. The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. In response to the substantial improvements in the functioning of most financial markets, the Federal Reserve is winding down the special liquidity facilities it created during the crisis. On February 1, a number of these facilities, including credit facilities for primary dealers, lending programs intended to help stabilize money market mutual funds and the commercial paper market, and temporary liquidity swap lines with foreign central banks, were allowed to expire.\1\ The only remaining lending program for multiple borrowers created under the Federal Reserve's emergency authorities, the Term Asset-Backed Securities Loan Facility, is scheduled to close on March 31 for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and on June 30 for loans backed by newly issued CMBS.--------------------------------------------------------------------------- \1\ Primary dealers are broker-dealers that act as counterparties to the Federal Reserve Bank of New York in its conduct of open market operations.--------------------------------------------------------------------------- In addition to closing its special facilities, the Federal Reserve is normalizing its lending to commercial banks through the discount window. The final auction of discount-window funds to depositories through the Term Auction Facility, which was created in the early stages of the crisis to improve the liquidity of the banking system, will occur on March 8. Last week we announced that the maximum term of discount window loans, which was increased to as much as 90 days during the crisis, would be returned to overnight for most banks, as it was before the crisis erupted in August 2007. To discourage banks from relying on the discount window rather than private funding markets for short-term credit, last week we also increased the discount rate by 25 basis points, raising the spread between the discount rate and the top of the target range for the Federal funds rate to 50 basis points. These changes, like the closure of most of the special lending facilities earlier this month, are in response to the improved functioning of financial markets, which has reduced the need for extraordinary assistance from the Federal Reserve. These adjustments are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about the same as it was at the time of the January meeting of the FOMC. Although the Federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time.\2\--------------------------------------------------------------------------- \2\ For further details on these tools and the Federal Reserve's exit strategy, see Ben S. Bernanke (2010), ``Federal Reserve's Exit Strategy,'' statement before the Committee on Financial Services, U.S. House of Representatives, February 10, www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm.--------------------------------------------------------------------------- Most importantly, in October 2008 the Congress gave statutory authority to the Federal Reserve to pay interest on banks' holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally. The Federal Reserve has also been developing a number of additional tools to reduce the large quantity of reserves held by the banking system, which will improve the Federal Reserve's control of financial conditions by leading to a tighter relationship between the interest rate paid on reserves and other short-term interest rates. Notably, our operational capacity for conducting reverse repurchase agreements, a tool that the Federal Reserve has historically used to absorb reserves from the banking system, is being expanded so that such transactions can be used to absorb large quantities of reserves.\3\ The Federal Reserve is also currently refining plans for a term deposit facility that could convert a portion of depository institutions' holdings of reserve balances into deposits that are less liquid and could not be used to meet reserve requirements.\4\ In addition, the FOMC has the option of redeeming or selling securities as a means of reducing outstanding bank reserves and applying monetary restraint. Of course, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. I provided more discussion of these options and possible sequencing in a recent testimony.\5\--------------------------------------------------------------------------- \3\ The Federal Reserve has recently developed the ability to engage in reverse repurchase agreements in the triparty market for repurchase agreements, with primary dealers as counterparties and using Treasury and agency debt securities as collateral, and it is developing the capacity to carry out these transactions with a wider set of counterparties (such as money market mutual funds and the mortgage-related government-sponsored enterprises) and using agency mortgage-backed securities as collateral. \4\ In December the Federal Reserve published a proposal describing a term deposit facility in the Federal Register (see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Board Proposes Amendments to Regulation D That Would Enable the Establishment of a Term Deposit Facility,'' press release, December 28, www.federalreserve.gov/newsevents/press/monetary/20091228a.htm) We are now in the process of analyzing the public comments that have been received. A revised proposal will be reviewed by the Federal Reserve Board, and test transactions could commence during the second quarter. \5\ See Bernanke, ``Federal Reserve's Exit Strategy,'' in note 2.---------------------------------------------------------------------------Federal Reserve Transparency The Federal Reserve is committed to ensuring that the Congress and the public have all the information needed to understand our decisions and to be assured of the integrity of our operations. Indeed, on matters related to the conduct of monetary policy, the Federal Reserve is already one of the most transparent central banks in the world, providing detailed records and explanations of its decisions. Over the past year, the Federal Reserve also took a number of steps to enhance the transparency of its special credit and liquidity facilities, including the provision of regular, extensive reports to the Congress and the public; and we have worked closely with the Government Accountability Office (GAO), the Office of the Special Inspector General for the Troubled Asset Relief Program, the Congress, and private-sector auditors on a range of matters relating to these facilities. While the emergency credit and liquidity facilities were important tools for implementing monetary policy during the crisis, we understand that the unusual nature of those facilities creates a special obligation to assure the Congress and the public of the integrity of their operation. Accordingly, we would welcome a review by the GAO of the Federal Reserve's management of all facilities created under emergency authorities.\6\ In particular, we would support legislation authorizing the GAO to audit the operational integrity, collateral policies, use of third-party contractors, accounting, financial reporting, and internal controls of these special credit and liquidity facilities. The Federal Reserve will, of course, cooperate fully and actively in all reviews. We are also prepared to support legislation that would require the release of the identities of the firms that participated in each special facility after an appropriate delay. It is important that the release occur after a lag that is sufficiently long that investors will not view an institution's use of one of the facilities as a possible indication of ongoing financial problems, thereby undermining market confidence in the institution or discouraging use of any future facility that might become necessary to protect the U.S. economy. An appropriate delay would also allow firms adequate time to inform investors through annual reports and other public documents of their use of Federal Reserve facilities.--------------------------------------------------------------------------- \6\ Last month the Federal Reserve said that it would welcome a full review by the GAO of all aspects of the Federal Reserve's involvement in the extension of credit to the American International Group, Inc. (see Ben S. Bernanke (2010), letter to Gene L. Dodaro, January 19, www.federalreserve.gov/monetarypolicy/files/letter_aig_20100119.pdf). The Federal Reserve would support legislation authorizing a review by the GAO of the Federal Reserve's operations of its facilities created under emergency authorities: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, the Primary Dealer Credit Facility, the Term Asset-Backed Securities Loan Facility, and the Term Securities Lending Facility.--------------------------------------------------------------------------- Looking ahead, we will continue to work with the Congress in identifying approaches for enhancing the Federal Reserve's transparency that are consistent with our statutory objectives of fostering maximum employment and price stability. In particular, it is vital that the conduct of monetary policy continue to be insulated from short-term political pressures so that the FOMC can make policy decisions in the longer-term economic interests of the American people. Moreover, the confidentiality of discount window lending to individual depository institutions must be maintained so that the Federal Reserve continues to have effective ways to provide liquidity to depository institutions under circumstances where other sources of funding are not available. The Federal Reserve's ability to inject liquidity into the financial system is critical for preserving financial stability and for supporting depositories' key role in meeting the ongoing credit needs of firms and households.Regulatory Reform Strengthening our financial regulatory system is essential for the long-term economic stability of the nation. Among the lessons of the crisis are the crucial importance of macroprudential regulation--that is, regulation and supervision aimed at addressing risks to the financial system as a whole--and the need for effective consolidated supervision of every financial institution that is so large or interconnected that its failure could threaten the functioning of the entire financial system. The Federal Reserve strongly supports the Congress's ongoing efforts to achieve comprehensive financial reform. In the meantime, to strengthen the Federal Reserve's oversight of banking organizations, we have been conducting an intensive self-examination of our regulatory and supervisory responsibilities and have been actively implementing improvements. For example, the Federal Reserve has been playing a key role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms, and we have been taking the lead in ensuring that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk-taking.\7\--------------------------------------------------------------------------- \7\ For further information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Issues Proposed Guidance on Incentive Compensation,'' press release, October 22, www.federalreserve.gov/newsevents/press/bcreg/20091022a.htm.--------------------------------------------------------------------------- The Federal Reserve is also making fundamental changes in its supervision of large, complex bank holding companies, both to improve the effectiveness of consolidated supervision and to incorporate a macroprudential perspective that goes beyond the traditional focus on safety and soundness of individual institutions. We are overhauling our supervisory framework and procedures to improve coordination within our own supervisory staff and with other supervisory agencies and to facilitate more-integrated assessments of risks within each holding company and across groups of companies. Last spring the Federal Reserve led the successful Supervisory Capital Assessment Program, popularly known as the bank stress tests. An important lesson of that program was that combining onsite bank examinations with a suite of quantitative and analytical tools can greatly improve comparability of the results and better identify potential risks. In that spirit, the Federal Reserve is also in the process of developing an enhanced quantitative surveillance program for large bank holding companies. Supervisory information will be combined with firm-level, market-based indicators and aggregate economic data to provide a more complete picture of the risks facing these institutions and the broader financial system. Making use of the Federal Reserve's unparalleled breadth of expertise, this program will apply a multidisciplinary approach that involves economists, specialists in particular financial markets, payments systems experts, and other professionals, as well as bank supervisors. The recent crisis has also underscored the extent to which direct involvement in the oversight of banks and bank holding companies contributes to the Federal Reserve's effectiveness in carrying out its responsibilities as a central bank, including the making of monetary policy and the management of the discount window. Most important, as the crisis has once again demonstrated, the Federal Reserve's ability to identify and address diverse and hard-to-predict threats to financial stability depends critically on the information, expertise, and powers that it has by virtue of being both a bank supervisor and a central bank. The Federal Reserve continues to demonstrate its commitment to strengthening consumer protections in the financial services arena. Since the time of the previous Monetary Policy Report in July, the Federal Reserve has proposed a comprehensive overhaul of the regulations governing consumer mortgage transactions, and we are collaborating with the Department of Housing and Urban Development to assess how we might further increase transparency in the mortgage process.\8\ We have issued rules implementing enhanced consumer protections for credit card accounts and private student loans as well as new rules to ensure that consumers have meaningful opportunities to avoid overdraft fees.\9\ In addition, the Federal Reserve has implemented an expanded consumer compliance supervision program for nonbank subsidiaries of bank holding companies and foreign banking organizations.\10\--------------------------------------------------------------------------- \8\ For further information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Proposes Significant Changes to Regulation Z (Truth in Lending) Intended to Improve the Disclosures Consumers Receive in Connection with Closed-End Mortgages and Home-Equity Lines of Credit,'' press release, July 23, www.federalreserve.gov/newsevents/press/bcreg/20090723a.htm. \9\ For more information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Approves Final Amendments to Regulation Z That Revise Disclosure Requirements for Private Education Loans,'' press release, July 30, www.federalreserve.gov/newsevents/press/bcreg/20090730a.htm; Board of Governors of the Federal Reserve System (2009), ``Federal Reserve Announces Final Rules Prohibiting Institutions from Charging Fees for Overdrafts on ATM and One-Time Debit Card Transactions,'' press release, November 12, www.federalreserve.gov/newsevents/press/bcreg/20091112a.htm; and Board of Governors of the Federal Reserve System (2010), ``Federal Reserve Approves Final Rules to Protect Credit Card Users from a Number of Costly Practices,'' press release, January 12, www.federalreserve.gov/newsevents/press/bcreg/20100112a.htm. \10\ For further information, see Board of Governors of the Federal Reserve System (2009), ``Federal Reserve to Implement Consumer Compliance Supervision Program of Nonbank Subsidiaries of Bank Holding Companies and Foreign Banking Organizations,'' press release, September 15, www.federalreserve.gov/newsevents/press/bcreg/20090915a.htm.--------------------------------------------------------------------------- More generally, the Federal Reserve is committed to doing all that can be done to ensure that our economy is never again devastated by a financial collapse. We look forward to working with the Congress to develop effective and comprehensive reform of the financial regulatory framework. RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEEmergency Lending Under Section 13(3)Q.1.a. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in a recent speech his belief that the Fed's emergency 13(3) lending authority should be either eliminated or severely curtailed (``The Federal Reserve System: Balancing Independence and Accountability,'' presented February 17, 2010 by President Plosser to the World Affairs Council of Philadelphia). He stated: I believe that the Fed's 13(3) lending authority should be either eliminated or severely curtailed. Such lending should be done by the fiscal authorities only in emergencies and, if the Fed is involved, only upon the written request of the Treasury. Any non-Treasury securities or collateral acquired by the Fed under such lending should be promptly swapped for Treasury securities so that it is clear that the responsibility and accountability for such lending rests explicitly with the fiscal authorities, not the Federal Reserve. To codify this arrangement, I believe we should establish a new Fed-Treasury Accord. This would eliminate the ability of the Fed to engage in `bailouts' of individual firms or sectors and place such responsibility with the Treasury and Congress, squarely where it belongs.Do you agree with President Plosser?A.1.a Since the fall of 2008, I have advocated that Congress establish a statutory resolution regime that provides a workable alternative to Government bailouts and disorderly bankruptcies. With enactment of a workable resolution regime for systemically important firms, I have also called for removal of the Federal Reserve's authority under section 13(3) to extend credit to troubled nonbanking entities. However, I believe that it would be appropriate for the Federal Reserve to retain the authority to lend to establish broad market-based credit facilities in unusual and exigent circumstances. In exceptional circumstances the preservation of financial stability may require that the Federal Reserve have the authority to provide liquidity to restart or encourage markets to operate, thereby providing liquidity needed to allow households, small businesses, depositors and others access to working liquid markets. The need for such authority was fully evident during the financial crisis, when preventing a financial catastrophe required that the Federal Reserve provide liquidity to money market mutual funds, primary dealers, the commercial paper market, and the market for student loans, credit card loans, small business loans and the commercial real estate market.Q.1.b. Do you believe that modifications to Section 13(3) of the Federal Reserve Act would be useful in clarifying emergency responses of various branches of government to financial crises? If so, what modifications do you believe would be most useful?A.1.b. Apart from a possible elimination of the authority to lend to single firms (as discussed above), I do not believe that significant modifications to section 13(3) are necessary or appropriate. The Federal Reserve has historically been extremely cautious in using the section 13(3) authority. Prior to the recent financial crisis, the Federal Reserve had authorized the extension of credit under section 13(3) in only one circumstance since the Great Depression and had not in fact extended credit under this section since the 1930s. During this financial crisis, the Federal Reserve worked closely with the Department of the Treasury before exercising authority under section 13(3). We believe this consultation is important and appropriate and would not object to a statutory provision requiring consultation with or approval by the Secretary of the Treasury prior to authorizing an extension of credit under section 13(3).Q.1.c. Do you favor the establishment of a new Fed-Treasury Accord to provide greater distinction between fiscal policy actions and lender-of-last resort actions taken by the Federal Reserve in an emergency?A.1.c. The Federal Reserve and the Treasury have an accord that sets forth the principles applied by each in addressing the current crisis. We would favor a legislative provision allowing the Federal Reserve to transfer to the Treasury obligations that, while acquired in the course of Federal Reserve action as the lender of last resort, become fiscal obligations more appropriately managed by the Treasury Department. We would be happy to work with you on developing this type of approach.Interest on ReservesQ.2. Congress provided the authority to pay interest on reserves to the Board of Governors of the Federal Reserve, and not the Federal Open Market Committee (FOMC). Similarly, the Board of Governors, and not the FOMC, has authority over setting the discount rate and reserve requirements. According to minutes of the January 26-27, 2010, FOMC meeting, the interest rate paid on excess reserve balances (the IOER rate) is one of the tools available to support a gradual return to a more normal monetary policy stance. Quoting from the minutes: Participants expressed a range of views about the tools and strategy for removing policy accommodation when that step becomes appropriate. All agreed that raising the IOER rate and the target for the Federal funds rate would be a key element of a move to less accommodative monetary policy. LAre there any possible future conflicts or difficulties that you could imagine might arise from having the Federal Reserve's target for the Federal funds rate determined by the FOMC while the IOER and discount rate are determined by the Board of Governors? LAs it moves toward a more normal monetary policy stance, the Federal Reserve may use the IOER rate to help manage reserve balances. If the IOER rate, rather than a target for a market rate, becomes an indicator of the stance of monetary policy for a time, will the balance of power over monetary policy between the FOMC and the Federal Reserve Board change?A.2. As you know, the Congress has assigned to the Board the responsibility for determining the rate paid on reserves. Although the Federal Open Market Committee (FOMC) by law is responsible for directing open market operations, the Congress has also assigned to the Board the responsibility for determining certain other important terms that are relevant for the conduct of monetary policy--for example, the Board ``reviews and determines'' the discount rates that are established by the Federal Reserve Banks; the Federal Open Market Committee has no statutory role in setting the discount rate. Similarly, the Board sets reserve requirements subject to the constraints established by the Congress; the Federal Open Market Committee has no statutory role in setting reserve requirements. For many years, the Board and the FOMC have worked collegially and cooperatively in setting the discount rate, the Federal funds target rate, and other instruments of monetary policy. I am convinced that the Board and the FOMC will continue to work cooperatively in the future in adjusting all of the instruments of monetary policy.Monetary Policy and Fiscal Policy DistinctionQ.3.a. Several regional Federal Reserve bank presidents have expressed concern that actions taken by the Fed, many under Section 13(3) authority, were actions to channel credit to specific firms or specific segments of financial markets and the economy. The concern is that some actions amounted to fiscal, and not lender of last resort, policies. Moreover, in a March 23, 2009 joint press release, the Fed and the Treasury stated the following: The Federal Reserve to avoid credit risk and credit allocation The Federal Reserve's lender-of-last-resort responsibilities involve lending against collateral, secured to the satisfaction of the responsible Federal Reserve Bank. Actions taken by the Federal Reserve should also aim to improve financial or credit conditions broadly, not to allocate credit to narrowly defined sectors or classes of borrowers. Government decisions to influence the allocation of credit are the province of the fiscal authorities. In accord with the joint statement, should the Fed's stock of agency debt and mortgage-backed securities along with its Maiden Lane holdings be swapped for Treasury securities, thereby transparently placing the channeling of credit support to the housing sector firmly in the hands of fiscal authorities?A.3.a. The Federal Reserve's purchases of agency debt and mortgage-backed securities, and the credit it has extended to the Maiden Lane entities, arose for different reasons and deserve different treatment. The primary purpose of the Federal Reserve's purchases of securities issued or guaranteed by Federal agencies was a monetary policy response intended to support the overall economy by providing support to the mortgage and housing sectors. The Federal Reserve believes that in routine circumstances the modes of government support for the housing sector should be determined by the Congress and carried out through agencies other than the Federal Reserve. For that reason, the Federal Reserve in recent decades minimized its participation in the agency securities markets. However, the highly strained financial market conditions of the past few years prevented the Federal Reserve's monetary policy actions to lower interest rates from being fully transmitted to housing markets, as would have happened in more normal times, and the Federal Reserve's ability to lower short-term interest rates further was constrained after short-term rates were lowered to essentially zero. In the circumstances, the Federal Reserve initiated a program to purchase agency debt and mortgage-backed securities. The credit extensions to AIG and the Maiden Lane entities represent exercise of the Federal Reserve's authority as lender of last resort. The Treasury Department is better suited to make the policy and management decisions that attend the longer term relationship with a nonbanking firm that requires government assistance. Accordingly, the Federal Reserve would support a transfer to the Treasury of its AIG and Maiden Lane credits. The issues regarding a possible swap of agency debt and MBS securities for Treasury securities are somewhat more complex and would require careful study.Q.3.b. The Fed has purchased over $1 trillion of agency mortgage-backed-securities and intends to complete purchases of $1.25 trillion of those securities by the end of March. To help finance those purchases, the Fed uses supplemental borrowing from the Treasury and issues interest-bearing reserve balances. In effect, the Fed is borrowing from the public, including banks, with promises to repay the borrowed sums plus interest. The Fed will continue that borrowing in order to hold on to its mortgage-backed securities until those assets gradually decline as they mature or are prepaid or sold. When the Fed effectively finances an enormous portfolio holding of a specific class of assets using interest bearing debt issued to the public, how is that not a fiscal policy exercise?A.3.b. Monetary policy and fiscal policy are different tools that both can be used to stimulate the economy. The purpose of the Federal Reserve's large-scale asset purchases was primarily to apply macroeconomic stimulus by lowering longer-term interest rates and by improving financial market functioning; fiscal policy applies stimulus by adjusting overall government spending or revenues. Because the Federal Reserve's large-scale asset purchases involved changes in the central bank's balance sheet--and, in particular, the creation of a large volume of reserves, it is clear that the purchases were a monetary policy action. Moreover, the Federal Reserve's decision to purchase a large volume of longer-term assets in the crisis was consistent with its statutory mandate to promote maximum employment and price stability, and it was clearly supported by its statutory authorities. These transactions can and will be unwound in a manner consistent with these same mandates.Systemic Risk RegulationQ.4.a. Your February 25, 2010, testimony identifies that the Fed is making fundamental changes in its supervision of bank holding companies to, in your words, ``incorporate a macroprudential perspective that goes beyond the traditional focus on safety and soundness of individual institutions.'' Could you precisely define what you mean by a ``macroprudential perspective,'' and what metrics guide that perspective?A.4.a. Our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. As was evident in the financial crisis, complex, global financial firms can be profoundly interconnected in ways that can threaten the viability of individual firms, the functioning of key financial markets, and the stability of the broader economy. A macroprudential perspective requires a more system-wide approach to the supervision of systemically critical firms that considers the interdependencies among firms and markets that have the potential to undermine the stability of the financial system. To that end, we have supported the creation of a council of regulators that would gather information from across the financial system, identify and assess potential risks to the financial system, and work with member agencies to address those risks. In our own supervisory efforts, we are reorienting our approach to some of the largest holding companies to better anticipate and mitigate systemic risks. For example, we expect to increase the use of horizontal reviews, which focus on particular risks or activities across a group of banking organizations. In doing so, we have drawn on our experience with the Supervisory Capital Assessment Program (SCAP), in which the Federal Reserve led a coordinated effort by the bank supervisors to evaluate on a consistent basis the capital needs of the largest banking institutions in an adverse economic scenario. Because the SCAP involved the simultaneous evaluation of potential credit exposures across all of the included firms, we were better able to consider the systemic implications of financial stress under an adverse economic scenario, in addition to the impact of an adverse scenario on individual firms. The SCAP also showed the benefits of drawing on the work of a wide range of staff--including supervisors, economists, and market and payments system experts--to comprehensively evaluate the risks facing financial firms. Going forward, the Federal Reserve is instituting a data-driven, quantitative surveillance mechanism that will draw on a similar range of staff expertise to provide an independent view of the risks facing large banking firms. As part of that effort, we are developing quantitative tools to help identify vulnerabilities at both the firm level and for the aggregate financial sector. We anticipate that these tools will incorporate macroeconomic forecasts, including spillover and feedback effects. We also expect to develop indicators of interconnectedness, which could encompass common credit, market, and funding exposures. The development of specific metrics will also depend, in part, on the availability of timely and comparable data from systemically important firms.Q.4.b. Does the Fed intend to redefine what regulators should regard as ``safety and soundness?''A.4.b. Ensuring the safety and soundness of institutions has been a cornerstone of the Federal Reserve's supervision program. The recent crisis has shown that large, interconnected firms can be buffeted by a market-driven crisis, magnifying weaknesses in risk management practices, and revealing capital and liquidity buffers calibrated to withstand institution-specific stress events to be insufficient. For this reason, leading supervisors in the United States and abroad are reviewing the prudential standards needed to ensure safety and soundness for individual firms and the financial system as a whole. The Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. We are working with our domestic and international counterparts to develop capital and prudential requirements that take account of the systemic importance of large, complex firms whose failure would pose a significant threat to overall financial stability. Options under consideration include assessing a capital surcharge on these institutions or requiring that a greater share of their capital be in the form of common equity. For additional protection, systemically important institutions could be required to issue contingent capital, such as debt-like securities that convert to common equity in times of macroeconomic stress or when losses erode the institution's capital base. U.S. supervisory agencies have already increased capital requirements for trading activities and securitization exposures, two of the areas in which losses were especially high. Liquidity requirements should also be strengthened for systemically critical firms, as even solvent financial institutions can be brought down by liquidity problems. The bank regulatory agencies are implementing strengthened guidance on liquidity risk management and weighing proposals for quantitatively based requirements. In addition to insufficient capital and inadequate liquidity risk management, flawed compensation practices at financial institutions also contributed to the crisis. Compensation should appropriately link pay to performance and provide sound incentives. The Federal Reserve has issued proposed guidance that would require banking organizations to review their compensation practices to ensure they do not encourage excessive risk-taking, are subject to effective controls and risk management, and are supported by strong corporate governance including board-level oversight.Federal Reserve's Asset HoldingsQ.5. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in a recent speech that . . . the Fed could help preserve its independence by limiting the scope of its ability to engage in activities that blur the boundary lines between monetary and fiscal policy. Thus, as the economic recovery gains strength and monetary policy begins to normalize, I would favor our beginning to sell some of the agency mortgage-backed securities from our portfolio rather than relying only on redemptions of these assets. Doing so would help extricate the Fed from the realm of fiscal policy and housing finance.Do you agree with President Plosser?A.5. I provided my views on asset sales in my March 25, 2010, testimony before the House Committee on Financial Services. The relevant passage is reproduced below. When these tools [reverse repurchase agreements and term deposits] are used to drain reserves from the banking system, they do so by replacing bank reserves with other liabilities; the asset side and the overall of the Federal Reserve's balance sheet remain unchanged. If necessary, as a means of applying monetary restraint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have the effect of reducing the size of the Federal Reserve's balance sheet as well as further reducing the quantity of reserves in the banking system. Restoring the size and composition of the balance sheet to a more normal configuration is a longer-term objective of our policies. In any case, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve's dual mandate of maximum employment and price stability.Treasury Financing Account at the FedQ.6. On February 23, 2010, the Treasury announced, rather suddenly and surprisingly, and without much explanation, that it anticipates increasing its Supplementary Financing Account at the Fed by around $200 billion over the next 2 months. This means, essentially, that the Treasury will borrow on behalf of the Fed and simply hold the funds in the Treasury's account at the Fed. I understand that the Treasury's Supplementary Financing Program helps the Fed absorb reserves from the banking system and manage its balance sheet. I wonder, however, about the lack of information concerning why the Treasury suddenly decided to increase its balance at the Fed. LWas the Treasury's February 23 announcement planned in advance and coordinated with the Fed, or was it a surprise to the Fed? LWhat are the future plans for the size of the Treasury's Supplemental Financing Account? LWho will decide what will be the future balances in the Supplemental Financing Account?A.6. The Treasury and the Federal Reserve consulted closely on the Treasury's February 23 announcement regarding the Supplementary Financing Program. However, the Treasury makes all decisions on balances to be held in the Supplementary Financing Account.Efforts to Toughen Capital and Liquidity RequirementsQ.7.a. Your testimony on February 25, 2010 identifies that . . . the Federal Reserve has been playing a key international role in international efforts to toughen capital and liquidity requirements for financial institutions, particularly systemically critical firms . . .Could you describe what those efforts have been?A.7.a. The Federal Reserve has an active leadership role within the Finance Stability Board, the Basel Committee for Banking Supervision, and various other international supervisory fora. Through these fora, especially the Basel Committee, the Federal Reserve has worked diligently with supervisors from around the world to develop a comprehensive series of reforms to address the lessons that we have learned from the recent global financial crisis. The goal of the Basel Committee's reform package is to improve the international banking sector's ability to deal with future economic and financial stress, thus reducing the contagion risk from the financial sector to the real economy. The Federal Reserve co-chairs three Basel Committee working groups that are focusing on reforms especially pertinent to systemically important institutions. These groups are developing: a) revisions to the capital regulations for trading book activities, designed to enhance risk measurement and to significantly increase the capital requirement associated with various financial instruments that contributed to losses at systemically important institutions during the crisis; b) enhanced and higher capital charges for counterparty credit risk, including a new charge for credit valuation allowances (CVA), which were a significant source of loss during the crisis; and c) new liquidity standards, which directly address a major challenge during the global turmoil. With regard to the latter, the proposed standards draw heavily from conceptual design work contributed by Federal Reserve staff. In addition, Federal Reserve staff made significant contributions to the Basel Committee's Principles for Sound Liquidity Risk Management and supervision issued in September 2008. In many cases, the international principles articulated drew heavily from established Federal Reserve guidance. Moreover, Federal Reserve economists and supervisors have been heavily involved in work conducted by the Basel Committee and by the Committee of Global Financial Stability to develop forward-looking measures of systemic liquidity risks and in assessing the current state of funding and liquidity risk management at internationally active financial institutions. Federal Reserve staff also are key players in the Basel Committee's working groups developing a new international leverage ratio standard, which is largely inspired by the U.S. leverage standard, and a new definition of regulatory capital for banking organizations, which is an area where the Federal Reserve provides insightful experience since almost all banking capital issuance in the U.S. is executed at the bank holding company level.\1\ Moreover, the Federal Reserve has also played an active role in the Basel Committee's working group that recently issued recommendations to strengthen the resolution of systemically significant cross-border banks.\2\--------------------------------------------------------------------------- \1\ See ``Strengthening the resilience of the banking sector-consultative document'' (December 2009), available at www.bis.org/publ/bcbs164.htm. \2\ See ``Report and recommendations of the Cross-border Bank Resolution Group-final paper'' (March 2009), available at www.bis.org/publ/bcbs169.htm.---------------------------------------------------------------------------Q.7.b. Could you define a ``systemically critical'' firm and identify how many such firms currently operate in the United States?A.7.b. A ``systemically critical'' firm is one whose failure would have significant adverse effects on financial markets or the economy. At any point in time, the systemic importance of an individual firm depends on a wide range of factors including whether the firm has extensive on- and off-balance sheet activities, whether the firm is interconnected--either receiving funding from, or providing funding to other systemically important firms--whether the firm plays a major role in key financial markets, and/or whether the firm provides crucial services to its customers that cannot easily or quickly be provided by other financial institutions. That said, the identification of systemic importance requires considerable judgment because each stress event is different, because market structure, business practices, financial products, technologies, supervisory practices and regulatory environments evolve over time. This evolution, of course, changes the interconnections between firms, their relative sizes, their functions and services, and the extent to which services can be obtained from other firms or in financial markets. As a practical matter, it is likely that the number of firms that are considered systemically critical will be less than 50. For example, only about 35 U.S. financial firms, with publicly traded stock outstanding, have total assets over $100 billion as of 2008:Q4. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR BROWN FROM BEN S. BERNANKEBank LendingQ.1. I have heard from Ohio banks that banking regulators are preventing them from expanding commercial lending by requiring them to maintain greater capital reserves. I agree that we need to ensure that our banks are well capitalized, but at some point we've got to get lending going again, particularly to businesses that will use their money to hire workers. How can banks strike a balance between being well capitalized and still lending like they are supposed to?A.1. The loss absorbing characteristics of capital provide the economic bedrock that supports prudent bank lending and, as such, it is not inconsistent for banks to remain well capitalized and concomitantly engage in healthy lending practices. However, during the financial crisis, many banks recorded significant financial losses that eroded their capital base and as a result, some banks may be operating with reduced capital bases to support lending activities. In other instances, well capitalized banks may be reluctant to lend if their outlook on economic conditions lead them to believe that additional losses are likely in the near term, which would further erode their current capital position. The Federal Reserve believes that, in cases where banks are concerned about potential additional losses, a prudent response would be for those banks to increase their capital position in order to address this concern and to take advantage of any demand in commercial lending. Likewise, we believe that an improving economic outlook should help banks to bolster their capital levels and contribute to increased willingness of banks to lend.Q.2. Have you considered taking any specific steps, like lowering the Fed's interest payments on excess bank reserves, or perhaps even imposing a penalty on hoarding money, to promote greater lending?A.2. The Federal Reserve's payment of interest on excess reserves is unlikely to be a significant factor in banks' current reluctance to lend. The Federal Reserve is currently paying interest at a rate of only one quarter of 1 percent on banks' reserve balances. By contrast, the prime rate is currently at 3 \1/4\ percent, and many bank lending rates are considerably higher than the prime rate. Given the large difference between the interest rate paid on excess reserves and the interest rates on banks, the ability to earn interest on excess reserves is unlikely to be an important reason for the tightening of banks' lending standards and terms over the past few years. Indeed, survey results suggest that the major reason that banks have tightened lending terms and standards over the past 2 years or so was their concern about the economic outlook. As you know, the Federal Reserve has acted aggressively from the outset of the financial crisis to stabilize financial market conditions and promote sustainable economic growth. An improving economic outlook should contribute to increased willingness of banks to lend.Bank ConcentrationQ.3. Banks are borrowing at record low interest rates--particularly those banks that are viewed as ``too big to fail.'' According to the Center for Economic and Policy Research, the 18 biggest banks are getting what amounts to a $34.1 billion a year subsidy because of their implicit government guarantee. More recent data from the FDIC shows that big banks are turning a profit, but small banks are not. Data from 1999 shows that large banks' fees for overdrafts are 41 percent higher than at small banks and bounced check fees are 43 percent higher. Now borrowers are having their lines of credit slashed and their bank fees are still increasing. So it appears that consumers and small banks are suffering, while the big banks thrive. And the market is only getting more concentrated: 319 banks were forced to merge or fail in 2009. What steps are the Fed taking to ensure that there is not excessive concentration in the banking industry, and that consumers are being well served through meaningful competition?A.3. The Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) of 1994 provides prudential protection against excessive concentration in the banking industry by prohibiting the Federal Reserve from approving a bank acquisition that would result in a bank holding company exceeding a nationwide deposit concentration limitation of more than 10 percent of the total amount of deposits of insured depository institutions in the United States. Notwithstanding that protection, there are many other potential methods to address the subsidies that may arise because of perceptions that large financial firms are ``too-big-to-fail.'' For example, firms that might reasonably be considered ``too-big-to-fail'' may be subject to higher capital (and liquidity) requirements, more highly tailored resolution mechanisms, tighter deposit share caps, required issuance of contingent capital instruments and/or subordinated debt instruments, limitations on, or a ban of, certain activities (e.g., hedge funds or private equity funds), and taxes on non-deposit balance-sheet liabilities. As the financial crisis winds down, many of these types of proposals to reduce the subsidies that arise from implicit guarantees are under consideration in the United States and abroad. In fact, Federal Reserve staff are participating on many international working groups that are considering the potential effects, including unintended consequences, that may arise from implementing such proposals either singularly, or in combination. A key factor in such analyses is the impact on competition here in the United States and internationally across borders. Research on whether consumers benefit from ``too-big-to-fail'' subsidies is scant. It is plausible that large financial institutions might pass along some of their subsidies to consumers to fuel their own growth at the expense of smaller peers. Some evidence, however, suggests otherwise. For example, Passmore, Burgess, Hancock, Lehnert, and Sherlund (in a presentation at the Federal Reserve Bank of Chicago Bank Structure Conference, May 18, 2006) estimate that just 5 percent of the Fannie Mae and Freddie Mac's borrowing advantage flowed through to mortgage rates, resulting in just a few basis points reduction in conforming mortgage loan rates. Even if financial firms do not pass along their ``too-big-to-fail'' subsidies to consumers, it does not necessarily imply that they cannot pass along the higher costs that would result from the reduction of such subsidies. Indeed, larger firms may set the market prices for some financial products because of other cost advantages associated with their size. In such circumstances, consumers may end up paying higher prices when ``too-big-to-fail'' subsidies are reduced (or eliminated) even though they did not previously much benefit from such subsidies. That said, all consumers benefit from a more stable financial system with less systemic risk and this is the goal of reducing or eliminating ``too-big-to-fail'' subsidies.Resolution of Failed BanksQ.4. You have previously said that you favor ``establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in any orderly fashion, without jeopardizing financial stability.'' There's been a lot of talk about whether this job should be done by banking regulators or a bankruptcy court. Do you have an opinion about this, particularly whether the FDIC is doing a good job with its resolution authority?A.4. In most cases, the Federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy code does not sufficiently protect the public's strong interest in ensuring the orderly resolution of a nonbank financial firm whose failure would pose substantial risks to the financial system and to the economy. A new resolution regime for systemically important nonbank financial firms, analogous to the regime currently used by the Federal Deposit Insurance Corporation for banks, would provide the government the tools to restructure or wind down such a firm in a way that mitigates the risks to financial stability and the economy and thus protects the public interest. It also would provide the government a mechanism for imposing losses on the shareholders and creditors of the firm. Establishing credible processes for imposing such losses is essential to restoring a meaningful degree of market discipline and addressing the ``too-big-to-fail'' problem. It would be appropriate to establish a high standard for invocation of this new resolution regime and to create checks and balances on its potential use, similar to the provisions governing use of the systemic risk exception to least-cost resolution in the Federal Deposit Insurance Act (FDI Act). The Federal Reserve's participation in this decisionmaking process would be an extension of our long-standing role in protecting financial stability, involvement in the current process for invoking the systemic risk exception under the FDI Act, and status as consolidated supervisor for large banking organizations. The Federal Reserve, however, is not well suited, nor do we seek, to serve as the resolution agency for systemically important institutions under a new framework. Because the suitability of an entity to serve as the resolution agency for any particular firm may depend on the firm's structure and activities, the Treasury Department should be given flexibility to appoint a receiver that has the requisite expertise to address the issues presented by a wind down of that firm.Banks Trading Commodities Futures DerivativesQ.5. You gave an address at Harvard in 2008 in which you talked about out-of-control crude oil prices. You said that ``demand growth and constrained supplies'' were responsible for ``intense pressure on [gas] prices.'' Senator Carl Levin investigated the crude oil market and found that speculation ``appears to have altered the historical relationship between [crude oil] price and inventory.'' In 2003, at the request of Citigroup and UBS, the Fed authorized bank holding companies to trade energy futures, both on exchanges and over-the-counter. Given that commodity prices affect the Consumer Price Index, which affects inflation, have you investigated what effect the rule change, and the resulting investments in commodities futures and other commodities-related derivatives, have had on oil prices?Q.6. If not, how can you conclude that rises in gasoline prices are due solely to simple changes in supply and demand?Q.7. If presented with evidence that energy speculation was driving up prices or affecting inflation, would you consider revoking the banks' authority to trade energy futures?A5.-7. The broad movements in oil and other commodity prices have been in line with developments in the global economy. They rose when global growth was strong and supply was constrained. and they collapsed with the onset of the global recession. As the global economy began to recover and financial conditions began to normalize, commodity prices rebounded. Nonetheless, the extreme price swings, particularly in the case of oil, have been surprising. Some have argued that speculative activities on the part of financial investors have been responsible for these outsized price movements. Notwithstanding considerable study, however, conclusive evidence of the role of speculators and financial investors remains elusive. The fundamentals of supply and demand, along with expectations for how these fundamentals will evolve in the future, remain the best explanation for the movements in commodity prices. That said, we must remain open to other possibilities, and if conclusive evidence emerged that commodity markets were not performing their price discovery and allocative role effectively, then changes in regulatory policies may be appropriate.Fed Purchases of Foreign Currency DerivativesQ.8. In the wake of the Greek debt crisis, I'm concerned about governments' use of foreign currency exchanges--that other governments might be using foreign currency swaps to mask their debt, or for other purposes. We know that the Federal Reserve entered into swaps with Foreign Central Banks and then those Foreign Central Banks bailed out their own banking systems. For example, the Federal Reserve worked with the Swiss central bank on the rescue effort for UBS, securing dollars through a swap agreement for francs. As of December 31, 2008, the United States had entered into $550 billion in liquidity swaps with foreign central banks. How are these arrangements between the Federal Reserve and the other central banks structured?A.8. The dollar liquidity swap arrangements that the Federal Reserve entered into with foreign central banks were fundamentally different from the currency swaps that have been discussed in the Greek context. According to reports, the Greek cross-currency swaps were highly structured arrangements initiated 8 or 9 years ago between the government of Greece and a private sector financial institution. These swaps apparently entailed payment obligations over a period of 15 to 20 years with large balloon payments at maturity, and they allowed the Greek government to exchange into euros the proceeds of borrowing it had done in Japanese yen and U.S. dollars at off-market rates of exchange. The dollar liquidity swaps, the volume of which is now zero following the termination of the arrangements in February, were more straightforward, shorter-term arrangements with foreign central banks of the highest credit standing. In each dollar liquidity swap transaction, the Federal Reserve provided U.S. dollars to a foreign central bank in exchange for an equivalent amount of funds in the currency of the foreign central bank, based on the market exchange rate at the time of the transaction. The parties agreed to swap back these quantities of their two currencies at a specified date in the future, which was at most 3 months ahead, using the same exchange rate as in the initial exchange. The Federal Reserve also received interest corresponding to the maturity of the swap drawing. Because the terms of each swap transaction were set in advance, fluctuations in exchange rates following the initial exchange did not alter the eventual payments. Accordingly, these swap operations carried no exchange rate or other market risks. In addition, we judged our swap line exposures to be of the highest quality and safety. The foreign currency held by the Federal Reserve during the term of the swap provided an important safeguard. Furthermore, our exposures were not to the institutions ultimately receiving the dollar liquidity in the foreign countries but to the foreign central banks. We have had long and close relationships with these central banks, many of which hold substantial quantities of U.S. dollar reserves in accounts at the Federal Reserve Bank ofNew York, and these dealings provided a track record that justified a high degree of trust and cooperation. The short tenor of the swaps, which ranged from overnight to 3 months at most, also offered some protection, in that positions could be wound down relatively quickly were it judged appropriate to do so.Q.9. Are these swaps being used in any way to mask U.S. Government debt?A.9. No. These swaps were limited to the exchange of U.S. dollar liquidity for foreign-currency liquidity and were not used in any way to mask U.S. Government debt.Q.10. Does the Federal Reserve keep track of which foreign banks ultimately receive U.S. money from foreign central banks? If so, what banks have gotten U.S. money, and how much has each gotten?A.10. The Federal Reserve's contractual relationships were with the foreign central banks and not with the financial institutions ultimately obtaining the dollar funding provided by these operations. Accordingly, the Federal Reserve did not track the names of the institutions receiving the dollar liquidity from the foreign central banks but instead left to the foreign central banks the responsibility for managing the distribution of the dollar funding. This responsibility included determining the eligibility of institutions that could participate in the dollar lending operations, assessing the acceptability of the collateral offered, and bearing any residual credit risk that might have arisen as a result of the lending operations.Q.11. Is the U.S. Treasury issuing Treasury bonds which the Fed is then buying through the U.K. or other foreign governments?A.11. No. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR MERKLEY FROM BEN S. BERNANKEQ.1. The homeownership rate in Canada is almost identical to that of the United States. Yet the percentage of U.S. mortgages in arrears is fast approaching 10 percent while the percentage of Canadian mortgages in arrears has been relatively stable for the past two decades at less than 1 percent. What characteristics of the mortgage market in Canada do you believe have helped that country avoid a similar foreclosure crisis?A.1. A number of characteristics of the Canadian mortgage market helped Canada avoid a foreclosure crisis. Canadian homeowners typically maintain greater equity in their homes, in part because mortgage insurance, which is required when loan-to-value ratios exceed 80 percent, is more costly than in the United States. Moreover, Canadian mortgages are subject to substantial pre-payment penalties, reducing the incentives of households to regularly refinance their mortgages. While in general this limits households' ability to take advantage of falling interest rates, it also reduces the number of ``cash out'' refinancings, increasing the average equity held by households. In addition, a greater fraction of Canadian mortgages are prime mortgages, which default at lower rates than sub-prime mortgages. One reason the sub-prime market was slower to grow in Canada is because of the incentives, noted above, for borrowers to make higher down payments. Another reason is that a smaller fraction of mortgages in Canada are securitized, because even mortgages that have been securitized and resold carry a capital charge, giving Canadian banks less incentive to securitize mortgages. A mortgage lender that plans to hold a mortgage to maturity likely employs higher underwriting standards than a mortgage lender that plans to securitize the loan. Finally, Canada has experienced a comparatively milder labor-market downturn than the United States and only a modest decline in house prices. These factors, too, have helped reduce the incidence of default.Q.2. All of the six major banks in Canada own investment banking and insurance subsidiaries. All five of the major banks in Canada would probably be considered ``too-big-to-fail.'' However, the Canadian banking regulators have prudently enforced more stringent capital requirements including a 7 percent minimum of Tier 1 capital and 10 percent minimum of total capital. Additionally, there is an Assets-to-Capital Multiple maximum of 20 (or leverage ratio). What lessons have you learned from observing the actions that Canadian regulators have taken regarding the use of more stringent capital requirements than those required under Basel II?A.2. At present, the U.S. regulatory capital rules result in a requirement for banking organizations to hold capital at levels that are equal to, or exceed, Canadian peers; notwithstanding that the stated required minimum Tier 1 risk-based capital ratio is 6 percent for ``well capitalized'' banks under PCA.\1\ Because of statutorily required responses to the breeching of a PCA capital threshold, market forces generally necessitate banks and bank holding companies to hold substantially more capital than the ``well capitalized'' ratio requirements to ensure that significant losses can be absorbed before a ``well capitalized'' ratio is breached. The following table outlines the Tier I, Total and Leverage ratios of the top six U.S. bank holding companies and provides our estimate of their respective Assets-to-Capital Multiple as computed under the Canadian regulatory capital regime. As shown below, each of the top six U.S. bank holding companies would easily exceed the Canadian standards outlined above.--------------------------------------------------------------------------- \1\ To be considered ``well capitalized'' under the U.S. Prompt Corrective Action (PCA) requirements, a bank must have a Tier 1 Leverage ratio of no less than 5 percent, a Tier I risk-based capital ratio of no less than 6 percent, a Total risk-based capital ratio of no less than 10 percent. Selected Capital Ratios Six Largest U.S. Bank Holding Companies (as of December 31, 2009)---------------------------------------------------------------------------------------------------------------- Assets-to- Tier 1 Capital Assets-to- Tier 1 Risk- Total Risk- Tier 1 Multiple Capital Based Based Leverage (Inverse of Multiple Capital Capital Ratio U.S. (Canadian Leverage Definition) Ratio)----------------------------------------------------------------------------------------------------------------Bank of America................................ 10.41% 14.67% 6.91% 14.5 11.6JP Morgan Chase................................ 11.10% 14.78% 6.88% 14.5 13.7Citigroup...................................... 11.67% 15.25% 6.89% 14.5 12.7Wells Fargo.................................... 9.25% 13.26% 7.87% 12.7 9.6Goldman Sachs.................................. 14.97% 18.17% 7.55% 13.2 12.3Morgan Stanley................................. 15.30% 16.38% 5.80% 17.2 17.1---------------------------------------------------------------------------------------------------------------- The Federal Reserve believes that, going forward, capital requirements will need to be recalibrated to directly address the inappropriate incentives that were the underlying causes of the financial crisis. We are engaged in a significant effort both here in the United States and abroad to achieve this objective.Q.3. Canada has an independent consumer protection agency, called the Consumer Financial Agency of Canada. Do you believe that this agency's mission and independence has helped the Canadian financial markets remain stable and well capitalized, even under the current economic conditions?A.3. Consumer protection laws are very important for maintaining a well-functioning financial system. The Financial Consumer Agency of Canada (FCAC) is responsible for ensuring compliance with consumer protection laws and regulations; monitoring financial institutions' compliance with voluntary codes of conduct; and informing consumers of their rights and responsibilities as well as providing general information on financial products. Ensuring compliance with consumer protection laws is an important defense against future financial problems, and informed consumers are undoubtedly less likely to enter unfavorable mortgage agreements. It is difficult to gauge, however, the extent to which the quality of consumer information and extent of consumer protection help explain why Canada had relatively few of the exotic, hard-to-understand sub-prime mortgages that have had such high default rates in the United States. As noted in the answer to the preceding question, other factors--the structure of the mortgage market and bank capital regulation in Canada--appear to represent more tangible reasons why the sub-prime market was slow to develop in Canada.Q.4. Throughout the past year, many witnesses before the Senate Banking Committee have argued that the widespread practice of securitizing mortgages helped propagate bad underwriting practices and contributed to the toxic nature of many, if not all, investments in subprime mortgages. The Canadian mortgage market only has approximately 5 percent of outstanding mortgages categorized as ``subprime.'' Additionally, according to the Bank of Canada, 68 percent of mortgages remain on the balance sheet of the lender and most residential mortgage financing is funded through deposits. Do you think that banks who keep major portions of their residential real estate lending ``on the books'' are less likely to engage in the financing of, ``subprime'' mortgage lending?A.4. It is unlikely that a requirement to keep mortgage exposures on balance sheet would make banking organizations less likely to underwrite ``subprime'' exposures. For instance, prior to the financial crisis, many banking organizations entered into ``subprime'' mortgage securitizations and retained the ``first loss'' positions ``on the books,'' reflecting a high risk tolerance for exposure to the ``subprime'' mortgage market. Additionally, many other banking organizations provided recourse on ``subprime'' mortgage exposures that they sold to securitization structures; again, a reflections of a high risk tolerance ``subprime'' mortgage exposures. If banking organizations were no longer allowed to place ``subprime'' mortgages into securitization vehicles, it could be reasonably posited that banking organizations would continue to underwrite ``subprime'' mortgages given the higher yield earned from these exposures and the fact that the current risk-based capital framework levies an identical capital requirement for a ``subprime'' exposure as it does for a ``prime'' exposure. There are several distinct differences between the U.S. and Canadian mortgage markets that raise difficulty in using the Canadian experience as a comparator. For example, the Canada Mortgage and Housing Corporation (CMHC), which serves a similar function as Freddie and Fannie, is guaranteed by the full faith and credit of Canada, in the same manner as GNMA is guaranteed by the United States. As a result, banking organizations that invest in securitization structures through the CMHC are required to hold no regulatory capital against their investment (0 percent risk-weight exposure), versus in the United States where banking organizations must risk-weight exposures to Freddie or Fannie at 20 percent. In addition, Canadian banking organizations are required to obtain private mortgage insurance (PMI) for all mortgages with a loan-to-value ratio over 80 percent and they must maintain the PMI for the life of the loan, regardless of any subsequent reduction in a mortgage's LTV that may result from loan repayment or house appreciation. However, banks that rely on private mortgage insurers receive a government guarantee against losses that exceed 10 percent of the original mortgage in the event of an insurer failure. As a result, Canadian banking organizations are required to hold relatively little capital against mortgage exposures that are held on balance sheet--either through on-balance sheet mortgage portfolios or through investments in CMHC securitizations. The market for ``subprime'' mortgages was all but ended for Canadian banking organizations in 2008 when the CMHC decided to no longer insure ``subprime'' mortgages. This provided a significant regulatory capital disincentive for Canadian banking organizations to underwrite ``subprime'' mortgages. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM BEN S. BERNANKEQ.1. Treasury recently announced they were starting up the Supplemental Financing Program again. Under that Program, Treasury issues debt and deposits the cash with the Fed. That is effectively the same thing as the Fed issuing its own debt, which is not allowed. What are the legal grounds the Fed and Treasury use to justify that program? And did anyone in the Fed or Treasury raise objections when the program was created?A.1. Section 15 of the Federal Reserve Act requires the Federal Reserve to act as fiscal agent for the United States and authorizes the Treasury to deposit money held in the general fund of the Treasury in the Federal Reserve Banks. Balances held by the Reserve Banks in the Treasury's Supplementary Financing Account (SFA) are deposited and held under this authority. Although the Treasury and the Federal Reserve have consulted closely on matters regarding the Supplemental Financing Program (SFP), the Treasury makes all decisions on balances to be held in the SFA. I am not aware of any staff member or policymaker raising legal objections to the creation of the SFP. However, at least one Federal Reserve policymaker has publicly expressed policy concerns with the SFP. See Real Time Economics, WSJ Blogs, ``Q&A: Philly Fed's Plosser Takes on `Extended Period' Language,'' March 1, 2010.Q.2. Given what you learned during the AIG crisis and bailout, do you think Congress should be doing something to address insurance regulation or the commercial paper market?A.2. The financial crisis has made clear that all financial institutions that are so large and interconnected their failure could threaten the stability of the financial system and the economy must be subject to consolidated supervision. Lack of strong consolidated supervision of systemically critical firms not organized as bank holding companies, such as AIG, proved to be a serious regulatory gap. The Federal Reserve strongly supports ongoing efforts in the Congress to reform financial regulation and close existing gaps in the regulatory framework. An effective framework for financial supervision and regulation also must address macroprudential risks--that is, risks to the financial system as a whole. The disruptions in the commercial paper market following the failure of Lehman Brothers on September 15, 2008 and the breaking of the buck by a large money fund the following day are examples of such macroprudential risks. Legislative proposals in both the House and Senate would also improve the exchange of information and the cross-fertilization of ideas by creating an oversight council composed of representatives of the agencies and departments involved in the oversight of the financial sector that would be responsible for monitoring and identifying emerging systemic risks across the full range of financial institutions and markets. The council would have the ability to coordinate responses by member agencies to mitigate identified threats to financial stability and, importantly, would have the authority to recommend that its member agencies, either individually or collectively, adopt heightened prudential standards for the firms under the agencies' supervision in order to mitigate potential systemic risks.Q.3.a. When did you know that AIG's swaps partners were going to be paid off at effectively par value in the Maiden Lane 3 transaction?Q.3.b. Did you or the Board approve the payments?A.3.a.-b. I was not directly involved in the negotiations with the counterparties that sold multi-sector collateralized debt obligations (``CDOs'') to Maiden Lane III LLC (``ML III'') in return for termination of credit default swaps AIG had written on those CDOs. These negotiations were handled by the staff of the Federal Reserve Bank of New York (``FRBNY''). I participated in and support the final action of the Board to authorize lending by the FRBNY to ML III for the purpose of purchasing the CDOs in order to remove an enormous obstacle to AIG's financial stability and thereby help prevent a disorderly failure of AIG during troubled economic times. As explained in the testimony of Thomas Baxter, Executive Vice President and General Counsel, FRBNY, before the Committee on Oversight and Government Reform on January 27, 2010, the Federal Reserve loan to ML III was used by ML III to purchase the multi-sector CDOs underlying AIG's CDS at their current market value (approximately $29 billion), which represented a significant discount to their par value ($62 billion). Collateral already posted by AIG (not ML III) under the terms of the CDS contracts was also relinquished by AIG in return for tearing-up the contracts and freeing AIG of further obligations under the CDS contracts. Before agreeing to the transaction, the Federal Reserve consulted independent financial advisors to assess the value of the underlying CDOs and the expectation that the value of the CDOs would be recovered. The advisors believed that the cash flow and returns on the CDOs would be sufficient, even under highly stressed conditions, to fully repay the Federal Reserve's loan to ML III. Under the terms of the agreement negotiated with AIG, the Federal Reserve will also receive two-thirds of any profits received on the CDOs after the Federal Reserve's loan and AIG's subordinated equity position are repaid in full.Q.3.c. When did you find out about the cover-up of the amount of the payments?Q.3.d. Did you approve of the efforts to cover up the amount of the payments?Q.3.e. If you did not approve of the cover-up at the time, do you believe that it was the right decision?A.3.c.-e. The amount of the payments to the CDS counterparties was fully disclosed by AIG. Moreover, the Federal Reserve fully disclosed the amount of its loan to ML III and the fair value of the assets that serve as collateral for that loan in both the weekly balance sheet of the Federal Reserve (available on the Board's website) and in the Board's reports to Congress as required by law. AIG was at all times responsible for complying with the disclosure requirements of the various securities laws. I was not involved in the discussions between the Federal Reserve and AIG related to AIG's securities law filings. I fully supported AIG's decision to release publicly in March 2009 the identities of these counterparties.Q.4. The Fed has been out in the press talking about how they are going to make money on their AIG loans, making it sound like a good deal for the taxpayers. However, that is not the whole story because Treasury has committed some $70 billion to the AIG bailout. So the taxpayers are still exposed to AIG, and in fact are likely to take losses. Do you agree that the Fed's exposure to AIG is not the whole story and the taxpayers are likely to face losses from the AIG bailout?A.4. As you know, the Federal Reserve provided liquidity to AIG through direct line of credit and through loans provided to two Maiden Lane facilities that funded certain assets of AIG. Extensive information about each of these credits is available on the Board's website and in reports and testimony provided by the Federal Reserve to Congress. Based on analysis of the collateral supporting these loans by experienced third-party advisors and the FRBNY, the Federal Reserve expects to be fully repaid on each of these credits, with no loss to the taxpayers. The Treasury Department has provided equity to AIG. Like the liquidity provided by the Federal Reserve, this equity was provided in order to prevent the disorderly collapse of AIG during a period of extreme financial stress that could have caused significant economic distress for policy holders, municipalities, and small and large businesses, and led to even greater financial chaos and a far deeper economic slump than the very severe one we have experienced.Q.5. Did you or the Board approve of then New York, Fed President Geithner staying on at the New York Fed while working for the Obama transition team? If yes, why did you think that was a good idea?A.5. Timothy Geithner was appointed President of the Federal Reserve Bank of New York for a 5-year term that extended until February 28, 2011. When President Geithner was asked by the President-elect of the United States to serve as Secretary of the Treasury, President Geithner withdrew from the Bank's day-to-day management pending his confirmation by the Senate. He also relinquished his Federal Open Market Committee (FOMC) responsibilities which were assumed by Christine Cumming, the Reserve Bank's alternate representative elected in accordance with the Federal Reserve Act. President Geithner did not attend the December 2008 FOMC meeting. Ms. Cumming served as a voting member of the FOMC until President Geithner's successor took office. It was expected that President Geithner would continue to serve as President of the Reserve Bank at least through the end of his term if he did not become Secretary of the Treasury.Q.6. Is the Fed now, or has the Fed in recent years, purchased Greek Government or bank debt?A.6. The Federal Reserve has not purchased debt of the government of Greece nor has the Federal Reserve purchased the debt of any Greek financial institution. Detailed information on the Federal Reserve's foreign exchange holdings, both currency and investments, is available in the quarterly Treasury and Federal Reserve Foreign Exchange Operations report published by the Federal Reserve Bank of New York. See http://www.newyorkfed.org/markets/quar_reports.html.Q.7. Unemployment numbers continue to bounce up and down every week. As this year goes on, the Census is going to be hiring 700,000 to 800,000 workers on a temporary basis. Are you worried those numbers will distort the true jobs picture, and that economic forecasts that use those jobs numbers will be wrong?A.7. As you suggest, hiring of temporary workers by the U.S. Bureau of the Census in support of the decennial census will elevate the total payroll employment counts reported by the Bureau of Labor Statistics (BLS) each month because these temporary workers are included in Federal Government employment in the Current Employment Statistics (CES) survey. However, I do not think that Census hiring will make it much more difficult than usual to interpret the monthly employment reports. The BLS is publishing information each month on the number of temporary census workers in the CES data, and thus it will be straightforward to adjust the data to calculate the monthly changes in payroll employment excluding the effects of Census hiring; moreover, Census hiring will not distort the BLS estimates of employment change in the private sector. In addition, the Bureau of the Census has made available its hiring plans for coming months, which economic forecasters can use in making their projections of employment changes for the remainder of this year. Although these plans are subject to change, based on this information, the Department of Commerce expects the effect on the level of payroll employment reported by the BLS to peak at about 635,000 jobs in May 2010 and to fall back to roughly 25,000 jobs by September. The extent to which Census hiring reduces the measured unemployment rate is more difficult to estimate because that effect depends on the prior labor force status of the temporary Census workers. However, based on the employment estimates, the peak effect on the unemployment rate in May would probably be between \1/4\ and \1/2\ percentage point.Q.8. Please explain how term deposits and reverse repo transactions are not the economic equivalent of the Fed issuing debt.A.8. There are a number of similarities and differences between term deposits, reverse repurchase agreements and agency debt obligations. In principle, each could be used to drain reserves from the financial system in order to reduce the potential for inflation and thereby maintain price stability. Indeed, various central banks use instruments similar to these to help manage interest rates and maintain price stability. In the United States, Congress has specifically authorized the Federal Reserve to accept deposits from depository institutions. (See 12 USC 342). Congress has also specifically authorized the Federal Open Market Committee to direct Reserve Banks to purchase and sell in the open market obligations of, or obligations guaranteed as to principal and interest by, the United States or its agencies. (See 12 USC 263 and 355). Reverse repurchase agreements represent the sale and purchase of obligations of, or obligations guaranteed as to principal and interest by, the United States or its agencies. Congress has not specifically authorized the Federal Reserve to issue its own agency debt obligations. Unlike deposits and reverse repurchase agreements, agency obligations are freely transferable. Term deposits may only be accepted from depository institutions and are not transferable. Reverse repurchase agreements also are not transferable and occur only with counterparties that are interested in purchasing qualifying government or agency securities.Q.9. Given that you have signaled that the Fed will be using the interest on reserves rate as a policy tool in the near future, do you believe that rate should be set by the Federal Open Market Committee rather than the Board of Governors?A.9. As you know, the Congress has assigned to the Board the responsibility for determining the rate paid on reserves. Although the Federal Open Market Committee (FOMC) by law is responsible for directing open market operations, the Congress has also assigned to the Board the responsibility for determining certain other important terms that are relevant for the conduct of monetary policy--for example, the Board ``reviews and determines'' the discount rates that are established by the Federal Reserve Banks; the FOMC has no statutory role in setting the discount rate. Similarly, the Board sets reserve requirements subject to the constraints established by the Congress; the FOMC has no statutory role in setting reserve requirements. For many years, the Board and the FOMC have worked collegially and cooperatively in setting the discount rate, the Federal funds target rate, and other instruments of monetary policy. I am convinced that the Board and the FOMC will continue to work cooperatively in the future in adjusting all of the instruments of monetary policy." CHRG-111shrg53822--67 Mr. Rajan," Very quickly, I think it is a mistake to identify systemically important institutions. Then you make the market actually treat them as systemically important and act accordingly. That is a problem. I think you can talk about systemically important. You can sort of have a broad definition. But, in general, regulations should not identify them and create a difference between systemically important and others. Perhaps you can have increasing capital requirements based on size, but it would not have to be capital requirements which suddenly change when you move from being an ordinary bank to becoming a systemically important bank. I think that will be the challenge that Congress has in devising regulations, how to deal with systemically important without actually identifying the specific institutions that are systemically important. Senator Warner. If I heard correctly, I think you have all said, you know, this is very challenging, do not leave it to the regulator, and you better not mess up, Congress. Thank you. I think the Committee will stand in recess until we are finished voting. [Recess.] Senator Akaka. [Presiding.] This hearing, Martin Baily, Raghuram Rajan and Peter Wallison, I will begin with you on questions to all of you. It is pretty clear that our current regulatory system failed to address the risks taken by many large financial organizations that resulted in the current economic crisis. It is equally clear that these companies grossly failed to manage their risks. And with all of this, we have been making every effort to deal with the problems they face and to try to stabilize the problems that we have. So, the second panel, I would like to ask you, should Congress impose a new regime that would simply not allow financial organizations to become too large or too complex, perhaps, by imposing strict size or activity restrictions? So let me first all on Mr. Wallison for your response. " CHRG-111hhrg48873--194 Mr. Bernanke," They would not be disadvantaged necessarily--well, they would in the following sense: the concern is that if banks were revealed to be borrowing and others were not, inference might be drawn that they were in weaker condition than they, in fact, might be. The problem is what is called stigma, so that if banks are being perceived as weaker, if they have to come to the Fed, then others might not wish to deal with them, and they might not come to the Fed. In fact, that was the problem we had at the beginning of this episode, that no one wanted to come borrow, even though it was clear that the banking system needed to get liquidity from us. So we have tried to make sure that their information is protected so they will, in fact, come and take the liquidity they need-- " fcic_final_report_full--379 The run on Wachovia Bank, the country’s fourth-largest commercial bank, was a “silent run” by uninsured depositors and unsecured creditors sitting in front of their computers, rather than by depositors standing in lines outside bank doors.  By noon on Friday, September , creditors were refusing to roll over the bank’s short-term funding, including commercial paper and brokered certificates of deposit.  The FDIC’s John Corston testified that Wachovia lost . billion of deposits and . bil- lion of commercial paper and repos that day.  By the end of the day on Friday, Wachovia told the Fed that worried creditors had asked it to repay roughly half of its long-term debt— billion to  billion.  Wa- chovia “did not have to pay all these funds from a contractual basis (they had not ma- tured), but would have difficulty [borrowing from these lenders] going forward given the reluctance to repay early,” Richard Westerkamp, the Richmond Fed’s lead exam- iner at Wachovia, told the FCIC.  In one day, the value of Wachovia’s -year bonds fell from  cents to  cents on the dollar, and the cost of buying protection on  million of Wachovia debt jumped from , to almost ,, annually. Wachovia’s stock fell , wiping out  billion in market value. Comptroller of the Currency John Dugan, whose agency regulated Wachovia’s commercial bank subsidiary, sent FDIC Chairman Bair a short and alarming email stating that Wachovia’s liquidity was unstable.  “Wachovia was at the front end of the dominoes as other dominoes fell,” Steel told the FCIC.  Government officials were not prepared to let Wachovia open for business on Monday, September , without a deal in place.  “Markets were already under con- siderable strain after the events involving Lehman Brothers, AIG, and WaMu,” the Fed’s Alvarez told the FCIC. “There were fears that the failure of Wachovia would lead investors to doubt the financial strength of other organizations in similar situa- tions, making it harder for those institutions to raise capital.”  Wells Fargo had already expressed interest in buying Wachovia; by Friday, Citi- group had as well. Wachovia entered into confidentiality agreements with both com- panies on Friday and the two suitors immediately began their due diligence investigations.  The key question was whether the FDIC would provide assistance in an acquisi- tion. Though Citigroup never considered making a bid that did not presuppose such assistance, Wells Fargo was initially interested in purchasing all of Wachovia without it.  FDIC assistance would require the first-ever application of the systemic risk ex- ception under FDICIA. Over the weekend, federal officials hurriedly considered the systemic risks if the FDIC did not intervene and if creditors and uninsured deposi- tors suffered losses. fcic_final_report_full--264 Disruptions quickly spread to other parts of the money market. In a flight to qual- ity, investors dumped their repo and commercial paper holdings and increased their holdings in seemingly safer money market funds and Treasury bonds. Market partici- pants, unsure of each other’s potential subprime exposures, scrambled to amass funds for their own liquidity. Banks became less willing to lend to each other. A closely watched indicator of interbank lending rates, called the one-month LIBOR-OIS spread, increased, signifying that banks were concerned about the credit risk involved in lending to each other. On August , it rose sharply, increasing three-to fourfold over historical values, and by September , it climbed by another . In , it would peak much higher. The panic in the repo, commercial paper, and interbank markets was met by imme- diate government action. On August , the day after BNP Paribas suspended redemp- tions, the Fed announced that it would “provid[e] liquidity as necessary to facilitate the orderly functioning of financial markets,”  and the European Central Bank infused billions of Euros into overnight lending markets. On August , the Fed cut the dis- count rate by  basis points—from . to .. This would be the first of many such cuts aimed at increasing liquidity. The Fed also extended the term of discount- window lending to  days (from the usual overnight or very short-term period) to of- fer banks a more stable source of funds. On the same day, the Fed’s FOMC released a statement acknowledging the continued market deterioration and promising that it was “prepared to act as needed to mitigate the adverse effects on the economy.”  SIV S : “AN OASIS OF CALM ” In August, the turmoil in asset-backed commercial paper markets hit the market for structured investment vehicles, or SIVs, even though most of these programs had lit- tle subprime mortgage exposure. SIVs had a stable history since their introduction in . These investments had weathered a number of credit crises—even through early summer of , as noted in a Moody’s report issued on July , , titled “SIVs: An Oasis of Calm in the Sub-prime Maelstrom.”  Unlike typical asset-backed commercial paper programs, SIVs were funded pri- marily through medium-term notes—bonds maturing in one to five years. SIVs held significant amounts of highly liquid assets and marked those assets to market prices daily or weekly, which allowed them to operate without explicit liquidity support from their sponsors. The SIV sector tripled in assets between  and . On the eve of the crisis, there were  SIVs with almost  billion in assets.  About one-quarter of that money was invested in mortgage-backed securities or in CDOs, but only  was in- vested in subprime mortgage–backed securities and CDOs holding mortgage-backed securities. Not surprisingly, the first SIVs to fail were concentrated in subprime mortgage– backed securities, mortgage-related CDOs, or both. These included Cheyne Finance (managed by London-based Cheyne Capital Management), Rhinebridge (another IKB program), Golden Key, and Mainsail II (both structured by Barclays Capital). Be- tween August and October, each of these four was forced to restructure or liquidate. Investors soon ran from even the safer SIVs. “The media was quite happy to sen- sationalize the collapse of the next ‘leaking SIV’ or the next ‘SIV-positive’ institution,” then-Moody’s managing director Henry Tabe told the FCIC.  The situation was complicated by the SIVs’ lack of transparency. “In a context of opacity about where risk resides, . . . a general distrust has contaminated many asset classes. What had once been liquid is now illiquid. Good collateral cannot be sold or financed at any- thing approaching its true value,” Moody’s wrote on September .  CHRG-111hhrg55814--250 Secretary Geithner," Right now, Congressman, who bears the cost when firms screw up? What happens now is, is that companies, families, businesses, taxpayers, community banks, bear that cost. We're proposing to change that. For the simple reason, it's not fair. And what is fair, we believe, is that in the end, because banks are special and risky, if they manage themselves to the point where they're imperiling the system, then if the government-- " CHRG-111hhrg55811--166 Mr. Gensler," Our concern is overall to lower risk in the system and enhance transparency, to promote the competition that you, too, as well want. But we want to ensure that there then wouldn't be some regulatory arbitrage that a non-bank could have zero capital and all the banks have to have capital. So we do think it is appropriate to have some minimum amount of capital if you are holding yourself out to the public as a dealer. This is the dealers themselves. And that is generally only in, as I said, the energy commodity swaps. " CHRG-110hhrg44901--19 Mr. Bernanke," Certainly. The recent financial crisis, which has been quite severe, as you know, has revealed a number of weak points in our economy, in our financial system, and they have required attention because we need to have a stable, well-working financial system in order for the economy to recover. In the longer term, I agree that market discipline is the best source of strength in the financial system. We need to take action to make sure that moral hazard doesn't induce excessive risk-taking. I spoke on this subject last week in a speech, and I indicated three directions forward that we could take to make sure that moral hazard is constrained in the future. The first is, now that the investment banks have received some support, in particular they have received access to, at least temporarily, to the discount window, I believe that we need to have legislated consolidated supervisory oversight over those firms that would ensure that they have adequate capital, adequate liquidity, and adequate risk management so they would not be taking advantage of any presumed backstop that they might otherwise see. Secondly, I talked about the need to strengthen our financial infrastructure. Part of the reason that it was a big concern to us when Bear Stearns came to the brink of failure was that we were concerned that there were various markets where the failure of a major counterparty would have created enormous strains on the financial system. One way to address the problem, and I discussed that at some length in my speech and I would be happy to talk more about it, is to make sure that the financial infrastructure, the systems through which lending and borrowing takes place, as well as the risk management of the lenders is strengthened to the point that the system could better withstand a failure, and therefore there would be less expectation of support in that situation. Finally, I think the issues we have approached like the investment banks, these circumstances were not contemplated in other areas like deposit-insured banks. There is a procedure, a set of rules, prompt corrective action, systemic risk, those sorts of things which tell the regulators how Congress wants them to proceed and create clarity in the market about under what circumstances assistance would be forthcoming. As Secretary Paulson has also indicated, I think we ought to be looking at clarifying the congressional expectations for how we would resolve--were the situation to arrive again, how to resolve such a problem. " CHRG-111shrg57709--10 Mr. Volcker," A familiar location, but I forgot to push the button. Let me say I do appreciate this unusual scheduling of the hearing. I did have a conflict this morning, coincidentally with the British Parliamentary Committee considering financial reform in Britain. So I am able to touch both sides of the Atlantic today with your rescheduling, and I appreciate that. Let me say off the bat, making a very simple statement because I think there is some confusion. A lot of this issue we are talking about today revolves around proprietary trading, and some people say, well, is it a big risk or a small risk or whatever. It certainly is a risk. Everything the banks do is a risk. This is not a question in my mind of what is the greater risk. It is a question of what risks are going to be protected by the Federal Government through the safety net, through deposit insurance, through the Federal Reserve, and other arrangements. And my view is that commercial banks have an essential function in the economy, and that is why they are protected. But we do not have to protect more speculative activities that are not an inherent function of commercial banking, and we should not extend the safety net, extend taxpayer protection to proprietary activities. So that is a very short summary of at least one of the issues here. As you know, the proposal that the President set out, if it was enacted, would restrict commercial banking organizations from certain proprietary and more speculative activities. But the first point I want to emphasize is that the proposed restrictions should be understood as part of the broader effort to deal with structural reform. It is particularly designed to help deal with the problem of too big to fail that Senator Shelby just emphasized--too big to fail and the related moral hazard that loom so large as an aftermath of the emergency rescues of financial institutions, bank and non-bank alike, in the midst of crises. Now, attached to this statement is a short essay that appeared in the press on Sunday to try to point out that larger perspective, but the basic point is that there has been and remains a strong public interest in providing a safety net--in particular, deposit insurance and the provision of liquidity in emergencies--for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds--taxpayer funds--protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs, unrelated to continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions. Those quintessential capital market activities have become a part, a natural part of investment banks. And a number of the most prominent of those firms, each heavily engaged in trading and other proprietary activity, failed or were forced into publicly assisted mergers under the pressure of the crisis. It also became necessary to provide public support via the Federal Reserve, the Federal Deposit Insurance Corporation, or the Treasury to the largest remaining American investment banks, both of which assumed the cloak of a banking license to facilitate the assistance. The world's largest insurance company, caught up in a huge portfolio of credit default swaps quite apart from its basic business, was rescued only by the injection of many tens of billions of dollars of public loans and equity capital. Not so incidentally, the huge financial affiliate of one of our largest industrial companies was also extended the privilege of a banking license and granted large assistance contrary to longstanding public policy against combinations of banking and commerce. Now, what we plainly need are the authority and methods to minimize the occurrence of those failures that threaten the basic fabric of financial markets. The first line of defense, along the lines of the Administration proposals and the provisions in the bill passed by the House last year, must be authority to regulate certain characteristics of systemically important non-bank financial institutions. The essential need is to guard against excessive leverage and to insist upon adequate capital and liquidity. It is critically important that those institutions, its managers and its creditors, do not assume--do not assume--a public rescue will be forthcoming in time of pressure. To make that credible, there is a clear need for a new ``resolution authority,'' an approach recommended by the Administration last year and included in the House bill. The concept is widely supported internationally. The idea is that, with procedural safeguards, a designated agency be provided authority to intervene and take control of a major financial institution on the brink of failure. The mandate is to arrange an orderly liquidation or merger. In other words, euthanasia, not a rescue. Apart from the very limited number of such ``systemically significant'' non-bank institutions, there are literally thousands of hedge funds, private equity funds, and other private financial institutions actively competing in the capital markets. They are typically financed with substantial equity provided by their partners or by other sophisticated investors. They are, and should be, free to trade, free to innovate, free to invest--and free to fail. Managements, stockholders, or partners would be at risk, able to profit handsomely or to fail entirely, as appropriate in a competitive free enterprise system. Now I want to deal as specifically as I can with questions that have arisen about the President's recent proposal. First, surely a strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multinational banks and active financial markets. That needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds, very substantial grounds, to anticipate success as the approach is fully understood. Second, the functional definition of hedge funds and private equity funds that commercial banks would be forbidden to own or sponsor is not difficult. As with any new regulatory approach, authority provided to the appropriate supervisory agency should be carefully specified. It also needs to be broad enough to encompass efforts sure to come to circumvent the intent of the law. We do not need or want a new breed of bank-based funds that in all but name would function as hedge or equity funds. Similarly, every banker I speak with knows very well what ``proprietary trading'' means and implies. My understanding is that only a handful of large commercial banks--maybe four or five in the United States and perhaps a couple of dozen worldwide--are now engaged in this activity in volume. In the past, they have sometimes explicitly labeled a trading affiliate or division as ``proprietary,'' with the connotation that the activity is, or should be, insulated from customer relations. Most of those institutions and many others are engaged in meeting customer needs to buy or sell securities: stocks or bonds, derivatives, various commodities or other investments. Those activities may involve taking temporary positions. In the process, there will be temptations to speculate by aggressive, highly remunerated traders. However, given strong legislative direction, bank supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and particularly of the relative volatility of gains and losses would itself go a long way toward informing such judgments. For instance, patterns of exceptionally large gains and losses over a period of time in the so-called trading book should raise an examiner's eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements. Third, I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a ``customer''--that is, when it is trading for its own account--it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. ``Inside'' hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same ``inside'' funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades. Now, I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses. But neither am I so naive as to think that, even with the best efforts of boards and management, so-called Chinese walls can remain impermeable against the pressures to seek maximum profit and personal remuneration. Now, in concluding, I have added a list of the wide range of potentially profitable activities that are within the province of commercial banks. Without reading that list, the point is there is plenty for banks to do beyond any concept of a narrow banking institution. It is quite a list, and I submit to you to provide the base for strong, competitive, and profitable commercial banking organizations able to stand on their own feet domestically and internationally, in fair times and foul. What we can do and what we should do is to recognize curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services. Recurrent pressures, volatility, and uncertainties are inherent in our market-oriented, profit-seeking financial system. But by appropriately defining the business of commercial banks, and by providing for the complementary resolution authority to deal with an impending failure of large capital market institutions, we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek. Thank you. " CHRG-110shrg50414--114 Secretary Paulson," You know, for $100,000. So what you need is if--but if a non-bank or for someone without deposit insurance fails, in many cases there is just bankruptcy, and that throws the system into disarray. So---- Senator Schumer. But this would be different, the FDIC---- " CHRG-111hhrg53245--26 Mr. Johnson," Yes, Mr. Chairman. That is an idea that technical people, experts on the banking system, are working on. And the people I know who have made the most progress have work that's not yet public, but I would be happy to-- " CHRG-111shrg54789--174 PREPARED STATEMENT OF EDWARD L. YINGLING President and Chief Executive Officer, American Bankers Association July 14, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, my name is Edward L. Yingling. I am President and CEO of the American Bankers Association (ABA). The 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. ABA appreciates how this Committee has responded to the financial crisis in a thoughtful, deliberative, and thorough manner. Changes are certainly needed, but the pros and cons and unintended consequences must be carefully evaluated before dramatic changes--affecting the entire structure of financial regulation--are enacted. That is why hearings like this one today are so important. I am pleased to present the ABA's views today on the proposal to create a new consumer regulatory body for financial services that would operate separate and apart from any future prudential regulatory structure. We believe that a separate consumer regulator should not be enacted, and, in fact, is in direct contradiction with an integrated, comprehensive approach that recognizes the reality that consumer protection and safety and soundness are inextricably bound. Consumer protection is not just about the financial product, it is also about the financial integrity of the company offering the product. Simply put, it is a mistake to separate the regulation of the banking business from the regulation of banking products. Financial integrity is at the core of good customer service. Banks can only operate safely and soundly if they are treating customers well. Banks are in the relationship business, and have an expectation to serve the same customers for years to come. In fact, 73 percent of banks (6,013) have been in existence for more than a quarter-century, 62 percent (5,090) more than half-century, and 31 percent (2,557) for more than a century. These banks could not have been successful for so many years if they did not pay close attention to how they serve customers. Satisfied customers are the cornerstone of the successful bank franchise. The proposal for a new consumer regulator, rather than rewarding the good banks that had nothing to do with the current problems, will add an extensive layer of new regulation that will take resources that could be devoted to serving consumers and make it more difficult for small community banks to compete. The banking industry fully supports effective consumer protection. We believe that Americans are best served by a financially sound banking industry that safeguards customer deposits, lends those deposits responsibly and processes payments efficiently. Traditional FDIC-insured banks--more than any other financial institution class--are dedicated to delivering consumer financial services right the first time and have the compliance programs and top-down culture to prove it. Certainly, there were deficiencies under the existing regulatory structure. Creating a new consumer regulatory agency, however, is not the solution to these problems. It would simply complicate our existing financial regulatory structure by adding another extensive layer of regulation. There is no shortage of laws designed to protect consumers. Making improvements to enhance consumer protection under the existing legal and regulatory structures--particularly aimed at filling the gaps of regulation and supervision of nonbank financial providers--is likely to be more successful, more quickly, than a separate consumer regulator. Certainly the Members of this Committee should look at this consumer agency proposal from the point of view of consumers, who are paramount. Later in this testimony, we will discuss how the proposal in our opinion is not the best approach for consumers and will actually undermine consumer choice, competition, and the availability of credit. However, we would also ask you to look at this issue from another point of view. While all banks would be negatively impacted, think of your local community banks, and credit unions also for that matter. These banks never made one subprime loan, and they have the trust and support of their local consumers. As Members of this Committee have previously noted, these community bankers are already overwhelmed with regulatory costs that are slowly but surely strangling them. Yet a few weeks ago, these community banks found the Administration proposing a potentially massive new regulatory burden that will fall disproportionately on them. The largest banks, which will certainly bear a significant burden as well, do have economies of scale. Nonbanks, the State regulated or unregulated financial entities that include those who are most responsible for the crisis, are covered, at least in part, by the new agency--and that is positive. However, based on history, their regulatory and enforcement burden is likely to be much less. In fact, according to the Administration proposal, the new agency will rely first on State regulation and enforcement for these entities, and yet we all know that the budgets for such State regulation and enforcement are completely inadequate to do the job. Community banks, on the other hand, are likely to have greatly increased fees to fund a system that falls disproportionately and unfairly on them. In both the Administration's white paper and the legislative language submitted by Treasury, it is now clear that the new agency would have vast and unprecedented authority to regulate in detail all bank consumer products and services. The agency is even empowered, in fact encouraged, to create its own standardized products and services--whatever it decides is ``plain vanilla''--and may compel banks to offer them. Even further, the agency is given the power, and basically urged, to give the products and services it designs regulatory preference over the bank's own products and services. The agency is even encouraged to require a Statement by the consumer acknowledging that the consumer affirmatively was offered and turned down the Government's product first. The proposal goes beyond simplifying disclosures--which is needed--to require that all bank communication with consumers be ``reasonable.'' This is a term so vague that no banker 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 all communications with the agency. All existing consumer laws, carefully crafted over the years by Congress, are transferred to the new agency, but they are rendered nothing more than floors. The new agency can do almost anything else it wants. CRA enforcement is apparently to be increased on these community banks, although they already strongly serve their communities. And that is not to mention the inherent conflicts, discussed below, that will occur between the prudential regulator and the consumer regulator, with the bank caught in the middle. All this cost, regulation, conflicting requirements, and uncertainty would be placed on community banks that in no way contributed to the financial crisis. We share the vision that greater transparency, simplicity, accountability, fairness, and access can be achieved by establishing common standards uniformly applied that reflect how consumers make their choices among innovative products and services. But this vision cannot be achieved by ignoring the experience of our recent financial crisis and failing to directly address those deficiencies that led to it. It is now widely understood that the current economic situation originated primarily in the unregulated or less regulated nonbank sector. For example, the Treasury's plan noted that 94 percent of high cost mortgages were made outside the traditional banking system. Many of these nonbank providers had no interest in building a long-term relationship with customers but, rather, were only interested in profiting from a quick transaction without regard to whether the mortgage loan or other financial product ultimately performed as promised. Thus, an important lesson learned is that certain unsupervised nonbank financial service providers and their less regulated financiers--the so-called ``shadow banking system''--undermined the entire system by abusing consumer and investor trust. A second lesson learned is that consumer protection and financial system safety and soundness are two sides of the same coin. Poor underwriting, and in some cases fraudulent underwriting, by mortgage brokers, which failed to consider the individual's ability to repay, set in motion an avalanche of loans that were destined to default. Good underwriting is the essence of both good consumer protection and good safety and soundness regulation. Loans that are based on the ability to repay protect the institution from losses on the loans and protect consumers from taking on more than they can handle. Thus, what is likely to protect both the lender and the customer cannot be, nor should be, separated. These lessons lead to two fundamental building blocks of any reform of consumer protection oversight. Uniform regulation and uniform supervision of consumer protection performance should be applied to nonbanks as rigorously as it has been applied to the banking industry. Regulatory policymakers for consumer protection should not be divorced from responsibility for financial institution safety and soundness.Separating the safety of the institution from the safety of its products means each agency has only half the story. Without building upon these keystones, the hope for better transparency, simplicity, accountability, fairness, and access will not be realized, and we will have missed the opportunity to build a strong consumer protection infrastructure across the financial services industry. Unfortunately, the Consumer Financial Products Agency (CFPA) proposal, in our opinion, contains a number of very serious flaws. The proposal: Severs the connection between consumer protection and safety and soundness--forcing each side to attempt to work independently and freeing each to contradict the valid goals of the other--to the detriment of consumer choice and safety and soundness. Subjects banks to added enforcement, but leaves the ``first line of defense'' for the supervision and examination of nonbanks to the States, which suffer from a lack of resources for meaningful enforcement. This is where the failure of nonbank regulation was most severe under the current system. Once again there would be perverse incentives for financial products to flow out of the closely examined banking sector to those who will skirt the meaning, and even the language, of regulations. Excludes competitor financial products from its reach-- including securities, money market funds, and insurance--thus further belying the promise of uniform or systemic oversight and creating incentives for development of products outside the scope of the CFPA that may be risky for consumers. Renders all the consumer laws created by Congress largely moot, as the very broad power of the CFPA would authorize the agency to go well beyond such laws in every instance. Imposes Government designed one-size-fits-all products--so- called ``plain-vanilla'' products--and places them in a preferred position over products that are designed by the private sector for an increasingly diverse customer base. These Government products would be given regulatory preference over the products designed by the individual banks, and consumers could even be required to sign a notice that they have first turned down the Government's product. Requires communications with consumers to be ``reasonable,'' an incredibly vague and unworkable standard that will cause tremendous uncertainty for years to come. Basically ends uniform national standards, quickly creating a patchwork of expensive and contradictory rules that will create uncertainty, increase consumer costs, and lead to constant litigation. Saddles providers, and, indirectly, consumers with a new regime of fees to fund yet another agency. Will inhibit innovation and competition, limit consumer choices, and lessen the availability of credit. To be successful in the regulation, examination, and enforcement of nonbanks, the agency will have to be very large and have a significant budget. We believe a better course exists. ABA offers to work with the Administration and the Congress to achieve meaningful regulatory reform to improve consumer protection and preserve financial system integrity. As the crisis has proven, a strong banking industry is indispensable to a strong economy; and a sound banking system is the greatest single protection of consumer access to financial services fairly delivered. Traditional banking is back in style, but that does not mean improvements cannot be made. We pledge to work with this Committee to find the best solutions to assure that consumers have the protection they deserve for any financial product. I would like to further discuss several points today: Consumer regulation should not be separated from safety and soundness regulation. The key focus of change should be on closing existing gaps in supervisory oversight across the financial institution marketplace, not on adding yet another vast layer. The proposal would give the agency unprecedented authority to control the products and services offered by banks and make all current consumer laws mere floors. The undermining of uniform national standards will increase costs and cause litigation and tremendous uncertainty. The question of how to pay for this new agency was left very vague and raises significant issues. The proposal will inhibit innovation and competition, limit consumer choices, and dramatically lessen the availability of credit. The regulatory authority to address consumer concerns is already there for highly regulated banks, particularly with the new focus on unfair and deceptive practices. However, improvements can be made, and ABA will work with the Committee to make such improvements. I will address each of these points in turn.Consumer Regulation Should Not Be Separated From Safety and Soundness Regulation Consumer regulation and safety and soundness regulation are two sides of the same coin. Neither one can be separated from the other without negative consequences; nor should they be separated. An integrated and comprehensive regulatory approach is the best method to protect consumers and protect the safety and soundness of the financial institution. While certainly improvements can be made, the current regulatory structure applied to banks provides an appropriate framework for effective regulation for both consumer protection and bank safety and soundness. As I note throughout this testimony, that same framework was virtually nonexistent for nonbank providers of financial products. FDIC Chairman Sheila Bair, testifying recently before Congress, summarized the synergies between both these elements: 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. \1\--------------------------------------------------------------------------- \1\ Bair, Sheila C., ``Modernizing Bank Supervision and Regulation'', testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 19, 2009. Attempts to separate out consumer protection from safety and soundness will lead to conflicts, duplication and inconsistent rules, which will likely result in finger-pointing as inevitable problems arise. What are banks to do when the consumer and safety and soundness regulators disagree, as they inevitably will? Almost every consumer bank product or service has both consumer issues and safety and soundness issues that need to be balanced and resolved. It is important to remember that one person's deposit funds another person's loan. It makes little sense to regulate the terms, conditions and prices of deposit products or loan products separately from the business aspects of a bank's fundamental process--turning deposits into loans. As I mentioned at the outset, the very nature and application of good underwriting standards is by definition both a consumer protection and a safety and soundness issue. A second simple example is check hold periods. Customers would like the shortest possible holds, 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 in the form of increased costs that are passed on--billions of dollars. Similarly, the Electronic Funds Transfer Act contains numerous important consumer protections, developed and modified over the years based on experience, new technologies, and new types of fraud. Separating the consumer consideration from the safety and soundness, antifraud, and systems considerations would certainly seem unworkable. Banks also have extensive duties under ``know your customer'' regulations designed to fight money laundering and terrorism. These critical regulations must be coordinated with consumer and safety and soundness regulation. A simple example is in the account opening process, which is subject to extensive consumer and ``know your customer'' regulations. It would be unworkable to separate these as well. And what about employee training? Banks spend billions of dollars training employees to comply with the heavy regulations to which banks are subjected. Examiners examine banks for their training programs. Front-line employees must have training in numerous consumer, safety and soundness, and antimoney laundering regulations. ABA offers dozens of courses in compliance for front-line employees. How would such training be effectively coordinated between agencies with differing views and objectives? Is the new agency going to examine banks and nonbanks equally for compliance training? It cannot be left to the States, where there is little precedent for extensive examining for compliance training outside banking. Rather than take to heart the lesson of the inseparability of safety and soundness and consumer protection, the Administration's proposal creates a different form of regulatory fragmentation along the fault lines of the jurisdiction of a new bureaucracy. A look at the proposal's enumeration of existing rule-making authorities to be transferred--mostly from the Federal Reserve Board--to the CFPA reveals an assortment of likely interagency conflicts that will generate future regulatory gaps rather than bridge the current ones. For instance, consumer privacy is placed in the CFPA, but identity theft protection is left out. The Electronic Funds Transfer Act is assigned to CFPA, but the rules for clearing electronic check images that make funds available for customers to access with their debit cards remains with the Federal Reserve. Truth in Lending Act rule-making over mortgages is assigned to the CFPA, but flood insurance coverage (FDPA) and private mortgage insurance (HOPA) laws protecting consumers who obtain mortgages remain with the banking agencies. These and other anomalies in the Administration proposal will set true consumer protection reform on the back-burner as countless hours and dollars are wasted grappling with the regulatory morass that will result from this ill-advised structural reform. The 30-year investment in coordinated supervision (FFIEC) will be washed away and replaced by interagency conflicts that are hardwired in the new bureaucracy without a means to resolve them. Finally, we are very concerned about conflicts over CRA. The banking industry has worked hard in serving its communities and in complying with CRA. We agree that CRA has not led to material safety and soundness concerns, and that bank CRA lending was prudent and safe for consumers. That is not to say that there is no debate about the correct balance between outreach and sound lending. However, that debate--that tension--is resolved now in a straightforward manner because the same agency is in charge of CRA and safety and soundness. To separate the two is a recipe for conflicting regulatory demands, with the bank caught in the middle. In the above examples and in many other areas, two different regulators--one focused on consumers and another focused on safety and soundness--will almost certainly come up with two different and conflicting rules and answers that, when added together, only create new costs, overlap and duplication, as well as an untenable situation for the financial institution.The Key Focus of Change Should Be on Closing Existing Gaps in Regulation, Not on Adding Yet Another Bureaucratic Layer The biggest failures of the current regulatory system, including consumer protection failures, have not been in the regulated banking system, but in the unregulated or weakly regulated sectors. \2\ As Members of Congress from both parties have noted, to the extent that the system did work, it is because of prudential regulation and oversight of banking firms. While improvements within the banking regulatory process can certainly be made, the most pressing need is to close the regulatory gaps outside the banking industry through better supervision and regulation--both on the consumer protection and safety and soundness sides of the coin.--------------------------------------------------------------------------- \2\ Before the recent crisis, a coalition of 46 State Attorneys General recognized that based on consumer complaints received, as well as investigations and enforcement actions undertaken by them, predatory lending abuses were largely confined to the subprime mortgage lending market and to nondepository institutions. Almost all of the leading subprime lenders were mortgage companies and finance companies, not banks or direct bank subsidiaries. We stress the past tense, because their lack of financial robustness assured that they would not be around to answer for their consumer protection misdeeds.--------------------------------------------------------------------------- Take the case of independent mortgage brokers and other nonbank originators. Again, as the Administration's own proposal States, 94 percent of the high cost mortgages occurred outside the regulated banking sector. And it is likely that an even higher percent of the most abusive loans were made outside our sector. In contrast to banks, these nonbank firms operate in a much less regulated environment, generally without regulatory examination of their conduct, without strong capital provisions, and with different reputational concerns. They have not been subjected to the breadth of consumer protection laws and regulations with which banks must comply. Equally important, a supervisory system does not exist to examine them for compliance even with the comparatively few laws that do apply to them. In addition, independent brokers typically do not have long-term business relationships with their customers. Instead, they originate a loan, sell the loan to a third party, and collect a fee. This results in a very different set of incentives and can and does work at cross-purposes with safe and sound lending practices. Proposals are also being offered with respect to credit derivatives, hedge funds, and others, and the ABA supports closing these regulatory gaps. In stark contrast to the weakness of oversight or examination of consumer compliance issues for most other financial service providers, bank regulators have an extraordinarily broad array of tools at their disposal to assure both consumer protection and safety and soundness. Banks are regularly examined for compliance with consumer regulations, and regulators devote significant resources to supervision and training in consumer compliance issues. \3\ These enforcement and supervisory options are coordinated through the Federal Financial Institutions Examination Council (FFIEC), \4\ which sets standards for both consumer and safety and soundness examination. \5\ The need is for the same banklike structure, supervision, and examination to be applied to nonbank financial service providers.--------------------------------------------------------------------------- \3\ Bank regulators are just as concerned about consumer protection as are law enforcement authorities, but the bank regulators are better able to achieve their objectives through an enormous array of enforcement and supervisory options that allow them to meet their broader mandate for law enforcement as well as financial stability. These range from the behind-the-scenes citation in an exam report as a matter requiring attention to the public actions of issuing a cease-and-desist or civil money penalty order or even closing a bank and imposing lifetime bans from participating in banking activities. Bank examiners can direct a bank to stop taking an action or to take some different action. These tools are most appropriately and effectively exercised by one regulator that is focused on achieving the balance described above. \4\ The FFIEC, represented by the Federal Reserve, OCC, FDIC, OTS, and NCUA, is charged with prescribing ``uniform principles and standards for the Federal examination of financial institutions'' designed to ``promote consistency in such examination and to insure progressive and vigilant supervision.'' \5\ In addition, the FFIEC agencies have set forth common standards for determining a bank's rating for consumer compliance performance. This rating stands as an identifiable grade, separate and apart from the CAMEL rating, so that boards of directors and regulators can hold management directly accountable for the quality of their institution's consumer compliance management programs and performance. Moreover, the FFIEC's agency members have endorsed top-down consumer compliance programs expected of banks that contain system controls, monitoring of performance, self-evaluation, accountability to senior management and the board, self-correcting processes, and staff training. The breadth of this supervisory authority is extensive. Consumer compliance management plays a role in every operational aspect where a bank comes into contact with customers--from the marketing of products, through account opening and credit Administration, to handling personal information and monitoring for financial crime. Further, banks hold their employees accountable for meeting their obligations. Every bank invests heavily in consumer compliance with dedicated compliance professionals who take great pride and apply tremendous effort to assure that consumers are being treated fairly.--------------------------------------------------------------------------- There obviously have been consumer concerns with respect to banks--we certainly know of this Committee's concerns with credit card practices--but if the great majority of abuses occurred outside the banking industry (with toxic subprime mortgages, for example), why would Congress create a new regulatory agency that will end up focusing its resources predominately on banks and not nonbanks? We see that the intention is to have regulations that cover most providers. However, regulation without enforcement can be worse than no regulation in that it gives rogue institutions a veneer of legitimacy. All evidence tells us that the States will not have the resources to enforce all these regulations. We have, frankly, little confidence that the CFPA will apply equal examination and enforcement on nonbank lenders and others, or that it will have the resources to do so. This concern is exacerbated by the incredibly vague funding provisions in the legislative language. How big is this agency to be? If it is not large, it cannot conceivably enforce its regulations on the thousands of institutions it is supposed to regulate. If it is big, how is it to be paid for?The Proposal Gives the CFPA Unprecedented Authority To Control the Products and Services Offered by Banks As Stated earlier, the proposal calls for an unprecedented delegation of legislative authority to the agency to control the way consumer products and services are designed, developed, marketed, delivered, and priced by banks and other financial service providers. In fact, the agency is encouraged to design products and services, mandate that banks offer them, regulate the products not designed by the agency more heavily than the Government product, and require consumers to sign a document that they do not want the Government-designed product. The agency can even heavily regulate compensation systems under very open-ended authority. All communications to consumers about products and services would have to be ``reasonable,'' a vague and unworkable standard if there ever was one. This would appear to give the agency an incredible amount of control over banks' and others' products without any real legislated standards. Simply put, this would appear to be the most powerful agency ever created in that it has almost unlimited power to regulate and even mandate the products offered by the regulated. It also would very much undermine incentives for innovation and better customer choice. Certainly banks and nonbanks would be less likely to create new products or consumer enhancements. Any deviations from the Government-designed product would be subject to additional regulation and clearances. Coupled with the prohibition that it is unlawful ``to advertise, market, offer, [or] sell . . . a financial product or service that is not in conformity with the [Act],'' the Administration's proposed new structure places banks and nonbanks alike at extreme risk when innovating and will chill efforts to respond to consumer demand for beneficial products and services. Proponents of the agency have regularly used the catch-phrase that we regulate toasters to keep them from blowing up (through the Consumer Product Safety Commission), but we don't regulate mortgages that can blow up consumers' finances. There are a number of problems with this analogy, including that mortgages are regulated and that, unlike a toaster with electrical problems, a financial product may often be a problem or not depending on to whom and how it is offered. More fundamentally, unlike the proposed CFPA, the Consumer Product Safety Commission is not set up to design a toaster; mandate that anyone selling toasters offer the Government toaster; and furthermore, to adjust regulation, disclosures, and liability to put the Government toaster in a preferred position. Of course such a Government toaster could not meet the multitude of preferences of single people on the run, small families, large families, those with small kitchens, those with large kitchens, those that just want toast, those that just want toast and English muffins, and those that want a multifunctional toaster oven, etc. And, of course, such a Government plain-vanilla toaster with such built in advantages would discourage innovation in the creation of new options for consumers and competition in the offering of alternatives. In many cases, the Government financial product might not fit with the institution's business plan. Niche banks, which serve important constituencies, such as small business owners or low income communities, would be required to offer products that simply do not fit. There will even be safety and soundness issues. For example, some banks that maintain all their loans in portfolios do not, and should not, hold 30-year fixed ``plain-vanilla'' mortgages. Furthermore, the incredible authority given to the proposed agency means that all the consumer laws enacted and modified by Congress over the years, which have resulted in hundreds and hundreds of pages of regulations, are to a large degree moot. They are mere floors; and, in fact, floors with holes in them. This new agency can do pretty much anything it wants in any of the areas specifically covered by the laws, and any other area relating to consumer financial products for that matter. In the final analysis, the basic premise of the Administration's proposal is to invite Congress to abdicate its legislative responsibilities to address the ever-evolving financial marketplace and delegate plenary discretion to a seemingly all-knowing and all-powerful agency. For example, this Congress just passed an extensive, tough new law on credit cards. Combined with the previous law, this creates a comprehensive congressionally crafted set of rules governing cards. Yet the proposed CFPA legislation would grant the agency authority to do practically anything it wants in the credit card area with respect to terms, delivery, disclosures, compensation and even mandated products, as long as it does not do less than the new card law. One wonders why Congress undertook such extensive reform of the credit card law if it was going to give almost open-ended authority to the CFPA shortly thereafter.The Undermining of National Standards Will Increase Costs and Cause Tremendous Litigation and Uncertainty The Commerce Clause of the Constitution was designed to allow products and services to flow freely across State lines. It is hard to think of an area of our economy where this should be encouraged more than in financial services, where the market for products from loans to deposits is national in scope. With changes in technology--such as the Internet--and the incredible mobility of our society, the free flow of financial services is even more pronounced. Furthermore, the National Bank Act, enacted during the Civil War, was created to provide for a national bank system that would not be subject, in its basic bank functions, to State laws. This national banking system, as part of the dual banking system, has served us well. However, a national system cannot function effectively if all national bank consumer products are subject to 50 different State laws. As we have noted, the safety and soundness regulator will not be able to do its job if it has no authority over consumer laws, much less if that authority is held by not only the Federal consumer regulator, but every State regulator, legislature, and attorney general as well. The multitude of rules--and do not underestimate how incredibly complex they would be--would subject banks to tremendous legal costs in order to comply, and also to deal with constant litigation. Every product, form, and customer communication would have to be checked and rechecked regularly for compliance with changing laws in all 50 States. Customers will move to other States regularly, and the bank would have to assume its customers could be in any State. There are many areas where problems will arise. ATM cards could be subject to different rules by State, resulting in their not being useable in every State at great inconvenience to travelers, who could be left stranded without funds. Online banking could be affected as differing rules would apply, depending on where the customer is located. Costs to consumers would increase as banks try to address all the different rules. Innovation would be discouraged as any changes would have to be tested against all the different State rules. The European Union is working to develop common rules in order to have greater efficiencies and innovation, and yet the Administration's proposal would go in exactly the opposite direction--toward balkanization. From a consumer's standpoint, such regulatory complexity will be translated to account or loan agreement legalese to rightfully protect the bank from elaborate and conflicting requirements--all to the detriment of simplifying consumer products and making transactions more transparent. Proponents of the proposal talk about providing one page of simple disclosures--a goal much to be sought; but how can such a goal be achieved if there would have to be page after page of disclosures to cover all the State law differences?The Question of How To Pay for This New Agency Was Left Very Vague and Raises Significant Issues To discharge its powers consistently over both banks and nonbanks, this new agency will have to be extraordinarily large. It will need to regulate, and in many cases examine, not just banks and credit unions, but finance companies, payday lenders, mortgage brokers, mortgage bankers, appraisers, title insurers and many others--apparently even pawn shops. However, under the proposal, no one has any idea how large this agency is to be. If it is small, its focus will inevitably be on the already regulated banks, even though, as already noted, 94 percent of the high cost mortgages came from outside banks. That would be incredibly unfair and counterproductive. To do its job as advertised by proponents, this agency would need to ensure that the thousands of nonbanks under its jurisdiction are reporting, examined, and subject to enforcement in the same way banks will be. While the States are supposed to be a front line of defense, it is not credible to argue that States will have the budgets to implement such reporting, examination, and enforcement even to a minimal degree. Therefore, the new agency will need to do it, or its whole rationale falls apart. Where is this agency's budget to come from? Apparently, the budget is to be based on fees on financial service products. The Consumer Products Safety Commission, said to be the model for the CFPA, is not funded by toy or appliance manufacturers, but rather by an appropriation. However, if the CFPA is to accomplish its goals and to effectively regulate nonbanks, it would need to be considerably bigger than the Consumer Products Safety Commission. Banks are already heavily burdened with funding their regulators, directly and indirectly (e.g., deposit insurance premiums fund the FDIC's regulatory costs). These costs cannot simply be split apart to pay for the banks' part of the consumer regulator, as the tremendous efficiencies that result from combining safety and soundness and consumer regulation will be lost. How is the agency to collect fees from nonbank providers? On what basis? How is it going to know about new entrants, unless they are required to register with the agency? As new types of providers spring up, how are they to be incorporated? There will, in fact, have to be a large bureaucracy just to collect the fees. Of course, these new costs, basic economics tells us, will ultimately be passed on to the users of the products, and so consumers will end up paying for this large new agency. Obviously, these are very difficult questions that were not addressed in the Administration's proposal, but which should be answered before proceeding. Given the incredibly broad authority and ambitions of the proposal, it is impossible for Congress to judge what it will, in fact, do without knowing the size it is going to be.The Proposal Will Inhibit Innovation and Competition, Limit Consumer Choices, and Dramatically Lessen the Availability of Credit The proposal will, first, create tremendous uncertainty in the financial community about what the rules will soon be. The entire body of rules that has governed the development, design, sales, marketing, and disclosure of all financial products would be subject to change, and be expected to change dramatically in many instances. When developing and offering products, firms rely on the basic rules of the road, knowing that they are subject to careful changes from time-to-time. Now there would be no certainty. This lack of certainty will cause firms to pull back from developing new products and new delivery systems. And it will chill lending, as firms will not know what the rules may be when they try to collect the loan a few years out. This problem should not be underestimated. Why design a new product if you do not know what regulatory rules will be applied to it? Why stretch to make a loan to a deserving consumer when it may be determined after the fact that your stretch terms and disclosures were unreasonable and the contract is therefore unenforceable. Everyone will be on hold, to some degree, waiting for the development, which will take years of regulatory action and judicial interpretation, of an entirely new roadmap. What makes this situation particularly difficult is that the proposed legislation, and the narrative provided with it, contains vague terminology that has little or no legal history. What on earth does ``reasonable'' mean for disclosures and communications? The legal concept of ``unfair and deceptive,'' developed over many years, is also changed. It will take years for these new legal concepts to be defined fully by the courts. In the meantime, lenders will have no idea what their potential legal rights and liabilities will be. Second, you have the huge cost for legal and other work for redoing the basis on which products are offered today. The current design of many products and disclosures is thrown into question by the concepts of this proposal. This is a cost that, again, will ultimately be borne in large part by consumers. For example, credit card companies are in the process of spending hundreds of millions of dollars to change their systems, their disclosures, their risk models, and basic parts of the product to meet the new regulations and law. If this proposal is enacted, given the testimony of Treasury, it seems quite likely that additional significant changes will be made in regulations. How is the financial industry to plan for such uncertainty? Third, the regime surrounding Government designed products will undermine innovation and the availability of credit. As noted previously, the Government designed products, given regulatory advantages, will undermine the incentive to develop new products. If an institution develops an idea that could enhance the basic product for all consumers or a subset of consumers, adding it will cause the product to no longer be ``Government approved'' and will subject it to discriminatory regulation and legal uncertainty. Why bother? Ideas that could give consumers benefits or lower costs will never see the light of day. The impact on lending will be profound. First, loan adjustments, which are made constantly in today's world, to fit a borrower's needs or allow the loan to be made simply will not happen. Those most hurt will be lower income consumers. Furthermore, the very large uncertainty and potential legal liabilities will cause less credit to be available, at the very time when credit is already scarce. Our Government is in danger of designing policies that are absolutely contradictory--encouraging more credit to be available, while at the same time, through the President's proposal, designing a legal morass that will have a dramatic effect in lowering the availability of credit.Improvements Can Be Made ABA agrees that improvements can and should be made to protect consumers. The great majority of the problems occur outside the highly regulated traditional banks, but there are legitimate issues relating to banks as well. The ABA is committed to working with Congress to address these concerns and implement improvements. In that regard, let me outline some concepts that should be considered. Enhance capabilities to apply unfair and deceptive practices: As you know, the Federal Reserve Board and the OTS have long had a very powerful tool called unfair and deceptive practices or UDAP. This had not been used as a broad regulatory tool for banks prior to the extensive credit card rule. However, use of this authority would address many of the issues raised. The UDAP authority is already in place. The ABA supports legislation the House passed last year to extend this authority in a coordinated fashion to the OCC and FDIC. The FTC has this authority for nonbanks, but there have been severe constraints in using it. Congress should work to give the FTC the capability and funding to apply it to nonbanks much more aggressively. Improve disclosure, using consumer testing: Disclosures can and should be improved, although it will not be easy. Current disclosures are by-and-large driven by lawyers and the need to cover the many legal complexities involved to protect against the real threat of litigation. Congress, the regulators, the industry, and consumer advocates need to overcome this bias. Progress has been made through the insights gained from consumer testing. Simple disclosures, perhaps in combination with larger, separate ones required for legal purposes, should be made in ways that most benefit consumers. Concepts gleaned from behavioral science relating to how consumers really react should be included in disclosure design. Enable basic products without stifling competition, innovation and consumer choice: In some cases financial products have become overly complex and difficult, if not impossible, for consumers to understand. This is not unusual in our economy as many product offerings--from consumer electronics, to telephone plans, to insurance--have become very complex. Often this complexity results from efforts to add options that consumers may want. Sometimes, as we all know, the complexity induces consumers to buy products or enhancements that are not right for them or for which they pay too much. However, as discussed previously, ABA believes the answer is not to have the Government design products, mandate that they be offered, and give them an advantage over private sector products. Nevertheless, there is a need to have product options that are basic and easily compared, and to have, at the same time, a flexible, private-sector driven system that does not stifle competition and innovation. For example, the private sector, perhaps through the ABA as the industry's trade association, could consult with the regulators, Congress, and consumer advocates to develop basic product forms that could be easily compared. Develop centralized call centers for consumer complaints: It is difficult, perhaps impossible, for many consumers to understand whom they should call in the Government to register concerns or complaints. ABA supports a centralized call center for consumers that could forward complaints to the right agency and serve as a coordinated information source. Require regular reports to Congress: The structure of consumer regulation within agencies can be reviewed and strengthened. Regular reports to Congress could be required. Empower the systemic risk oversight regulator to look specifically at consumer issues that pose systemic concerns: One clear lesson from the mortgage crisis is that consumer issues can raise systemic issues. If a systemic regulator had been in place, we would hope that it would have identified the rapid growth of subprime lending as a problem that had to be addressed well before it grew to such a hurricane force. The systemic regulator could be given the power to require regulatory agencies to address in a timely manner systemic consumer issues.Conclusion The ABA has very serious concerns about the proposed CFPA and the authorities it is to be given under the President's proposal. We believe it will result in a huge regulatory burden, particularly for community banks, while nonbanks, which are primarily responsible for the crisis, will have ineffective enforcement. Healthy, well-regulated banks have already been hurt deeply by unscrupulous players and regulatory failures. They watched mortgage brokers and others make loans to consumers that a good banker just would not make. They watched local economies suffer when the housing bubble burst. Now they face the prospect of another burdensome layer of regulation. It is simply unfair to inflict another burden on these banks that had nothing to do with the problems that were created. The separate consumer regulator will only add costs to these banks, particularly community banks, which already suffer under the enormous regulatory burden placed on them. As you contemplate major changes in regulation--and change is needed--I urge you to ask this simple question: How will this change impact those thousands of banks that did not create the problem and are making the loans needed to get our economy moving again? Another question that should be asked is: How will this proposal really assure strong enforcement and examination of the nonbanks? Furthermore, the proposal will dramatically undermine incentives to innovate and to offer new products from which consumers will benefit. Competition will be lessened, as the Government designed products limits avenues for competition. Finally, the availability of credit will be reduced, particularly in the short run, because of great uncertainty about the new, evolving rules and the increased legal liability. As outlined above, we believe that separating safety and soundness regulation from consumer regulation would be a mistake. Nevertheless, there are important improvements that can and should be made in the consumer arena, and we will work with Members of this Committee to make such improvement in this arena, as well as on the many other important issues in regulatory reform. ______ CHRG-111hhrg56776--3 Mr. Bachus," Thank you, Mr. Chairman. As Congress looks at ways to reform the country's financial infrastructure, we need to ask whether bank supervision is central to central banking. It is worth examining whether the Federal Reserve should conduct monetary policy at the same time it regulates and supervises banks or whether it should concentrate exclusively on its microeconomic responsibilities. It is no exaggeration to say the health of our financial system depends on getting this answer right. Frankly, the Fed's performance as a holding company supervisor has been inadequate. Despite its oversight, many of the large complex banking organizations were excessively leveraged and engaged in off balance sheet transactions that helped precipitate the financial crisis. Just this past week, Lehman Brothers' court-appointed bankruptcy examiner report was made public. The report details how Lehman Brothers used accounting gimmicks to hide its debt and mask its insolvency. According to the New York Times, all this happened while a team of officials from the Securities and Exchange Commission and the Federal Reserve Bank of New York were resident examiners in the headquarters of Lehman Brothers. As many as a dozen government officials were provided desks, phones, computers, and access to all of Lehman's books and records. Despite this intense on-site presence, the New York Fed and the SEC stood idle while the bank engaged in the balance sheet manipulations detailed in the report. This raises serious questions regarding the capability of the Fed to conduct bank supervision, yet even if supervision of its regulated institutions improved, it is not clear that oversight really informs monetary policy. If supervision does not make monetary policy decisions better, then the two do not need to be coupled. Vince Reinhart, a former Director of the Fed's Division of Monetary Affairs and now a resident scholar at the American Enterprise Institution, said that collecting diverse responsibilities in one institution is like asking a plumber to check the wiring in your basement. It seems that when the Fed is responsible for monetary policy and bank supervision, its performance in both suffers. Microeconomic issues cloud the supervisory judgments, therefore impairing safety and soundness. There are inherent conflicts of interest where the Fed might be tempted to conduct monetary policy in such a way that hides its mistakes by protecting the struggling banks it supervises. An additional problem arises when the supervision of large banks is separated from small institutions. Under Senator Dodd's proposal, the Fed would supervise 40 or 50 large banks, and the other 7,500 or so banks would be under the regulatory purview of other Federal and State banking agencies. If this were to happen, the Fed's focus on the mega banks will inevitably disadvantage the regional and community banks, and I think on this, Chairman Bernanke, you and I are in agreement, that there ought to be one regulator looking at all the institutions. H.R. 3311, the House Republican regulatory reform plan, would correct these problems. It would refocus the Fed on its monetary policy mandate by relieving it of its regulatory and supervisory responsibilities and reassign them to other agencies. By contrast, the regulatory reform legislation passed by the House in December represented a large expansion of the Fed's regulatory role since its creation almost 100 years ago. Senator Dodd has strengthened the Fed even more. His regulatory reform bill empowers the Fed to regulate systemically significant financial institutions and to enforce strict standards for institutions as they grow larger and more complex, adopts the Volcker Rule to restrict proprietary trading and investment by banks, and creates a new consumer financial protection bureau to be housed and funded by the Fed. In my view, the Democrats are asking the Fed to do too much. Thank you again, Mr. Chairman, for holding this hearing. I look forward to the testimony. " Mr. Watt," [presiding] I thank the gentleman for his opening statement. Let me see if I can try to use some of the chairman's time and my time to kind of frame this hearing in a way that we will kind of get a balanced view of what folks are saying. The Federal Reserve currently has extensive authority to regulate and supervise bank holding companies and State banks that are members of the Federal Reserve System, and foreign branches of member banks, among others. Last year, the House passed our financial services reform legislation that substantially preserved the Fed's power to supervise these financial institutions. The Senate bill recently introduced by Senator Dodd, however, would strip the Fed's authority to supervise all but approximately the 40 largest financial institutions. This hearing was called to examine the potential policy implications of stripping regulatory and supervisory powers over most banks from the Fed, especially the potential impact this could have on the Fed's ability to conduct monetary policy effectively. Proponents of preserving robust Fed supervision authority cite three main points to support their position that the Fed should retain broad supervisory powers. First, they say that the Fed has built up over the years deep expertise in microeconomic forecasting of financial markets and payment systems which allows the effective consolidated supervision of financial institutions of all sizes and allows effective macro prudential supervision over the financial system. Proponents of retaining Fed supervision say this expertise would be costly and difficult if not impossible to replicate in other agencies. Second, the proponents say that the Fed's oversight of the banking system improves this ability to carry out central banking responsibilities, including the responsibility for responding to financial crises and making informed decisions about banks seeking to use the Fed's discount window and lender of last resort services. In particular, proponents say that knowledge gained from direct bank supervision enhances the safety and soundness of the financial system because the Fed can independently evaluate the financial condition of individual institutions seeking to borrow from the discount window, including the quality and value of these institutions' collateral and their overall loan portfolio. Third, proponents say that the Fed's supervisory activities provide the Fed information about the current state of the economy and the financial system that influences the FOMC in its execution of monetary policy, including interest rate setting. On the flip side, there obviously are many critics of the Fed's role in bank supervision. Some of these critics blast the Fed for keeping interest rates too low for too long in the early 2000's, which some say fueled an asset price bubble in the housing market and the resulting subprime mortgage crisis. Consumer advocates and others accuse the Fed of turning a blind eye to predatory lending throughout the 1990's and 2000's, reminding us that Congress passed the HOEPA legislation in 1994 to counteract predatory lending, but the Fed did not issue final rules until well after the subprime crisis was out of control. Other critics accuse the Fed of ignoring the consumer protection role during supervisory examinations of banks and financial institutions across a wide range of financial products, including overdraft fees and credit cards and other things. Perhaps the appropriate policy response lies somewhere between the proponents and critics of the Fed bank supervision. I have tried to keep an open mind about the role of the Fed going forward, and hope to use today's hearing to get more information as we move forward to discussions with the Senate, if the Senate ever passes a bill. We are fortunate to have both the current Chairman and a former Chairman who are appearing today to inform us on these difficult issues, and with that, I will reserve the balance of our time and recognize Dr. Paul, my counterpart, the ranking member of the subcommittee. Dr. Paul. I thank the chairman for yielding. Yesterday was an important day because it was the day the FOMC met and the markets were hanging in there, finding out what will be said at 2:15, and practically, they were looking for two words, whether or not two words would exist: ``extended period.'' That is, whether this process will continue for an extended period. This, to me, demonstrates really the power and the control that a few people have over the entire economy. Virtually, the markets stand still and immediately after the announcement, billions of dollars can be shifted, some lost and some profits made. It is a system that I think does not have anything to do with free market capitalism. It has to do with a managed economy and central economic planning. It is a form of price fixing. Interest rates fixed by the Federal Reserve is price fixing, and it should have no part of a free market economy. It is the creation of credit and causing people to make mistakes, and also it facilitates the deficits here. Congress really does not want to challenge the Fed because they spend a lot. Without the Fed, interest rates would be very much higher. To me, it is a threat to those of us who believe in personal liberty and limited government. Hardly does the process help the average person. Unemployment rates stay up at 20 percent. The little guy cannot get a loan. Yet, Wall Street is doing quite well. Ultimately, with all its power, the Fed still is limited. It is limited by the marketplace, which can inflate like crazy. It can have financial bubbles. It can have housing bubbles. Eventually, the market says it is too big and it has to be corrected, but the mistakes have been made. They come in and the market demands deflation. Of course, Congress and the Fed do everything conceivable to maintain these bubbles. It is out of control. Once the change of attitude comes, when that inflated money supply decides to go into the market and prices are going up, once again the Fed will have difficulty handling that. The inflationary expectations and the velocity of money are subjectively determined, and no matter how objective you are about money supply, conditions, and computers, you cannot predict that. We do not know what tomorrow will bring or next year. All we know is that the engine is there, the machine is there, the high powered money is there, and of course, we will have to face up to that some day. The monetary system is what breeds the risky behavior. That is what we are dealing with today. Today, we are going to be talking about how we regulate this risky behavior, but you cannot touch that unless we deal with the subject of how the risky behavior comes from easy money, easy credit, artificially low interest rates, and the established principle from 1913 on that the Federal Reserve is there to be the lender of last resort. As long as the lender of last resort is there, all the regulations in the world will not touch it and solve that problem. I yield back. " CHRG-111shrg57320--5 Mr. Thorson," Chairman Levin, Senator Coburn, and Members of the Subcommittee, we thank you for the opportunity to be here today with my colleague, Mr. Rymer, to testify about our joint evaluation of the failure of Washington Mutual Savings Bank.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Thorson appears in the Appendix on page 101.--------------------------------------------------------------------------- Over the past 2 years, our country has found itself immersed in a financial crisis that started when housing prices stopped rising and borrowers could no longer refinance their way out of financial difficulty. Since then, we have seen record levels of delinquency, defaults, foreclosures, and declining real estate values. As a result, securities tied to real estate prices have plummeted. Financial institutions have collapsed. In many cases, these financial institutions seemed financially sound, but the warning signs were there as they were in the case of WaMu. At the time of its failure in September 2008, WaMu was one of the largest federally insured financial institutions, operating 2,300 branches in 15 States with assets of $307 billion. A very brief background. My office performs audits and investigations of most Treasury bureaus and offices and that includes OTS. We are required to conduct what is known as a material loss review (MLR), whenever a failed Treasury regulated bank or thrift results in a loss of $25 million or more to the FDIC's Deposit Insurance Fund. These MLRs determine the causes of an institution's failure and assess the supervision exercised over that failed institution. Since the WaMu failure did not result in a loss, it did not trigger a MLR by my office. Nonetheless, given the size of WaMu, Mr. Rymer and I decided that a MLR-like review was warranted. We completed that review on April 9, 2010. I will discuss the principal findings regarding the causes of WaMu's failure and OTS' supervision of WaMu. Mr. Rymer will then follow with a discussion of FDIC's role. WaMu failed because its management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. WaMu's high-risk strategy, combined with the housing and mortgage market collapse in mid-2007, left WaMu with loan losses, borrowing capacity limitations, and a falling stock price. In September 2008, WaMu was unable to raise capital to counter significant depositor withdrawals sparked by rumors of WaMu's problems and other high-profile failures at the time. Mr. Chairman, as you pointed out in your opening statement, during the 8 days following the collapse of Lehman Brothers in 2007, they experienced net deposit outflows of $16.7 billion. With the severity and swiftness of the financial crisis, while that contributed to WaMu's failure, it is also true that WaMu was undone by a flawed business strategy. In 2005, it shifted away from originating traditional single-family homes towards the riskier subprime loans and Option Adjustable Rate Mortgages, also known as Option ARMs. They pursued this new strategy in anticipation of higher earnings and to compete with Countrywide Financial Corporation, who it viewed as its strongest competitor. To give the Subcommittee a sense of the profits that could be made, at least in the short term, with the type of non-traditional loan products that WaMu pursued, in 2006, WaMu estimated that its internal profit margin on Option ARMs was more than eight times that of government-backed loans, FHA or VA, and nearly six times that of normal fixed-rate 30-year loans. WaMu saw these riskier loan vehicles as an easy way to substantially increase its profitability. Unfortunately, they expanded into these riskier products without the appropriate level of risk management controls needed to effectively manage that risk. With respect to OTS' supervision, WaMu was the largest institution under OTS' regulation. At the time, it represented as much as 15 percent of OTS' fee revenue, and I should point out that like the other bank regulators, OTS is not taxpayer funded. It is funded with fees collected from those that it regulates. So that meant that OTS was collecting more than $30 million from WaMu annually. OTS conducted regular risk assessments and examinations that rated their overall performance satisfactory through the early part of 2008, though supervisory efforts, however, did identify the core weaknesses that eventually led to WaMu's demise--high-risk products, poor underwriting, and weak risk controls. Issues related to poor underwriting and weak risk controls were noted as far back as 2003, but the problem was OTS did not ensure that WaMu ever corrected those weaknesses. We had a hard time understanding why OTS would allow these satisfactory ratings to continue given that, over the years, they found the same things over and over. Even in WaMu's asset quality in their reports of examination, they wrote, ``We believe the level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. We are concerned further that the current market environment is masking potentially higher credit risk.'' And despite what I just read to you, which was out of their own reports, it was not until WaMu began experiencing losses in 2007 and into 2008 that they began to downgrade their rating. When we asked OTS examiners why they did this, why they didn't lower it earlier, they told us that even though underwriting risk management practices were less than satisfactory, they were making money and loans were performing. As a result, they thought it would be difficult to lower the asset quality rating, and this position surprised us because their own guidance states, ``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 significant losses in the near term.'' Given this guidance, those things should have been done much sooner. In fact, OTS did not take a single safety and soundness enforcement action until 2008, and even then, what they took was quite weak. As troubling as that was, we became even more concerned when we discovered that OTS West Region Director overruled issues raised by his own staff with regard to one of those enforcement actions, which you mentioned, Mr. Chairman, the March 2008 Board Resolution. The Board Resolution only addressed WaMu's short-term liquidity issues and did not require it to address systemic problems repeatedly noted by OTS. Despite the concerns of his own staff, the OTS West Region Director approved the version of the Board Resolution written by WaMu. And as previously reported by my office, this was the same OTS official who also gave approval for IndyMac to improperly backdate a capital contribution to maintain its well-capitalized position just 2 months before IndyMac collapsed. As a final note, I just want to make one comment quickly about the contributions of our outstanding staff, which I always do in these things. I want to mention Marla Freedman, Bob Taylor, Don Benson, Jason Madden, and Maryann Costello, because it is their work that allows me to come here and read these statements. I thank you for the opportunity to be here and will answer whatever questions you have. Senator Levin. Thank you. Your appreciation of staff, I know, comes from long experience on Capitol Hill some years ago. We remember you well. " Mr. Rymer," TESTIMONY OF HON. JON T. RYMER,\1\ INSPECTOR GENERAL, FEDERAL CHRG-111shrg54533--44 Secretary Geithner," We are trying to do two difficult things. One is to make sure there is much clearer accountability, matched with authority, in the areas that are critical to building a more stable, stronger system, and those areas are market integrity, investor protection, combined responsibility now of the CFTC and SEC; consumer protection; supervision of banks; resolution authority; and the ability to deal with systemic threats to the system, which we are investing--proposing to invest more clearly with the Fed. That will not close all gaps in the system, but those are the core functional responsibilities of policy in any financial system. Now, to make sure that we take an integrated look at the system as a whole, to make sure the system has the capacity to evolve in the future, we are going to establish this council with a mandate to play that basic role, and the council will have the ability to make recommendations for changes by the underlying functional supervisors where there are gaps and problems, boundaries, conflicts, overlap in that context. Now, Senator, we are not proposing an elegant, neat structure. We are not proposing to put together all those functions. I would just say in part because if you look at other countries that have done that, I do not believe you can show sufficient improvements in outcomes in building a more stable system. Many of the countries that adopted a much more streamlined, simplified regulatory system still got themselves in the position where their banking system grew to a point where it is much, much larger relative to the economy than happened in the United States. Our banks are roughly one times GDP now, even with the investment banks now as bank holding companies. In many of the major economies in Europe, banking systems got to the point where they were 2, 3, 4, 5, 8 times GDP in Switzerland, even with neat consolidations, more elegant appearing, simple accountability. So the core thing to making the system more stable is getting the rules better, smarter, to induce thicker cushions, better shock absorbers, better able to withstand risk. Senator Tester. My time is up. I look forward to working with you on these issues as we go forward. I am not sure that the accountability is there for actually getting rough with folks, but I appreciate--and I mean this. I appreciate your bringing forth an initiative that we can sit down and have an honest discussion about how to move this forward. Thank you very much. Senator Johnson. Senator Johanns. Senator Johanns. Mr. Chairman, thank you. And, Mr. Secretary, thanks for being here today. Your proposal I do think gives us some things to consider and debate, and I think your testimony has been very, very thoughtful. But I, like so many of my colleagues, do have some concerns. Let me, if I could, start with some comments that my colleague Senator Warner made about the economy. We certainly cannot dispute the fact that the market is better. We can look at some other things. Certainly it is painful for all of us to see unemployment going up. It does not show any signs of subsiding at the moment. That hurts real people. We are on this just historic spending spree that I think just grows exponentially. You were in China recently. I have worked with China as a Cabinet member. I remember the many times China, when I wanted to talk about them opening their market to beef, they wanted to remind me of how much debt they had bought the week before. I think that puts us in a very precarious position. To use very inartful terminology, I really worry today if what we are seeing is kind of a dead cat bounce where all we are doing is pushing so much borrowed liquidity into our marketplace that we are just setting ourselves up for the next cliff. So I wanted to say that because I think our debt, our spending, our taxing, all of that is a very, very troublesome trend, especially as we are starting to think about a whole new initiative to spend over a trillion dollars, the health care initiative. But let me focus in on your proposal. The issue with the Fed I think is really a fundamental issue, and I can argue it from a lot of different directions about how uncomfortable I am to see the Fed get in the middle of this. On the one hand, I must admit, although some of my colleagues on this side of the aisle would probably argue with me, the independence of the Fed has served us well over time. I really believe that. I have watched Presidents avoid criticizing the Fed as interest rates went up and this and that, so that independence I think is a good thing. The more we entangle them in managing systematic risk or overseeing systematic risk, et cetera, the more we are going to be tempted--maybe not us so much, but the next generation, the next generation of Congress, the more the temptation is going to be to demand that oversight--justifiably so, I might add--then all of a sudden the independence I believe starts to go away. I would like to hear your thoughts on that issue, and then I would also like your thoughts on--on page 3 of your proposal, you talk about the Financial Services Oversight Council dealing with identifying emerging systemic risk and then the new authority of the Federal Reserve. Was it your attempt there to try to blend maybe the idea of this collegial oversight of systemic risk with the Federal Reserve actually being a regulator here? Talk us through that, because I find that to be an interesting concept, actually. " fcic_final_report_full--1  PREFACE The Financial Crisis Inquiry Commission was created to “examine the causes of the current financial and economic crisis in the United States.” In this report, the Com- mission presents to the President, the Congress, and the American people the results of its examination and its conclusions as to the causes of the crisis. More than two years after the worst of the financial crisis, our economy, as well as communities and families across the country, continues to experience the after- shocks. Millions of Americans have lost their jobs and their homes, and the economy is still struggling to rebound. This report is intended to provide a historical account- ing of what brought our financial system and economy to a precipice and to help pol- icy makers and the public better understand how this calamity came to be. The Commission was established as part of the Fraud Enforcement and Recovery Act (Public Law -) passed by Congress and signed by the President in May . This independent, -member panel was composed of private citizens with ex- perience in areas such as housing, economics, finance, market regulation, banking, and consumer protection. Six members of the Commission were appointed by the Democratic leadership of Congress and four members by the Republican leadership. The Commission’s statutory instructions set out  specific topics for inquiry and called for the examination of the collapse of major financial institutions that failed or would have failed if not for exceptional assistance from the government. This report fulfills these mandates. In addition, the Commission was instructed to refer to the at- torney general of the United States and any appropriate state attorney general any person that the Commission found may have violated the laws of the United States in relation to the crisis. Where the Commission found such potential violations, it re- ferred those matters to the appropriate authorities. The Commission used the au- thority it was given to issue subpoenas to compel testimony and the production of documents, but in the vast majority of instances, companies and individuals volun- tarily cooperated with this inquiry. In the course of its research and investigation, the Commission reviewed millions of pages of documents, interviewed more than  witnesses, and held  days of public hearings in New York, Washington, D.C., and communities across the country that were hard hit by the crisis. The Commission also drew from a large body of ex- isting work about the crisis developed by congressional committees, government agencies, academics, journalists, legal investigators, and many others. CHRG-111shrg51290--30 Mr. Bartlett," Well, Senator, it is awfully tempting, given the crisis that we are in now, to sit around this table and say, well, let us design the financial products and we will have three of them, but that would be a disaster for the American people, if not in the short-run, at least in the medium-run. Innovation does help consumers. That is why it is innovative. That is not to say that nothing should happen. In fact, I am calling for some massive additional more effective regulation to regulate the standards, responsibility, accepting the responsibility and accountability both by the agencies and by the companies, uniform national standards, and a system of enforcement. But the idea to then convert over to a system where the government simply in whatever form designs what a financial product should look like, I think would do a great disservice, both in the near-term and the long-term. Senator Bennet. Mr. Chairman, that is not what I am suggesting, but I think that even the most simple products, in some respects, at the consumer level, I think what we are seeing now is that in their aggregation and in the secondary markets into which they are sold, there is a level of complexity at that point that has, at the very least, created a lack of transparency about what is going on on the balance sheets of our major banks, and in the worst cases helped contribute to where we are. I think I am just trying to, with the other Committee members, figure out what we can do to redesign things so that we don't find ourselves here again, not to rewrite these rules. Professor McCoy, just one question. You mentioned this in your testimony, both written and spoken. I just wanted to come back to it. Tell us a little more about--and you proposed setting up a separate agency for consumer protection. But one of the reasons for that is your observation that you think there has been a reluctance on the part of the existing regulatory agencies to exercise their enforcement authority. Can you talk more about where you think that reluctance springs from? Ms. McCoy. I think there are various sources. One is this longstanding bank regulatory culture of dialog and cooperation with regulated banks. It may, in fact, be that the reluctance to bring formal enforcement action is part of a longstanding tradition of secrecy, lack of transparency in bank regulation due to fears about possible runs on deposit. But what we have ended up with is an enforcement system that is entirely opaque. It is very, very difficult to see what is happening behind the curtain. One other thing I failed to mention was that the late Governor Gramlich in 2007 stated that the Federal Reserve had not been doing routine examinations of the mortgage lending subsidiaries that were under its watch. It was not going in and examining at all except in emergency situations. Thank you. Senator Bennet. Thank you, Mr. Chairman. " CHRG-111shrg50564--561 VOLCKER Q.1. There is pressure to move quickly and reform our financial regulatory structure. What areas should we address in the near future and which areas should we set aside until we realize the full cost of the economic fallout we are currently experiencing? A.1. I recognize the desire to move quickly to reform the financial regulators structure, but more important is to get it right. Speed should not become the enemy of the good, and a piece-meal approach may inadvertently prejudice the thoroughgoing comprehensive measures we need. There may be a few measures--such as the proposed new crisis resolution procedure--that may be usefully enacted promptly, but we still have much to learn from unfolding experience and about the need to achieve international consistency. Q.2. The largest individual corporate bailout to date has not been a commercial bank, but an insurance company. Given the critical role of insurers in enabling credit transactions and insuring against every kind of potential loss, and the size and complexity of many insurance companies, do you believe that we can undertake serious market reform without establishing Federal regulation of the insurance industry? A.2. Consideration of Federal regulation of insurance companies and their holding companies is an example of the need for a comprehensive approach. A feasible starting point should be the availability of a Federal charter, at least for large institutions operating inter-state and internationally, with the implication of Federal supervision. Q.3. As Chairman of the G-30, can you go into greater detail about the report's recommended reestablishment of a framework for supervision over large international insurers? Particularly, cm you provide some further details or thoughts on how this recommendation could be developed here in the United States? Can you comment on the advantages of creating a Federal insurance regulator in the United States? A.3. As indicated, the absence of a Federal charter and supervision for insurance companies is a gap in our current regulatory framework. I am not prepared now to opine whether the Federal regulator should be separate from other supervisory agencies but some means of encouraging alignment is necessary. Again, I'd prefer to see the issue resolved in the context of a more comprehensive approach; in this case including consideration of appropriate and feasible international standards. Q.4. How should the Government and regulators look to mitigate the systemic risks posed by large interconnected financial companies? Do we risk distorting the market by identifying certain institutions as systemically important? How do foreign countries identify and regulate systemically critical institutions? A.4. The question of mitigating systemic risks is a key issue in financial reform, and can be approached in different ways. Specifically identifying particular institutions as systemically important, with the implication of special supervisory attention and support, has important adverse implications in terms of competitive balance and moral hazard. I am not aware of any foreign country that explicitly identifies and regulates particular systemically critical institutions, but in practice sizable banking institutions have been protected. An alternative approach toward systemic risk would be to provide a designated regulatory agency with authority to oversee banks and other institutions, with a mandate to identify financial practices (e.g., weak credit practices, speculative trading excesses, emerging ``bubbles'', capital weaknesses) that create systemic risk and need regulatory supervision. Particular institutions need not be identified for special attention. Q.5. In your testimony you say that you support continuing past U.S. practice of prohibiting ownership or control of Government-insured, deposit-taking institutions by non-financial firms. What are your thoughts on the commercial industrial loan company (ILC) charter? Should this continue to exist? A.5. I do believe recent experience only reinforces long-standing American aversion to mixtures of banking and commerce. The commercial industrial loan companies and other devices to blur the distinction should be guarded against, severely limited if not prohibited. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM GENE L. CHRG-111hhrg48875--92 Secretary Geithner," You said in your opening remarks, and you're saying again now that this question about who bears the losses, how you pay for these things, is very important and complicated. And we are going to have to look carefully at how the costs of these interventions are shared across the system. Right now, in the current system, it is fundamentally unfair, because smaller banks are forced to absorb a disproportionate cost of interventions needed to protect the system from often mistakes made by larger institutions. We would like to change that and put in place a fee structure that is a bit more just and fair in that context. " CHRG-110shrg38109--57 Chairman Bernanke," I will address that, sir. Just very quickly, though, on the forecasting power of the yield curve: There has been a good bit of evidence that declines in the term premium and perhaps a great deal of saving chasing a relatively limited number of investment opportunities around the world have led to a somewhat permanent flattening--or even inversion--of the yield curve, and that pattern does not necessarily predict slowing in the economy or a recession. Indeed, if you look at other measures of financial markets such as corporate bond spreads, you do not see anything that suggests anticipations of future stress. The question you raise is a different one, of course, which is the effect on the banking system. Specifically, banks that do their traditional business of taking deposits and making loans are going to be put under pressure because the short-term deposit rates tend to be higher than the loan rates they can get. I recognize that is a problem for some banks. Other banks have been able to deal with it by hedging interest rate risk, by getting fees, and finding other ways of doing their business. So, overall, I do not see the banking sector as being under tremendous pressure in terms of its profits and asset quality at the moment. But I recognize--particularly for smaller banks, which have fewer options in terms of raising funds and earning fees and income--that the inverted yield curve does produce some pressure. From the Federal Reserve's point of view, we are entirely cognizant of that and hear about it from bankers. We have to set monetary policy, of course, to achieve overall price stability and maximum sustainable employment growth. So we sometimes find that in the context of various industries policy creates some pressure in individual industries. But we only have this one tool, and we try to use it to achieve overall macroeconomic stability, while fully recognizing that it does create some problems for some sectors. Senator Bunning. You are telling us today that an inverted yield curve down the road will not affect the economy. Did I misunderstand that, or is that accurate? " CHRG-111shrg57319--452 Mr. Killinger," Yes, that is right. I just wanted to be sure that we understood the primary cause was that the refinancing boom from 2002 and 2003 subsided in the other period. Senator Levin. Now, you also changed your strategy. What year was that? " CHRG-111shrg53822--51 Mr. Stern," Well, shareholders, of course, in some of these cases have lost a lot of money, and that has been appropriate, but it is not sufficient to address moral hazard. It is the creditors, the uninsured creditors, that need to take some losses going forward--not in the middle of a crisis like this, I will hasten to add, but going forward. And so we want to put ourselves in a position to do that. The legislation is not up to me, but, obviously, if it is going to contain, as it may well appropriately contain, a systemic risk exception so that, you know, if there really is the threat of systemic difficulties that would threaten not only the functioning of the financial system but maybe parts of the economy as well, clearly policymakers ought to be able to deal with those. What you want to put yourself in the position to do is to invoke that systemic risk exception as infrequently with as low a probability as possible. So it seems to me that legislation can help, but it is not going to get you the entire way, assuming it has that systemic risk exception--and, indeed, it seems appropriate to have such a thing. Senator Merkley. Sheila, do you wish to add at all to that? Ms. Bair. No. I would agree with that. With the bank resolution process we have now, Congress has laid out a very clear claims priority for us. One of the benefits of having a resolution authority for holding companies and perhaps non-bank financial institutions is that Congress would lay out what the rules of the game are so market participants could understand in advance what their losses will be if an institution gets into trouble. I think that increases the market discipline, which is what we are all trying to get back into the system. Senator Merkley. Well, thank you very much to both of you for your testimony and for helping us wrestle with this pretty sizable issue. " CHRG-111hhrg53240--70 Mr. Meeks," Thank you, Mr. Chairman. And thank you, Ms. Duke. Let me ask you, we had a panel here earlier before the full committee, and what I was trying to figure out and what a number of individuals are talking about is the fact that some are questioning whether the systemic risk regulator should be the Fed. The Fed has been--they have talked about giving the Fed a lot more jurisdiction, a lot more responsibility. And some are concerned about--and I think that based upon the White Paper that the President has put out, that there is going to be tremendous responsibility that is going to cause a lot more work. Now we want to make sure, because we are looking forward to put some legislation that we think is going to take place and survive for 70, 80, 100 years. What is wrong with letting the Fed focus as a systemic risk regulator and doing what it has to do in maintaining this whole spectrum of responsibilities, and then having another agency whose primary focus is on consumer protection? It seems to me to make sense so that we are not overburdening the Fed. What is wrong with that? Ms. Duke. If the question is the overburdening of the Fed, the first thing I would say about the systemic risk responsibility that is in the proposal from the Administration is actually not an incrementally large increase in the activities we have today. The systemically important institutions, the vast majority of them were not necessarily bank holding companies last Fall, but through the crisis became bank holding companies. And I am not aware of very many institutions that would be considered systemically important that we don't supervise today. I think the difference would be probably in the focus of that supervision which would look not just to the individual institutions themselves, but also to the impact of their activities across the financial system. " CHRG-111hhrg51698--228 Mr. Conaway," Okay. I am an oil and gas producer, and I drill for oil and gas. I find some reserves. I get a petroleum engineer who gives me an estimate of that value. I go to my bank and want to borrow against that reserve. The bank says, well, you can do that, but you have to hedge the price that you used in your valuation contest. I own the barrels. I am long the barrels. I can somehow manipulate the system by doing that? " fcic_final_report_full--258 SUMMER 2007: DISRUPTIONS IN FUNDING CONTENTS IKB of Germany: “Real money investors” .........................................................  Countrywide: “That’s our /” ........................................................................  BNP Paribas: “The ringing of the bell” ..............................................................  SIVs: “An oasis of calm” .....................................................................................  Money funds and other investors: “Drink[ing] from a fire hose ........................  In the summer of , as the prices of some highly rated mortgage securities crashed and Bear’s hedge funds imploded, broader repercussions from the declining housing market were still not clear. “I don’t think [the subprime mess] poses any threat to the overall economy,” Treasury Secretary Henry Paulson told Bloomberg on July .  Mean- while, nervous market participants were looking under every rock for any sign of hidden or latent subprime exposure. In late July, they found it in the market for asset-backed commercial paper (ABCP), a crucial, usually boring backwater of the financial sector. This kind of financing allowed companies to raise money by borrowing against high-quality, short-term assets. By mid-, hundreds of billions out of the . trillion U.S. ABCP market were backed by mortgage-related assets, including some with subprime exposure.  As noted, the rating agencies had given all of these ABCP programs their top in- vestment-grade ratings, often because of liquidity puts from commercial banks. When the mortgage securities market dried up and money market mutual funds be- came skittish about broad categories of ABCP, the banks would be required under these liquidity puts to stand behind the paper and bring the assets onto their balance sheets, transferring losses back into the commercial banking system. In some cases, to protect relationships with investors, banks would support programs they had sponsored even when they had made no prior commitment to do so. IKB OF GERMANY: “REAL MONEY INVESTORS” The first big casualty of the run on asset-backed commercial paper was a German  bank, IKB Deutsche Industriebank AG. Since its foundation in , IKB had fo- cused on lending to midsize German businesses, but in the past decade, management diversified. In , IKB created an off-balance-sheet commercial paper program, called Rhineland, to purchase a portfolio of structured finance securities backed by credit card receivables, business loans, auto loans, and mortgages. It made money by using less expensive short-term commercial paper to purchase higher-yielding long- term securities, a strategy known as “securities arbitrage.” By the end of June, Rhineland owned  billion (. billion) of assets,  of which were CDOs and CLOs (collateralized loan obligations—that is, securitized leveraged loans). And at least  billion (. billion) of that was protected by IKB through liquidity puts.  Importantly, German regulators at the time did not require IKB to hold any capital to offset potential Rhineland losses.  CHRG-111shrg51395--66 Mr. Ryan," Thank you for your question. We have given a lot of thought to a number of issues, and on some of these issues we do not have final decisions. I am talking now within the industry. For instance, we spent a lot of time talking about should we recommend the Fed immediately as the systemic regulator, and we have not come to that conclusion yet. If we had to do it right away, they are probably the best qualified to do it, but we think that the industry and the Congress, the American people, deserve a really comprehensive view. The same is true of who is systemically important. It is pretty easy to identify the early entrants because they meet the test that Professor Coffee has enunciated. They are too interconnected. They are very large. They are providing consolidated services to the citizens of this country and we need a better understanding of their interconnected aggregated risks. So the first group will be easy. The second group will be more difficult because they may not be so interconnected. They may not even be that large. But they may be engaged in practices which could have a very dramatic impact on our health. So our hope would be that we anoint a systemic regulator, maybe it is a new entity, maybe it is within Treasury, maybe it is the Fed, that we orient them in legislation toward preselection of the people who are very obvious, and that we give them the flexibility to include and actually to have people move out of systemically important status going forward. So once you are in it doesn't necessarily mean that you will stay in it. I think it is pretty clear, though, we all know the basic early entrants and they are our larger financial institutions. We, by the way, would not limit this by charter at all, so there will be banks, there will be insurance companies, there will be hedge funds, there could be private equity players. It is people who could have a dramatic effect on our lives. Senator Shelby. Professor Coffee, why should we continue to prop up banks that are basically insolvent, some of our large banks that are walking dead, so to speak, give them a transfusion, and there is no end in sight? Why should we do that rather than take over some of their--guarantee some of their assets and whatever we have to do and wind them down? " CHRG-109shrg30354--131 RESONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM BEN S. BERNANKEQ.1. I am very concerned about the potential efforts in this Congress to change the manner in which we regulate derivatives or to impact the manner in which derivatives operate in the economy. As you know, the President's Working Group on Financial Markets has explained why proposals we have faced in the last couple of years for additional regulation of energy derivatives were not warranted, and has urged Congress to be aware of the potential for unintended consequences. Do you share this view? Do you agree with the view of Alan Greenspan and others that derivatives have helped create a far more flexible, efficient, and resilient financial system? Are you aware of any evidence that additional reporting requirements or other regulatory actions would reduce energy prices and price volatility or are energy prices and price volatility determined by the market?A.1. I share the view that additional regulation of energy derivatives is not warranted. More generally, I agree that derivatives have created a more flexible, efficient, and resilient financial system. To be sure, as Chairman Greenspan recognized, derivatives pose a variety of risk management challenges that users must address. In particular, they must effectively manage the counterparty risks associated with derivatives. Thus far, with a few notable exceptions they have done so and, as a result, derivatives have produced the benefits that you have mentioned. I am unaware of any evidence that supports a view that additional reporting requirements or other new regulations would reduce energy prices or energy price volatility. Prices and volatility are indeed determined by the market, and as far as I am aware, energy prices and volatility recently have moved in ways that seem sensibly related to fundamentals.Q.2. Mr. Chairman, in your Sea Island speech in May on the subject of ``Hedge Funds and Systemic Risk,'' you noted that ``[t]he primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors.'' You further observed that, in light of 1998's LTCM episode, the President's Working Group's ``central policy recommendation was that regulators and supervisors should foster an environment in which market discipline--in particular, counterparty risk management--constrains excessive leverage and risk-taking.'' You also noted that the PWG rejected so-called ``direct regulation'' of hedge funds, observing that ``[d]irect regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work. Investors, creditors, and counterparties have significant incentives to rein in hedge funds' risktaking. Moreover, direct regulation would impose costs in the form of moral hazard, the likely loss of private market discipline, and possible limits on funds' ability to provide market liquidity.'' Can you tell us a little more about what is involved in fostering market discipline in the hedge fund context and why you believe that is a superior approach to ``direct regulation?''A.2. The creditors and counterparties of hedge funds are regulated banks and securities firms. Banking and securities supervisors have been fostering market discipline by issuing supervisory guidance on counterparty risk management, by encouraging private sector initiatives to identify and promote best practices for risk management, and by undertaking supervisory reviews that assess whether banks and securities firms' practices are consistent with supervisory guidance and emerging best practices. As I indicated in my Sea Island speech, I believe that it is a reasonable presumption that market discipline can effectively constrain hedge funds' leverage. The banks and securities firms that provide hedge funds with leverage have strong incentives and capabilities to constrain their leverage so as to avoid counterparty losses. Supervisors of those banks and securities firms can and should take action if competition appears to be dulling those incentives in ways that threaten the counterparties and the financial system. Direct regulation of hedge funds could weaken market discipline if hedge funds' creditors and counterparties came to view direct regulation as an effective substitute for their own due diligence and monitoring of risks. Furthermore, development of an effective regulatory regime for hedge funds would be challenging in light of the diversity of hedge fund investment strategies and the speed with which their risk profiles tend to change. A regulatory regime that was insufficiently risk sensitive could impair hedge funds' ability to bear risks and provide liquidity to financial markets, which would make our financial system less efficient and less resilient." CHRG-111shrg57709--189 Mr. Volcker," At that point, people were not so proud of the regulatory system in Canada. Senator Schumer. Right. So another question, the inverse of this question. Here, you had Canada, big, big banks and relatively secure. Just because an institution is small doesn't mean it is not risky, and I would argue these days doesn't even mean they don't pose systemic risk. Maybe one hedge fund doesn't, but if 50 hedge funds do the same thing, together, they pose a problem of systemic risk if it is a risky activity. And with all of the counterparty risk and the intertwined spaghetti-like nature of the financial system, I mean, even back a while ago, whatever the place was in Greenwich, long-term---- " CHRG-111hhrg48875--15 Secretary Geithner," Excellent question. Let me just start by saying, you know, what we need is better, smarter, tougher regulation. Because we have seen that the costs of these weaknesses and gaps are catastrophic for the system as a whole. And we have an enormously complicated system in the United States with regulation at the Federal and State level, multiple bank supervisors, multiple authorities, and it just didn't work. It did not deliver what it has to deliver. And I think that we have to start by making sure we have in place effective consolidated supervision over those entities that could pose potential risks to the system. Now, that does not mean that we should supplant and take away the existing authorities that State insurance companies, that State insurance supervisors have over those institutions, or that the bank regulators have over depositories. And so what we're suggesting is fully compatible with maintaining their important role in supervising insurance companies. But again, for these core institutions, you need to have much stronger, more effective supervision applied on a consolidated basis if you're going to get better results in the future. " CHRG-111shrg57321--236 Mr. McDaniel," We were observing deterioration in performance of mortgages. That is what had the impact on the market, I believe---- Senator Levin. Yes. The subprime market just collapsed, right. " CHRG-111shrg57709--168 Mr. Volcker," That is the core. Senator Schumer. Yes. OK. So now I would like to ask a few questions to help us understand and probe it. From what I am told of the questions here, there is still a lot of trying to drill down as to what exactly we are talking about. I would like to talk a little bit about Canada and use it by way of contrast. They have a banking system, as you know, dominated by six large full-service banks, but it was the only G-7 country where the government didn't have to bail out its banking system in the recent crisis. Some people say it was cultural, arguing Canadians are simply more risk averse as a society than Americans and their bankers are no different. But others have argued the answer had more to do with their regulatory system. I tend to believe that. I don't know exactly how it works, but I know enough culture, maybe were the British more risky than the Canadians culturally? Who knows. But this regulatory system, and particularly its willingness to just say no to risky practices. So here are my specific questions and then general. Consumer protection--Canada has a separate Consumer Protection Agency, and despite home ownership levels higher than the United States, the percentage of Canadian mortgages that are subprime is less than half of that in the United States. The default rate is less than 1 percent in Canada compared to 10 percent in the United States. What role do you think Canada's Consumer Protection Agency played in maintaining a safe and robust mortgage market and not allowing billions of dollars of no-doc loans to just be stamped, stamped, stamped, and securitized? " CHRG-111shrg54533--12 Secretary Geithner," Senator Shelby, you are right that the Federal Reserve structure, the system established by the Congress almost 90 years ago for the Federal Reserve, is a complicated mix of different things. You are absolutely right. And we are suggesting--we do propose in our recommendations that the Fed take a close look, in consultation with outside experts and the Treasury, and come forward with proposals by, I believe we say the end of October, for how to adapt that basic governance structure to respond to some of the concerns you have raised and we have talked about before. And I think there are things that the Fed should reflect on there that would provide a better balance, reduce the risk of perceived conflict in these areas. But I think the short answer to your question is to say the Chairman of the Board of the Federal Reserve would be accountable, as he is now. And I think in the current framework of the Fed as designed by the Congress, the responsibilities for supervision, to the extent the Fed has them now, are concentrated at the Board of Governors, overseen by a board of people appointed by the President, confirmed by the Senate, and that Board and that Chairman would be the one accountable to you. Senator Shelby. Mr. Secretary, the administration's proposal chooses to grant the Fed authority to regulate systemic risk because, ``it has the most experience to regulate systemically significant institutions.'' I personally believe this represents a grossly inflated view of the Fed's expertise. Presently, the Fed regulates primarily bank holding companies and State banks. As a systemic risk regulator, the Fed would likely have to regulate insurance companies, hedge funds, asset managers, mutual funds, and a variety of other financial institutions that it has never supervised before. Since I believe the Fed lacks much of the expertise it needs to have as an effective systemic regulator, why couldn't the responsibility for regulating systemic risk just as easily be given to another or a newly created entity, as some have proposed? " CHRG-111shrg56376--49 Mr. Dugan," I was just going to say I agree completely with everything Sheila just said, and attached to my testimony are examples of a number of the ways in which integrated safety and soundness and consumer protection supervision has found issues for both safety and soundness purposes and for consumer protection purposes that otherwise would not have been found under the current system. We believe that under the examination and supervision system currently in place, bank examiners are good at implementing rules that are written, and to the extent that a new agency writes strong rules, they will be complied with by banks through this function better than any other alternative model. Senator Menendez. So basically--and, Mr. Chairman, I will end on this. My understanding from the panel is that you are all in support of a consumer financial protection agency? " CHRG-111shrg57320--42 Mr. Rymer," I believe, sir, that as far as I can tell, WaMu was unique in the fact that OTS does have a tracking system, at least in place now, and perhaps it was put in place recently. But WaMu was the only bank, I believe, OTS said that it was allowing to track its own recommendations. Senator Coburn. Well, I would have no doubt that OTS has a system today, especially in light of the hearings that have been held. It would be important if you all could give us what your findings were in terms of when you saw that, because if, in fact, you are looking at WaMu, you have got to be looking at OTS as you did that. When, in fact, did they institute that system? Or did they have that system in place all along and ignored it with WaMu? Because now we have become criminally negligent if, in fact, we are using selective tools of enforcement for one thrift organization as to another. Is it true in your findings that there was no internal tracking system at OTS to look at all of their enforcement actions against WaMu? " CHRG-111hhrg48873--165 Mr. Bernanke," As I discussed in some detail in my testimony, the systemic risk goes well beyond specific counterparties. In the case of the company you are referring to, perhaps they were hedged, but then it means that some other party that hedged them would have lost. But more important than the specific losses associated with the counterparties would be the loss of the confidence in the system as a whole and the likelihood that we would have seen a run on banks, given that markets would not know ultimately who was exposed to AIG. " CHRG-111shrg54789--128 Mr. Blumenthal," Thank you, Senator. Senator Reed. As a neighbor in Rhode Island, I am well aware of what you have done for your State and for the Nation. Mr. Yingling suggested that we should put our attention on the nonbanking system, and yet your testimony suggests that there are real problems within the banking system because Federal regulators have essentially interfered with your ability to regulate what might be Connecticut chartered companies. Is that fair, and can you elaborate? " CHRG-111shrg53085--193 Mr. Whalen," I am because I think we are here now. I think we may have to invite the industrial sector into the financial sector at some point to provide new capital. But let me put it to you this way. There is a tension that has been illustrated in the last few months between the creditors of a bank holding company and the counterparties of the subsidiary bank. One could argue that the counterparties to the subsidiary bank, all of them, are now senior to the creditors of the parent bank holding company. I don't think that serves any public policy purpose. I would rather see the bank at the top issuing debt, issuing equity, issuing deposits, and paying a full load to the FDIC or whoever is the systemic risk regulator to contribute to the Resolution Fund. " CHRG-111hhrg48674--59 Mr. Bernanke," We are repaid. We are repaid, without exception. We are going to provide as much information as we can. But there is a good reason. The one, in particular, you mentioned is, why don't we reveal the overnight short-term loans we make to banks? In the recent period, almost every big bank and many of the medium and small banks in the country have borrowed from us for short periods, and we could give that list, I suppose. The risk we have is that during periods where fewer banks borrow, being put on that list is some sort of saying to the market, I had to go to the Fed, maybe there is something wrong with me, and that causes trouble for the bank. So if we have to give that information, and we will if Congress insists, but if we have to give that information, it will destroy that program and have a significant adverse effect on the liquidity provision and the stability of the financial system. So that is one case where I think that there is nothing devious going on. " fcic_final_report_full--165 The investment banks also owned depository institutions through which they could provide FDIC-insured accounts to their brokerage customers; the deposits pro- vided cheap but limited funding. These depositories took the form of a thrift (super- vised by the OTS) or an industrial loan company (supervised by the Federal Deposit Insurance Corporation and a state supervisor). Merrill and Lehman, which had among the largest of these subsidiaries, used them to finance their mortgage origina- tion activities. The investment banks’ possession of depository subsidiaries suggested two obvi- ous choices when they found themselves in need of a consolidated supervisor. If a firm chartered its depository as a commercial bank, the Fed would be its holding company supervisor; if as a thrift, the OTS would do the job. But the investment banks came up with a third option. They lobbied the SEC to devise a system of regu- lation that would satisfy the terms of the European directive and keep them from European oversight  —and the SEC was willing to step in, although its historical fo- cus was on investor protection. In November , almost a year after the Europeans made their announcement, the SEC suggested the creation of the Consolidated Supervised Entity (CSE) program to oversee the holding companies of investment banks and all their subsidiaries. The CSE program was open only to investment banks that had large U.S. broker-dealer subsidiaries already subject to SEC regulation. However, this was the SEC’s first foray into supervising firms for safety and soundness. The SEC did not have express leg- islative authority to require the investment banks to submit to consolidated regula- tion, so it proposed that the CSE program be voluntary; the SEC crafted the new program out of its authority to make rules for the broker-dealer subsidiaries of in- vestment banks. The program would apply to broker-dealers that volunteered to be subject to consolidated supervision under the CSE program, or those that already were subject to supervision by the Fed at the holding company level, such as JP Mor- gan and Citigroup. The CSE program would introduce a limited form of supervision by SEC examiners. CSE firms were allowed to use a new methodology to calculate the regulatory capital that they were holding against their securities portfolios—a methodology based on the volatility of market prices. This methodology, referred to as the “alternative net capital rule,” would be similar to the standards—based on the  Market Risk Amendment to the Basel rules—that large commercial banks and bank holding companies used for their securities portfolios. The traditional net capital rule that had governed broker-dealers since  had required straightforward calculations based on asset classes and credit ratings, a bright-line approach that gave firms little discretion in calculating their capital. The new rules would allow the investment banks to create their own proprietary Value at Risk (VaR) models to calculate their regulatory capital—that is, the capital each firm would have to hold to protect its customers’ assets should it experience losses on its securities and derivatives. All in all, the SEC estimated that the proposed new re- liance on proprietary VaR models would allow broker-dealers to reduce average cap- ital charges by . The firms would be required to give the SEC an early-warning notice if their tentative net capital (net capital minus hard-to-sell assets) fell below  billion at any time. FinancialCrisisInquiry--518 WALLISON: Let me modify that then. Let’s leave the banks out, which are already subject to a system of resolution because of exactly what you’re saying; the government is backing them. But for institutions that are not backed by the government, what is the reason for having oversight and keeping them from going bankrupt? CHRG-111shrg50564--11 Chairman Dodd," Let me draw upon your experience as the Chairman of the Federal Reserve System, and you correct me if my facts are wrong about this thing. But as I understand it, there are about 1,800 economists that work for the various Federal Reserve banks across the country. " CHRG-111hhrg53245--97 Mr. Zandi," To me, too big to fail is more than the interconnectedness of the institutions, it also goes to the confidence we have in our system. You would get bank runs, and if you go into a bankruptcy proceeding, you may be able to solve the interconnectedness problems, but confidence would still be an issue. " CHRG-110shrg50409--57 Mr. Bernanke," About 95, as I recall. As I said, I think the banking system came into this episode with good capital basis and with strong earnings. Senator Tester. OK. Thank you, Mr. Chairman. I appreciate that. Thank you. " CHRG-111shrg53822--79 Mr. Rajan," Well, this follows on the comments I just made, which is that if capital on the balance sheet is not going to work that well because banks will find ways to offset it, maybe the idea is to get capital which comes only in bad times. It might be cheaper to arrange for that kind of capital rather than have capital sitting on balance sheets through good times and bad times. And if you can do it in a clever enough way, banks will not be able to exploit that capital and take on more risks a priori, given that they know that capital will come in. So two examples of how this could be done. One, which Mr. Baily has also talked about, which comes from a common group that we work in, is this idea of what is called reversed convertible debt. And this convertible debt is debt which will convert into equity in times like the current ones. So it is a pre-assured source of buffer which will protect the taxpayer from having to fund these institutions. And that debt will convert, provided the bank's capital ratio goes below a certain level. That is one condition. The second condition is that this be a systemic crisis so that banks do not sort of willfully convert this debt and get additional buffers. Another variant of this would be what we call the capital insurance plan, which is you issue bonds, which are called capital insurance bonds. The bank issues these bonds. The proceeds from the bonds are taken and invested in Treasuries. And the holders of these bonds get the Treasury rate of return plus an insurance premium, which the banks pays. In bad times, when the bank's capital goes below a certain level and there is a systemic crisis, the bonds will start, essentially, paying out to the bank. It would be equity at that point for the bank, and the bank would be recapitalized. So the main difference is, in one, the bonds convert to equity; in the other, the bonds just pay in. There is no commensurate equity, which is issued. Both have the effect of recapitalizing the bank in bad times. Senator Akaka. Thank you. Further comment, Mr. Wallison? " CHRG-111hhrg56776--13 Mr. Volcker," I appreciate your invitation to address important questions concerning the link between monetary policy and Federal Reserve responsibilities for the supervision and regulation of financial institutions. Before addressing the specific questions you have posed, I would like to make clear my long-held view, a view developed and sustained by years of experience in the Treasury, the Federal Reserve, and in private finance. Monetary policy and concerns about the structure and condition of banks in the financial system more generally are inextricably intertwined, and if you need further proof of that proposition, just consider the events of the last couple of years. Other agencies, certainly including the Treasury, have legitimate interests in regulatory policy, but I do insist that neither monetary policy nor the financial system will be well served if our central bank is deprived from interest in and influence over the structure and performance of the financial system. Today, conceptual and practical concerns about the extent, the frequency, and the repercussions of economic and financial speculative excesses have come to occupy our attention. The so-called ``bubbles'' are indeed potentially disruptive of economic activity. Then important and interrelated questions arise for both monetary and supervisory policies. Judgment is required about if and when an official response, some form of intervention is warranted. If so, is there a role for monetary policy, for regulatory actions, or for both? How can those judgments and responses be coordinated and implemented in real time in the midst of crisis in a matter of days? The practical fact is the Federal Reserve must be involved in those judgments and that decision-making, beyond this broad responsibility for monetary policy and its influence on interest rates. It is the agency that has the relevant technical experience growing out of working in the financial markets virtually every day. As a potential lender of last resort, the Fed must be familiar with the condition of those to whom it lends. It oversees and participates in the basic payment system, domestically and internationally. In sum, there is no other official institution that has the breadth of institutional knowledge, the expertise, and the experience to identify market and institutional vulnerabilities. It also has the capability to act on very short notice. The Federal Reserve, after all, is the only agency that has financial resources at hand in amounts capable of emergency response. More broadly, I believe the experience demonstrates conclusively that the responsibilities of the Federal Reserve with respect to maintaining economic and financial stability require close attention to manage beyond the specific confines of monetary policy, if we interpret monetary policy narrowly, as influencing monetary aggregates and short-term interest rates. For instance, one recurring challenge in the conduct of monetary policy is to take account of the attitudes and approaches of banking supervisors as they act to stimulate or to restrain bank lending, and as they act to adjust capital standards of financial institutions. The need to keep abreast of rapidly developing activity in other financial markets, certainly including the markets for mortgages and derivatives, has been driven home by the recent crisis. None of this to my mind suggests the need for regulatory and supervisory authority to lie exclusively in the Federal Reserve. In fact, there may be advantages in some division of responsibilities. A single regulator may be excessively rigid and insensitive to market developments, but equally clearly, we do not want competition and laxity among regulators aligning with particular constituencies or exposed to narrow political pressures. We are all familiar in the light of all that has happened with weaknesses in supervisory oversight, with failures to respond to financial excesses in a timely way and with gaps in authority. Those failings spread in one way or another among all the relevant agencies, not excepting the Federal Reserve. Both law and practice need reform. However these issues are resolved, I do believe the Federal Reserve, our central bank, with the broadest economic responsibility, with a perceived mandate for maintaining financial stability, with the strongest insulation against special political or industry pressures, must maintain a significant presence with real authority in regulatory and supervisory matters. Against that background, I respond to the particular points you raised in your invitation. I do believe it is apparent that regulatory arbitrage and the fragmentary nature of our regulatory system did contribute to the nature and extent of the financial crisis. That crisis exploded with a vengeance outside the banking system, involving investment banks, the world's largest insurance company, and government-sponsored agencies. Regulatory and supervisory agencies were neither reasonably equipped nor conscious of the extent of their responsibilities. Money market funds growing over several decades were essentially a pure manifestation of regulatory arbitrage. Attracting little supervisory attention, they broke down under pressure, a point of significant systemic weakness, and the remarkable rise of the subprime mortgage market developed through a variety of channels, some without official oversight. There are large questions about the role and supervision of the two hybrid public/private organizations that came to dominate the largest of all our capital markets, that for residential mortgages. Undeniably, in hindsight, there were weaknesses and gaps in the supervision of well-established financial institutions, including banking institutions, major parts of which the Federal Reserve carries direct responsibility. Some of those weaknesses have been and should have been closed by more aggressive regulatory approaches, but some gaps and ineffective supervision of institutions owning individual banks and small thrifts were loopholed, expressly permitted by legislation. As implied by my earlier comments, the Federal Reserve, by the nature of its core responsibilities, is thrust into direct operational contact with financial institutions and markets. Beyond those contacts, the 12 Federal Reserve banks exercising supervisory responsibilities provide a window into both banking developments and economic tendencies in all regions of the country. In more ordinary circumstances, intelligence gleaned on the ground about banking attitudes and trends will supplement and color forecasts and judgments emerging from other indicators of economic activity. When the issue is timely identification of highly speculative and destabilizing bubbles, a matter that is both important and difficult, then there are implications for both monetary and supervisory policy. Finally, the committee has asked about the potential impact of stripping the Federal Reserve of direct supervisory and regulatory power over the banks and other financial institutions, and whether something can be learned about the practices of other nations. Those are not matters that permit categorical answers good for all time. International experience varies. Most countries maintain a position, often a strong position, and a typically strong position for central banks' financial supervision. In some countries, there has been a formal separation. At the extreme, all form of supervisory regulatory authority over financial institutions was consolidated in the U.K. into one authority, with rather loose consultative links to the central bank. The approach was considered attractive as a more efficient arrangement, avoiding both agency rivalries and gaps or inconsistencies in approach. The sudden pressure of the developing crisis revealed a problem in coordinating between the agency responsible for the supervision, the central bank, which needed to take action, and the Treasury. The Bank of England had to consider intervention with financial support without close and confident appraisals of the vulnerability of affected institutions. As a result, I believe the U.K. itself is reviewing the need to modify their present arrangements. For reasons that I discussed earlier, I do believe it would be a really grievous mistake to insulate the Federal Reserve from direct supervision of systemically important financial institutions. Something important but less obvious would also be lost if the present limited responsibilities for smaller member banks were to be ended. The Fed's regional roots would be weaker and an useful source of information lost. I conclude with one further thought. In debating regulatory arrangements and responsibilities appropriate for our national markets, we should not lose sight of the implications for the role of the United States in what is in fact a global financial system. We necessarily must work with other nations and their financial authorities. The United States should and does still have substantial influence in those matters, including agreement on essential elements of regulatory and supervisory policies. It is the Federal Reserve as much as and sometimes more than the Treasury that carries a special weight in reaching the necessary understandings. That is a matter of tradition, experience, and of the perceived confidence in the authority of our central bank. There is a sense of respect and confidence around the world, matters that cannot be prescribed by law or easily replaced. Clearly, changes need to be made in the status quo. That is certainly true within the Federal Reserve. I believe regulatory responsibilities should be more clearly focused and supported. The crisis has revealed the need for change within other agencies as well. Consideration of broader reorganization of the regulatory and supervisory arrangements is timely. At the same time, I urge in your deliberations that you do recognize what would be lost, not just in the safety and soundness of our national financial system, but in influencing and shaping the global system, if the Federal Reserve were to be stripped of its regulatory and supervisory responsibilities, and no longer be recognized here and abroad as ``primus inter pares'' among the agencies concerned with the safety and soundness of our financial institutions. Let us instead strengthen what needs to be strengthened and demand high levels of competence and performance that for too long we have taken for granted. Thank you, ladies and gentlemen. [The prepared statement of Chairman Volcker can be found on page 100 of the appendix.] " CHRG-111shrg50564--8 Mr. Volcker," The Group of 30 is a group of people drawn from the private and public sectors with experience in finance, and I emphasize that it is international, and this report was directed not just toward the United States, although it is perhaps most relevant to the United States. But it is directed toward authorities in any country that has extensive financial operations around the world. It does not discuss all the origins of the crisis. It does touch upon it, but that is not my purpose in appearing before you this morning. What is evident is, whatever the cause is--and we could go into that. What is evident is that we do meet at a time, as you have emphasized, of acute distress in financial markets. Strongly adverse effects on the economy more broadly are apparent. There is a clear need, I think, for early and effective governmental programs. They cannot wait a year for attacking the immediate problems to support economic activity and to ease the flow of credit. But I think it is also evident that more fundamental changes are needed in the financial system, and they will take some time to work out. But to the extent that we have some sense of the direction of those reform efforts, I think it will help the more immediate problem. The important thing is that we do not and should not want to contemplate a repetition of this experience, and that is what this report is aimed at, and I am sure will be your concerns over time. I understand that President Obama and his people are going to be placing before you some more immediate measures. They are not the subject of our report. But when we look further ahead, I do think the more we have a sense of the longer-term future, the better place you will be for appraising the immediate actions to make sure they are consistent with what we would like to see in the longer run. The basic thrust of the G-30 report is to distinguish among the basic functions of any financial system. First, there is a need for strong and stable institutions that serve the needs of individuals, of businesses, of governments, and others for a safe and sound repository of funds, providing a reliable source of credit, and maintaining a robust financial infrastructure able to withstand and diffuse shocks and volatility that are inevitable in the future. I think of that as the service-oriented part of the financial system. It deals primarily with customer relationships. It is characterized mainly by commercial banks that have long been supported and protected by deposit insurance, by access to the Federal Reserve credit, and by other elements of the so-called Federal safety net. Now, what has become apparent during this period of crisis is increasing concentration in banking and the importance of official support for what is known as systemically important institutions when they become at risk of failure. What is apparent is that a sudden breakdown or discontinuity in the functioning of those institutions risks widespread repercussions on markets, on closely interconnected financial institutions, and at the end of the day, on the broader economy. The design of any financial system raises large questions about the appropriate criteria for, and the ways and means of, providing official support for these systemically important institutions. In common ground with virtually all official and private analysts, the G-30 Report calls for ``particularly close regulation and supervision, meeting high and common international standards'' for such institutions deemed systemically critical. It also explicitly calls for restrictions on ``proprietary activities that present particularly high risks and serious conflicts of interest'' deemed inconsistent with the primary responsibilities, I would say the primary fiduciary responsibilities, of those institutions to its customers. Of relevance in the light of recent efforts of some commercial enterprises to recast financial affiliates as bank holding companies, the report strongly urges continuing past U.S. practice of prohibiting ownership or control of Government-insured, deposit-taking institutions by non-financial firms. Second, the report implicitly assumes that while regulated banking institutions will be dominant providers of financial services, a variety of capital market institutions will remain active. Organized markets and private pools of capital will be engaging in trading, transformation of credit instruments, and developing derivatives and hedging strategies. They will take place in other innovative activities, potentially adding to market efficiency and flexibility. Now, these institutions do not directly serve the general public; individually, they are less likely to be of systemic significance. Nonetheless, experience strongly points to the need for greater transparency. Specifically beyond some minimum size, registration of hedge and equity funds should be required, and if substantial use of borrowed funds takes place, an appropriate regulator should be able to require periodic reporting and appropriate disclosure. Furthermore, in those exceptional cases when size, leverage, or other characteristics pose potential systemic concerns, the regulator should be able to establish appropriate standards for capital, liquidity, and risk management. Now, the report does not deal with important and sensitive questions of the appropriate administrative arrangements for the regulatory and supervisory functions, which agency will supervise which institutions. These are in any case likely to be influenced by particular national traditions and concerns. What is emphasized is that the quality and effectiveness of prudential regulation and supervision must be improved. Insulation from political and private special interests is a key, along with adequate and highly competent staffing. That implies adequate funding. The precise role and extent of the central bank with respect to regulation and supervision is not defined in the report. It is likely to vary country by country. There is, however, a strong consensus that central banks should accept a continuing role in promoting and maintaining financial stability, not just in times of crisis, but in anticipating and dealing with points of vulnerability and risk. The report also deals with many more specific issues cutting across all institutions and financial markets. These include institutional and regulatory standards for governance and risk management, an appropriate accounting framework (including common international standards), reform of credit rating agencies, and appropriate disclosure and transparency standards for derivatives and securitized credits. Specifically, the report calls for ending the hybrid private/public nature of the two very large Government-sponsored mortgage enterprises in the United States. Under the pressure of financial crisis, they have not been able to serve either their public purposes or their private stockholders successfully. To the extent that the Government wishes to provide support for the residential mortgage market, it should do so by means of clearly designated Government agencies. Finally, I want to emphasize that success in the reform effort, in the context of global markets and global institutions, will require consistency in approach among countries participating significantly in international markets. There are established fora for working toward such coordination. I also trust that the forthcoming G-20 meeting, bringing together leaders of so many relevant nations, can provide impetus for thoughtful and lasting reform. Thank you, Mr. Chairman. I am delighted to have any comments or questions. " CHRG-111hhrg53248--156 Secretary Geithner," Let me just give you some of the most compelling examples of that. Countrywide and WAMU were banks, found the strictures of being banks inconvenient, shifted their charter to a thrift charter, and were able to take advantage of what in retrospect can only be judged as lower standards of enforcement, and they grew dramatically or a more rapid pace after they made that basic switch. That is one example. But there were others in our system, too. " FOMC20050202meeting--13 11,CHAIRMAN GREENSPAN.," Without objection, that is approved. The next item on the agenda is the selection of a Federal Reserve Bank to execute transactions for the System Open Market Account. My notes indicate to me, and I quote, “New York is the odds-on favorite.” [Laughter] In that event, not wishing to go against the odds, I will entertain any motion which is restricted to nominating the Federal Reserve Bank of New York!" CHRG-110shrg50414--52 Mr. Cox," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for inviting me here to today to discuss the current turmoil in our markets and our policy responses to it. The extraordinary nature of recent events has required an extraordinary response from both policymakers and regulators. Last week, by unanimous decision of the Commission and with the support of the Secretary of the Treasury and the Federal Reserve, as well as in close coordination with regulators around the world, the SEC took emergency action to ban short selling in financial securities to stabilize markets as you consider this legislation. At the same time, the Commission unanimously approved two additional measures to ease the crisis of confidence in the markets. One makes it easier for issuers to repurchase their own shares on the open market, thus providing additional liquidity. The second requires weekly reporting to the Securities and Exchange Commission by large investment managers of their daily short positions. In addition, the SEC recently issued new rules that more strictly enforce the ban on abusive naked short selling under our Regulation SHO. Beyond these immediate steps, the SEC is vigorously investigating how illegal activities may have contributed to the subprime crisis and the recent instability in our markets. First and foremost, the SEC is a law enforcement agency, and we already have over 50 ongoing investigations in the subprime area alone. The Division of Enforcement has undertaken a sweeping investigation into market manipulation of financial institutions, including through the use of credit default swaps, a multi-trillion-dollar market is completely lacking in transparency and is completely unregulated. Last month, the Enforcement Division, working with State regulators, entered into agreements that will be the largest settlements in SEC history, in behalf of investors who bought auction rate securities from Merrill Lynch, Wachovia, UBS, and Citigroup. Happily, the terms of these agreements would provide complete recovery for individual investors. The Commission also recently brought enforcement actions against portfolio managers at Bear Stearns Asset Management for deceiving investors about the hedge funds' overexposure to subprime mortgages. The Commission is using its regulatory authority simultaneously to ensure that the market continues to function. Last week, the Commission's Office of Chief Accountant provided guidance to clarify the accounting treatment of banks' efforts to support their money market mutual funds. This will help protect investors in those funds. And our examinations of the major credit rating agencies for mortgage-backed securities exposed weaknesses in their ratings processes and led to our sweeping new rules to regulate this industry under the new authority that this Committee and the Congress have given us. We are also moving quickly to mitigate the impact of recent events. In the past week, the SEC oversaw the sale of substantially all of the assets of Lehman Brothers, Inc., to Barclays Capital. Hundreds of thousands of Lehman's customer accounts with over $1 billion in assets can now be transferred in a matter of days, instead of going through a lengthy brokerage liquidation process. With all that has happened, it is important to keep in mind how we got here. The problems that each of these actions has addressed have their roots in the subprime mortgage crisis, which itself was caused by a failure of lending standards. The complete and total mortgage market meltdown that led to the taxpayer rescue of Fannie Mae and Freddie Mac was not built into the stress scenarios and the capital and liquidity standards of any financial institution. Bank risk models in every regulated sector, for better or for worse, failed to incorporate this scenario that has caused so much damage in financial services firms of all kinds. The SEC's own program of voluntary supervision for investment bank holding companies, the Consolidated Supervised Entity program, put in place in 2004, was fundamentally flawed because it adopted these same bank capital liquidity standards and because it was purely voluntary. It became abundantly clear with the near collapse of Bear Stearns that this sort of voluntary regulation does not work. Working with the Federal Reserve, the Division of Trading and Markets moved quickly last spring to strengthen capital and liquidity at investment bank holding companies far beyond what the banking standards require, and we immediately entered into a formal Memorandum of Understanding with the Fed to share both information and expertise. But the fact remains that no law authorizes the SEC to supervise investment bank holding companies let alone to monitor the broader financial system for risk. For the moment, this regulatory hole in the statutory scheme is being addressed in the market by the conversion of investment banks to bank holding companies. But the basic problem must still be addressed in statute by filling that regulatory hole, as I have reported to Congress on previous occasions. I will conclude, Mr. Chairman, by warning of another similar regulatory hole in statute that must be immediately addressed or we will have similar consequences. The $58 trillion notional market in credit default swaps, to which several of you have referred in your opening comments--that is double the amount that was outstanding in 2006--is regulated by absolutely no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This market is ripe for fraud and manipulation, and indeed we are using the full extent of our antifraud authority, our law enforcement authority, right now to investigate this market. Because CDS buyers do not have to own the bond or the debt instrument upon which the contract is based, they can effectively ``naked short'' the debt of companies without any restriction, potentially causing market disruption and destabilizing the companies themselves. As the Congress considers reform of the financial system in the current crisis, I urge you to provide in statute for regulatory authority over the CDS market. This is vitally important to enhance investor protection and to ensure the continued operation of fair and orderly markets. Mr. Chairman, I appreciate the opportunity to discuss the current market turmoil, and I look forward to answering your questions. " CHRG-111shrg52619--96 Mr. Dugan," Senator, as I said before, we certainly did have some institutions that were engaged in subprime lending, and what I said also is that it is a relatively smaller share of overall subprime lending in the home market and what you see. It was roughly ten to 15 percent of all subprime loans in 2005 and 2006, even though we have a much larger share of the mortgage market. I think you will find that of the providers of those loans, the foreclosure rates were lower and were somewhat better underwritten, even though there were problem loans, and I don't deny that at all, and I would say that, historically, the commercial banks, both State and national, were much more heavily intensively regulating and supervising loans, including subprime loans. We had had a very bad experience 10 years ago or so with subprime credit cards, and as a result, we were not viewed as a particularly hospitable place to conduct subprime lending business. So even with organizations that were complex bank holding companies, they tended to do their subprime lending in holding company affiliates rather than in the bank or in the subsidiary of the bank where we regulated them. We did have some, but it turned out it was a much smaller percentage of the overall system than the subprime loans that were actually done. Senator Menendez. Well, subprimes is one thing. The Alternate As is another. Let me ask you this. How many examiners, on-site examiners, did you recently have at Bank of America, at Citi, at Wachovia, at Wells? " CHRG-111hhrg48867--159 Mr. Bartlett," Congressman, let me take them one at a time. We do think that there should be some basic reformulation and convergence, that there should be a prudential supervisor that should supervise banks, insurance, and securities at the national level with uniform national standard. It should follow the ``quack like a duck'' theory. If it quacks like a duck, walks like a duck, and talks like a duck, then it is a duck, and should be regulated like a duck, the same with banks, insurance companies, or securities. And today we have a hodgepodge of chaotic hundreds of agencies that regulate the same kinds of activities in widely different ways. We found, and there is nothing perfect, we think that the Fed is the best equipped to be a systemic regulator, as we have described it, which is no list of--not a list of specific firms, but rather the systemic oversight. We think that is very consistent with their monetary policy, which is the strengthening and the stability of the economy. We do recommend that the regulation of State chartered banks be moved over to the bank regulator. And we have struggled with this. We do think that the bank holding company regulation should stay at the Fed. Probably the main reason for that is just they do it very well and we don't see a reason to change it. And then last is the Federal Reserve has the breadth and the scope and the institutional knowledge of almost a century of understanding both the economy and the financial markets, and we don't think that that can be duplicated or replicated in the space of half a dozen years perhaps. So we think we should use that to the government's advantage. " CHRG-111hhrg56241--86 Mr. Stiglitz," I would like to emphasize two things that we did not do when we turned over money to these banks. First, we didn't relate giving them money to their behavior, not just with respect to the issue of compensation schemes, but also with respect to lending, which was the reason we were giving them money. That relates to the issue of jobs that has come up here a number of times. The fact that compensation went out meant there was less money inside the banks and therefore less ability or willingness to lend. The second point is that the U.S. taxpayer was not, when it gave the banks money, compensated for the risk that they bore. In some cases, we got repaid. But we ought to look at the transaction that Warren Buffet had with Goldman Sachs, which was an arm's-length transaction. If we wanted what would have been a fair compensation to the taxpayer, the bailouts would have reflected the same terms, and we would have gotten back a lot more. Mr. Moore of Kansas. Thank you, sir. I am interested in better understanding how the culture of excessive lending, abusive leverage, and excessive compensation contributed to the financial crisis. This applies across-the-board for consumers who are in over their head with maxed-out credit cards and homes they couldn't afford, to major financial firms leveraged 35 to 1. Is there anything the government can and should do in the future to prevent a similar carefree and irresponsible mindset from taking hold and exposing our financial system to another financial crisis? Professor Bebchuk? " CHRG-111hhrg48875--52 Secretary Geithner," No, I wouldn't frame it that way. Could I step back and frame the broad objective? You know, right now, we have a very resilient, diverse financial system. Parts of the system have a lot of capital. Parts of the system, in the eyes of the market, need some more capital. And what this assessment is designed to do, and this assessment is run by the Fed, not by the Treasury, is to assess what potential losses these institutions might face in the event we faced a deeper recession. And to make sure the government's willing to give, able to provide capital to help backstop the system through this period of time. Most institutions want to go raise any additional capital they may need from the markets, but we're going to make sure that the markets understand that the government will be there with capital if that's necessary. In our judgment, that will help reduce the risk that the system pulls back more from providing the credit that recovery needs. We don't want the system sucking more oxygen out of the economy just as we're trying to lay the foundation for recovery and providing capital to the system is an important part of that. Giving these banks a chance to sell assets into a market will be helpful to restoring confidence in their financial soundness and make it easier, in our judgment, for them to go out and raise private capital, as well. " FOMC20071211meeting--113 111,MR. WARSH.," Thank you, Mr. Chairman. Like many of you, I think that the risks of bad economic outcomes are higher than they were when we met in October, both here in the United States and among our trading partners. The profound deterioration in financial markets—which in my view has changed significantly, more so than the data on the real economy—as been much discussed already. I’ll make two separate observations about that deterioration now versus on the darkest days in August or September. First, we’re seeing a very meaningful preference for Treasuries as opposed to agencies. In our discussions and in the data several months ago, they would have tended to be bundled together, but are putting more pressure on Treasuries in this current environment. Second, it strikes me that more overnight funding is being done by more large financial institutions, and that has to concern us as we talk in the next round about policy. Liquidity conditions have been hurt by several related factors, most of which speak to a lack of confidence. Certainly there are lower expectations about the macroeconomic environment and a lack of confidence in counterparties and in funding through year-end; but perhaps mostly, the escalating risk aversion within the four walls of most, but not all, very large financial institutions has caused this market turmoil, both in the formal banking system and in what President Yellen described as the shadow banking system. So why have these institutions lost faith and so much conviction? I’ll give a few reasons. First, senior management instability. Second, a lack of confidence—by boards, senior managers who are still around, and the rest of their people—in the risk-management systems. There is a growing chasm of confidence between the boards—and those who are around them—about their stress tests and about their ability to withstand a series of shocks that could lead to further deterioration. There is also a very bad risk-reward tradeoff for those who are prepared or have been given some ability to put balance sheet capital to work. If they make a bet and it turns out to be very bad in this environment, their jobs and the jobs of many of their peers will be over. If they make a bet and it turns out to be as good as they expect, they won’t be keeping much of the fruits of that trade. As a result, I think we are finding that key people across institutions—which President Fisher and others talked about as keen to provide opportunistic capital—have stepped back, I would say materially. Finally, it’s not year-end pressures with respect to balance sheets that strike me as having the biggest effect here. It’s that, as these managers are looking at their businesses for 2008, they’re fundamentally having to ask themselves the questions about what businesses they are really in—whether they all should be originators, distributors, and holders of credit and risk or whether they need to go back to where they were five or six years ago, when they were picking their comparative advantages. As they look at the budgets for next year, I think they have a lot of understanding of what their cost structures are if they don’t change their personnel, but they have very little clarity about what their top-line revenue will be. That has led to some serious questions about putting capital to work when you’re really not sure what your core businesses are. I expect that process not to be completed in weeks or months but really in quarters, and it’s for that reason, among others—as Governor Kohn referenced—that I expect this period of relative strain to last for a while. Let me raise a question that I asked at the last FOMC meeting. Are we seeing merely a change in the competitive landscape or a fundamental weakening across classes of financial institutions? I would say that today most large financial institutions, both money center commercial banks and large investment banks, are on the sidelines to some meaningful extent—unable or unwilling to put their balance sheets with any real force to work on new capital or on new projects. They’re likely to be stuck there for a while. Surely there are a few large institutions with both capital and conviction that are opportunistically deploying capital with extremely compelling equity risk premiums. I think about that more as cherry-picking than any interest or ability of these institutions to buy the entire orchard. So they will be survivors, but they are being very, very careful. Is there enough opportunistic credit from those institutions that distinguish themselves, along with classes of other institutions that we talked about today—large foreign banks, U.S. branches, super-regional banks, mid-sized banks, community banks, credit units, the GSEs, the Home Loan Banks—to pick up market share and take advantage of that slack that’s been left for a period? I think in a word the answer is “no.” That is, they will inevitably pick up some market share during this period. This is good news for the institutions that had been crowded out by the money center banks invading some of these regions. But as I look at their own conviction, at their own balance sheets, and importantly, at where their source of credit might come from—from these same capital markets that are in dysfunction—I get encouraged that they can pick up some of the slack, but I wouldn’t expect them to be able to pick up enough for us to avoid the spillover effect to the real economy. It is true that many of these institutions now find business and new loans to be on better terms. They’re price leaders rather than price takers. There is less competition for some of these new C&I loans and some of these new consumer loans. This is a good thing, but again, I wouldn’t overemphasize that they are somehow going to be able to pick up the slack. What about other forms of opportunistic capital, like sovereign wealth funds and hedge funds that are playing an important role in re-liquefying large banks? Again, I see that as part of a solution, but in my view, we’re really still early in that process, and most of those institutions that are out looking for capital are likely to get more rounds of capital in the coming weeks, months, and quarters. The terms of the investment by some of these external funds suggest that this is not the final fund raising but really one of the first. In some ways, this is a much trickier position than if we saw one class of financial institutions that was weaker and thought that others could fill in. Again, the provision of credit normally made possible in this environment by the structured finance markets is affecting all financial intermediaries—the weak, the strong, the regulated, the unregulated, those on Wall Street, and those in other cities. So what does the immediate future hold? Let me spend a moment breaking down a few classes of these institutions. Investment banks first. I expect most of them to be on the sidelines for a while. I expect the 2008 budgets, which are still coming together now, to likely suggest that they are exiting from some businesses and firing employees in larger numbers than markets expect right now. What about large money center commercial banks, particularly those that have been in the headlines? Obviously I would expect them, with some leadership clarity, to take a direction, but these businesses take a very long time to turn. So what will they do? They will continue to prune their balance sheets, continue to sell noncore assets and businesses, continue raising capital, and continue their discussions with rating agencies about meeting rating agencies’ expectations. These rating agencies want to be observers. They no longer want to be market makers or market participants, but I suspect they’re going to find a reversion to the role of some years ago hard to pull off in this environment. What about super-regionals and community banks, which many of you spoke about with some view that their current balance sheets look okay? I think there is a sense of foreboding in that group about their commercial real estate exposures. Even though they are largely open for business, we shouldn’t overstate their ability to pick up some slack. After all, the secondary market is closed for many of them. Their portfolio lending is up. The credit line utilizations are being fully tapped. Their own profit projections are likely to be coming down over 2008, and even though they certainly want to increase market share, they’re reading the same headlines, and my own judgment is they’re likely to be still somewhat worried. In sum, these problems appear to me to have been long in the making—long before they struck the housing markets—and will be somewhat longer in the rebound than we might have thought even some weeks ago. The catalysts for improvement, though, are manifold. First, new leaders with dispassionate views are coming to many of these financial institutions and are willing to sell assets at prices that the leaders who brought them into different businesses might have been unwilling to do. Again, it strikes me that the ability to sell an entire book of business at a fixed dollar amount and run a competitive auction might help clear many of these prices that have otherwise looked pretty stubborn and pretty hard to mark. In terms of other validators that might be coming into these new investments, as I mentioned, I think the raising of equity funds is encouraging, but these validators, particularly those in the United States and some in sovereign wealth funds elsewhere, are pretty patient, and I don’t see any of them thinking that they need to deploy their capital quickly or on terms with which they are uncomfortable because they will have an opportunity to look at tens and dozens more term sheets in the next several quarters. As many of them are making investments now, they have a range of term sheets in front of them, and that judgment won’t be rushed in their view. So the idea that it would be a panacea for the real economy strikes me as a bit overstated in the current environment. So what about the real economy? No doubt the turmoil in financial markets, some of which was self-inflicted, has the potential to do more harm to the broader economy in the fourth quarter and in early next year. But we have to be humble about our understanding of that transmission mechanism. The preceding discussion strikes me as giving less comfort than I had at the last FOMC meeting on the short-term resilience and dynamism of our financial markets to repair themselves quickly. I’m still very optimistic over the forecast period and the medium term, but it puts more of a burden on the resilience and dynamism of our labor markets and more of a focus on the resilience and dynamism of our product markets and of our businesses. They do appear to be holding up okay. In my view, if you look at the various surveys that were referenced earlier today and the Business Roundtable survey of CEOs, these would be much more dire forecasts if we were in recession now than they appear to be at this moment. Most of these CEOs, who are not great at calling inflection points, still think that their business is okay. The economy has slowed; it is riskier; but it strikes me that we have a good shot of being able to follow through on the pattern outlined in the Greenbook. Finally, just let me make a quick note about inflation risks. I think the inflation risks have garnered certainly less of my attention in this intermeeting period and might have garnered even somewhat less of the discussion around this table. The inflation risks that we saw six weeks ago strike me as not having improved very much. Inflation risks are quite real, and so as we are choosing our policy options, we have to keep these in mind. But we obviously have to take the shorter-term risks and the illiquidity in the markets into account first and foremost as we think about both monetary policy and liquidity policy. Thank you, Mr. Chairman." fcic_final_report_full--338 The chief concerns were Lehman’s real estate–related investments and its reliance on short-term funding sources, including . billion of commercial paper and  billion of repos at the end of the first quarter of . There were also concerns about the firm’s more than , derivative contracts with a myriad of counterparties.  As they did for all investments banks, the Fed and SEC asked: Did Lehman have enough capital—real capital, after possible asset write-downs? And did it have suffi- cient liquidity—cash—to withstand the kind of run that had taken down Bear Stearns? Solvency and liquidity were essential and related. If money market funds, hedge funds, and investment banks believed Lehman’s assets were worth less than Lehman’s valuations, they would withdraw funds, demand more collateral, and cur- tail lending. That could force Lehman to sell its assets at fire-sale prices, wiping out capital and liquidity virtually overnight. Bear proved it could happen. “The SEC traditionally took the view that liquidity was paramount in large securi- ties firms, but the Fed, as a consequence of its banking mandate, had more of an em- phasis on capital raising,” Erik Sirri, head of the SEC ’s Division of Trading and Markets, told the FCIC. “Because the Fed had become the de facto primary regulator because of its balance sheet, its view prevailed. The SEC wanted to be collaborative, and so came to accept the Fed’s focus on capital. However, as time progressed, both saw the importance of liquidity with respect to the problems at the large investment banks.”  In fact, both problems had to be resolved. Bear’s demise had precipitated Lehman’s “first real financing difficulties” since the liquidity crisis began in , Lehman Treasurer Paolo Tonucci told the FCIC.  Over the two weeks following Bear’s collapse, Lehman borrowed from the Fed’s new lending facility, the Primary Dealer Credit Facility (PDCF),  but had to be careful to avoid seeming overreliant on the PDCF for cash, which would signal funding problems. Lehman built up its liquidity to  billion at the end of May, but it and Merrill performed the worst among the four investment banks in the regulators’ liquidity stress tests in the spring and summer of . Meanwhile, the company was also working to improve its capital position. First, it reduced real estate exposures (again, excluding real estate held for sale) from  bil- lion to  billion at the end of May and to  billion at the end of the summer. Sec- ond, it raised new capital and longer-term debt—a total of . billion of preferred stock and senior and subordinated debt from April through June . Treasury Undersecretary Robert Steel praised Lehman’s efforts, publicly stating that it was “addressing the issues.”  But other difficulties loomed. Fuld would later describe Lehman’s main problem as one of market confidence, and he suggested that the company’s image was damaged by investors taking “naked short” positions (short selling Lehman’s securities without first borrowing them), hoping Lehman would fail, and potentially even helping it fail by eroding confidence. “Bear went down on ru- mors and a liquidity crisis of confidence,” Fuld told the FCIC. “Immediately there- after, the rumors and the naked short sellers came after us.”  The company pressed the SEC to clamp down on the naked short selling.  The SEC’s Division of Risk, Strategy and Financial Innovation shared with the FCIC a study it did concerning short selling. As Chairman Mary Schapiro explained to the Commission, “We do not have information at this time that manipulative short selling was the cause of the col- lapse of Bear and Lehman or of the difficulties faced by other investment banks dur- ing the fall of .” The SEC to date has not brought short selling charges related to the failure of these investment banks.  FinancialCrisisInquiry--195 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. CHAIRMAN ANGELIDES: So, let’s start with our questioning, and I will lead off. Let me ask each of you a question or two. And, again, brief, succinct, direct. Mr. Zandi, and I shouldn’t do this, but if people haven’t read your book, it’s worth reading, “Financial Shock.” How’s that for a cheap plug? ZANDI: Yes. I hear it’s good on Kindle, too. (LAUGHTER) CHRG-111shrg53822--10 Chairman Dodd," Okay. Let me raise this with both of you, if I can. Peter Wallison is going to testify in our second panel, be a witness in the second panel, and he raises an interesting concern: that a new system that tries to identify, regulate, resolve systemically important financial institutions may create a new class of protected companies that enjoy lower funding costs due to perceived Government backing and the like. I find that idea he has is intriguing, one that needs to be addressed. He sees this framework as expanding the safety net and adding moral hazard to the financial system in a way. Sheila, how do you react to that? Ms. Bair. I think the concern relates to what we are talking about. We are talking about a resolution mechanism, not a bailout mechanism, and we think if you are going to create a new systemic risk regulator and identify it, particularly if that will involve identifying in advance institutions that could be systemic, that to do that without a separate resolution mechanism would dramatically increase moral hazard, because then you would be anointing institutions as those that the Government would continue to step in and support. So we think there needs to be a resolution mechanism that takes care of that, but we would certainly hope that Congress, if you took this step, would clearly set out a claims priority and say that the private stakeholders--the shareholders, and the unsecured creditors--would take losses and the priority for collateralized counterparties, et cetera. Also, the direction should be to resolve the institution promptly, not to just keep it going, but to break it up. I think a good bank/bad bank model would be a good one. We are set up already with our bridge bank authority to do that type of model. There was a good op-ed in the Wall Street Journal yesterday by Glenn Hubbard outlining that type of approach. Others have talked about it as well. But I think we need to be very clear that we are talking about a resolution mechanism, not a bailout mechanism, if we do that. " CHRG-111shrg51395--119 Under high competition, lower ratings declined and investment grade rations soared. The authors conclude that increased competition may impair ``the reputational mechanism that underlies the provision of good quality ratings.'' \28\--------------------------------------------------------------------------- \28\ Id. at 21.--------------------------------------------------------------------------- The anecdotal evidence supports a similar conclusion: the major rating agencies responded to the competitive threat from Fitch by making their firms ``more client-friendly and focused on market share.'' \29\ Put simply, the evidence implies that the rapid change toward a more competitive environment made the competitors not more faithful to investors, but more dependent on their immediate clients, the issuers. From the standpoint of investors, agency costs increased.--------------------------------------------------------------------------- \29\ See ``Ratings Game--As Housing Boomed, Moody's Opened Up,'' The Wall Street Journal, April 11, 2008, at p. A-1.---------------------------------------------------------------------------The Responsibility of the SEC Each of the major investment banks that failed, merged, or converted into bank holding companies in 2008 had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War era. Yet, each either failed or was gravely imperiled within the same basically 6 month period following the collapse of Bear Stearns in March 2008. \30\--------------------------------------------------------------------------- \30\ For a concise overview of these developments, see Jon Hilsenrath, Damian Palette, and Aaron Lucchetti, ``Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid To Ride Out Crisis,'' The Wall Street Journal, September 22, 2008, at p. A-1 (concluding that independent investment banks could not survive under current market conditions and needed closer regulatory supervision to establish credibility).--------------------------------------------------------------------------- If their uniform collapse is not alone enough to suggest the likelihood of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC's Consolidated Supervised Entity (``CSE'') Program, which was established by the SEC in 2004 for only the largest investment banks. \31\ Indeed, these five investment banks were the only investment banks permitted by the SEC to enter the CSE program. A key attraction of the CSE Program was that it permitted its members to escape the SEC's traditional net capital rule, which placed a maximum ceiling on their debt to equity ratios, and instead elect into a more relaxed ``alternative net capital rule'' that contained no similar limitation. \32\ The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly over the brief two year period following their entry into the CSE Program, as shown by Figure 1 below: \33\--------------------------------------------------------------------------- \31\ See Securities Exchange Act Release No. 34-49830 (June 21, 2004), 69 FR 34428 (``Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities''). \32\ The SEC's ``net capital rule,'' which dates back to 1975, governs the capital adequacy and aggregate indebtedness permitted for most broker-dealers. See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''). 17 C.F.R. 240.15c3-1. Under subparagraph (a)(1)(i) of this rule, aggregate indebtedness is limited to fifteen times the broker-dealer's net capital; a broker-dealer may elect to be governed instead by subparagraph (a)(1)(ii) of this rule, which requires it maintain its net capital at not less than the greater of $250,000 or two percent of ``aggregate debit items'' as computed under a special formula that gives ``haircuts'' (i.e., reduces the valuation) to illiquid securities. Both variants place fixed limits on leverage. \33\ This chart comes from U.S. Securities and Exchange Commission, Office of the Inspector General, ``SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program'' (`Report No. 446-A, September 25, 2008) (hereinafter ``SEC Inspector General Report'') at Appendix IX at p. 120. For example, at the time of its insolvency, Bear Stearns' gross leverage ratio had hit 33 to 1. \34\--------------------------------------------------------------------------- \34\ See SEC Inspector General Report at 19.--------------------------------------------------------------------------- The above chart likely understates the true increase in leverage because gross leverage (i.e., assets divided by equity) does not show the increase in off-balance sheet liabilities, as the result of conduits and liquidity puts. Thus, another measure may better show the sudden increase in risk. One commonly used metric for banks is the bank's value at risk (VaR) estimate, which banks report to the SEC in their annual report on Form 10-K. This measure is intended to show the risk inherent in their financial portfolios. The chart below shows ``Value at Risk'' for the major underwriters over the interval 2004 to 2007: \35\--------------------------------------------------------------------------- \35\ See Ferrell, Bethel, and Hu, supra note 15, at Table 8. Value at risk estimates have proven to be inaccurate predictors of the actual writedowns experienced by banks. They are cited here not because they are accurate estimates of risk, but because the percentage increases at the investment banks was generally extreme. Even Goldman Sachs, which survived the crisis in better shape than its rivals, saw its VaR estimate more than double over this period. Value at Risk, 2004-2007------------------------------------------------------------------------ 2004 2005 2006 2007 Firms ($mil) ($mil) ($mil) ($mil)------------------------------------------------------------------------Bank of America................. $44.1 $41.8 $41.3 -Bear Stearns.................... 14.8 21.4 28.8 $69.3Citigroup....................... 116.0 93.0 106.0 -Credit Suisse................... 55.1 66.2 73.0 -Deutsche Bank................... 89.8 82.7 101.5 -Goldman Sachs................... 67.0 83.0 119.0 134.0JPMorgan........................ 78.0 108.0 104.0 -Lehman Brothers................. 29.6 38.4 54.0 124.0Merrill Lynch................... 34.0 38.0 52.0 -Morgan Stanley.................. 94.0 61.0 89.0 83.0UBS............................. 103.4 124.7 132.8 -Wachovia........................ 21.0 18.0 30.0 -------------------------------------------------------------------------VaR statistics are reported in the 10K or 20F (in the case of foreign firms) of the respective firms. Note that the firms use different assumptions in computing their Value of Risk. Some annual reports are not yet avaialble for 2007. Between 2004 and 2007, both Bear Stearns and Lehman more than quadrupled their value at risk estimates, while Merrill Lynch's figure also increased significantly. Not altogether surprisingly, they were the banks that failed. These facts provide some corroboration for an obvious hypothesis: excessive deregulation by the SEC caused the liquidity crisis that swept the global markets in 2008. \36\ Still, the problem with this simple hypothesis is that it may be too simple. Deregulation did contribute to the 2008 financial crisis, but the SEC's adoption of the CSE Program in 2004 was not intended to be deregulatory. Rather, the program was intended to compensate for earlier deregulatory efforts by Congress that had left the SEC unable to monitor the overall financial position and risk management practices of the nation's largest investment banks. Still, even if the 2004 net capital rule changes were not intended to be deregulatory, they worked out that way in practice. The ironic bottom line is that the SEC unintentionally deregulated by introducing an alternative net capital rule that it could not effectively monitor.--------------------------------------------------------------------------- \36\ For the bluntest statement of this thesis, see Stephen Labaton, ``S.E.C. Concedes Oversight Plans Fueled Collapse,'' New York Times, September 27, 2008, at p. 1. Nonetheless, this analysis is oversimple. Although SEC Chairman Cox did indeed acknowledge that there were flaws in the ``Consolidated Supervised Entity'' Program, he did not concede that it ``fueled'' the collapse or that it represented deregulation. As discussed below, the SEC probably legitimately believed that it was gaining regulatory authority from the CSE Program (but it was wrong).--------------------------------------------------------------------------- The events leading up to the SEC's decision to relax its net capital rule for the largest investment banks began in 2002, when the European Union adopted its Financial Conglomerates Directive. \37\ The main thrust of the E.U.'s new directive was to require regulatory supervision at the parent company level of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or insurance company). The E.U.'s entirely reasonable fear was that the parent company might take actions that could jeopardize the solvency of the regulated subsidiary. The E.U.'s directive potentially applied to the major U.S. investment and commercial banks because all did substantial business in London (and elsewhere in Europe). But the E.U.'s directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed ``equivalent'' to that envisioned by the directive. For the major U.S. commercial banks (several of which operated a major broker-dealer as a subsidiary), this afforded them an easy means of avoiding group-wide supervision by regulators in Europe, because they were subject to group-level supervision by U.S. banking regulators.--------------------------------------------------------------------------- \37\ See Council Directive 2002/87, Financial Conglomerates Directive, 2002 O.J. (L 35) of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives. For an overview of this directive and its rationale, see Jorge E. Vinuales, The International Regulation of Financial Conglomerates: A Case Study of Equivalence as an Approach to Financial Integration, 37 Cal. W. Int'l L.J. 1, at 2 (2006).--------------------------------------------------------------------------- U.S. investment banks had no similar escape hatch, as the SEC had no similar oversight over their parent companies. Thus, fearful of hostile regulation by some European regulators, \38\ U.S. investment banks lobbied the SEC for a system of ``equivalent'' regulation that would be sufficient to satisfy the terms of the directive and give them immunity from European oversight. \39\ For the SEC, this offered a serendipitous opportunity to oversee the operations of investment bank holding companies, which authority the SEC had sought for some time. Following the repeal of the Glass-Steagall Act, the SEC had asked Congress to empower it to monitor investment bank holding companies, but it had been rebuffed. Thus, the voluntary entry of the holding companies into the Consolidated Supervised Entity program must have struck the SEC as a welcome development, and Commission unanimously approved the program without any partisan disagreement. \40\--------------------------------------------------------------------------- \38\ Different European regulators appear to have been feared by different entities. Some commercial banks saw French regulation as potentially hostile, while U.S. broker-dealers, all largely based in London, did not want their holding companies to be overseen by the U.K.'s Financial Services Agency (FSA). \39\ See Stephen Labaton, ``Agency's '04 Rule Let Banks Pile Up Debt and Risk,'' New York Times, October 3, 2008, at A-1 (describing major investment banks as having made an ``urgent plea'' to the SEC in April, 2004). \40\ See Securities Exchange Act Release No. 34-49830, supra note 31.--------------------------------------------------------------------------- But the CSE Program came with an added (and probably unnecessary) corollary: Firms that entered the CSE Program were permitted to adopt an alternative and more relaxed net capital rule governing their debt to net capital ratio. Under the traditional net capital rule, a broker-dealer was subject to fixed ceilings on its permissible leverage. Specifically, it either had to (a) maintain aggregate indebtedness at a level that could not exceed fifteen times net capital, \41\ or (b) maintain minimum net capital equal to not less than two percent of ``aggregate debit items.'' \42\ For most broker-dealers, this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin.--------------------------------------------------------------------------- \41\ See Rule 15c3-1(a)(1)(i)(``Alternative Indebtedness Standard''), 17 C.F.R. 240.15c3-1(a)(1). \42\ See Rule 15c3-1(a)(1)(ii)(``Alternative Standard''), 17 C.F.R. 240.15c3-1(a)(1)(ii). This alternative standard is framed in terms of the greater of $250,000 or 2 percent, but for any investment bank of any size, 2 percent will be the greater. Although this alternative standard may sound less restrictive, it was implemented by a system of ``haircuts'' that wrote down the value of investment assets to reflect their illiquidity.--------------------------------------------------------------------------- Why did the SEC allow the major investment banks to elect into an alternative regime that placed no outer limit on leverage? Most likely, the Commission was principally motivated by the belief that it was only emulating the more modern ``Basel II'' standards that the Federal Reserve Bank and European regulators were then negotiating. To be sure, the investment banks undoubtedly knew that adoption of Basel II standards would permit them to increase leverage (and they lobbied hard for such a change). But, from the SEC's perspective, the goal was to design the CSE Program to be broadly consistent with the Federal Reserve's oversight of bank holding companies, and the program even incorporated the same capital ratio that the Federal Reserve mandated for bank holding companies. \43\ Still, the Federal Reserve introduced its Basel II criteria more slowly and gradually, beginning more than a year later, while the SEC raced in 2004 to introduce a system under which each investment bank developed its own individualized credit risk model. Today, some believe that Basel II represents a flawed model even for commercial banks, while others believe that, whatever its overall merits, it was particularly ill-suited for investment banks. \44\--------------------------------------------------------------------------- \43\ See SEC Inspector General Report at 10-11. Under these standards, a ``well-capitalized'' bank was expected to maintain a 10 percent capital ratio. Id. at 11. Nonetheless, others have argued that Basel II ``was not designed to be used by investment banks'' and that the SEC ``ought to have been more careful in moving banks on to the new rules.'' See ``Mewling and Puking: Bank Regulation,'' The Economist, October 25, 2008 (U.S. Edition). \44\ For the view that Basel II excessively deferred to commercial banks to design their own credit risk models and their increase leverage, see Daniel K. Tarullo, BANKING ON BASEL: The Future of International Financial Regulation (2008). Mr. Tarullo has recently been nominated by President Obama to the Board of Governors of the Federal Reserve Board. For the alternative view, that Basel II was uniquely unsuited for investment banks, see ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Yet, what the evidence demonstrates most clearly is that the SEC simply could not implement this model in a fashion that placed any real restraint on its subject CSE firms. The SEC's Inspector General examined the failure of Bear Stearns and the SEC's responsibility therefor and reported that Bear Stearns had remained in compliance with the CSE Program's rules at all relevant times. \45\ Thus, if Bear Stearns had not cheated, this implied (as the Inspector General found) that the CSE Program, itself, had failed. The key question is then what caused the CSE Program to fail. Here, three largely complementary hypotheses are plausible. First, the Basel II Accords may be flawed, either because they rely too heavily on the banks' own self-interested models of risk or on the highly conflicted ratings of the major credit rating agencies. \46\ Second, even if Basel II made sense for commercial banks, it may have been ill-suited for investment banks. \47\ Third, whatever the merits of Basel II in theory, the SEC may have simply been incapable of implementing it.--------------------------------------------------------------------------- \45\ SEC Inspector General Report, 10. \46\ The most prominent proponent of this view is Professor Daniel Tarullo. See supra note 44. \47\ See ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Clearly, however, the SEC moved faster and farther to defer to self-regulation by means of Basel II than did the Federal Reserve. \48\ Clearly also, the SEC's staff was unable to monitor the participating investment banks closely or to demand specific actions by them. Basel II's approach to the regulation of capital adequacy at financial institutions contemplated close monitoring and supervision. Thus, the Federal Reserve assigns members of its staff to maintain an office within a regulated bank holding company in order to provide constant oversight. In the case of the SEC, a team of only three SEC staffers were assigned to each CSE firm \49\ (and a total of only thirteen individuals comprised the SEC's Office of Prudential Supervision and Risk Analysis that oversaw and conducted this monitoring effort). \50\ From the start, it was a mismatch: three SEC staffers to oversee an investment bank the size of Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned. \51\--------------------------------------------------------------------------- \48\ The SEC adopted its CSE program in 2004. The Federal Reserve only agreed in principle to Basel II in late 2005. See Stavros Gadinis, The Politics of Competition in International Financial Regulation, 49 Harv. Int'l L. J. 447, 507 n. 192 (2008). \49\ SEC Inspector General Report at 2. \50\ Id. Similarly, the Office of CSE Inspectors had only seven staff. Id. \51\ Moreover, the process effectively ceased to function well before the 2008 crisis hit. After SEC Chairman Cox re-organized the CSE review process in the Spring of 2007, the staff did not thereafter complete ``a single inspection.'' See Labaton, supra note 39.--------------------------------------------------------------------------- This mismatch was compounded by the inherently individualized criteria upon which Basel II relies. Instead of applying a uniform standard (such as a specific debt to equity ratio) to all financial institutions, Basel II contemplated that each regulated financial institution would develop a computer model that would generate risk estimates for the specific assets held by that institution and that these estimates would determine the level of capital necessary to protect that institution from insolvency. Thus, using the Basel II methodology, the investment bank generates a mathematical model that crunches historical data to evaluate how risky its portfolio assets were and how much capital it needed to maintain to protect them. Necessarily, each model was ad hoc, specifically fitted to that specific financial institution. But no team of three SEC staffers was in a position to contest these individualized models or the historical data used by them. Effectively, the impact of the Basel II methodology was to shift the balance of power in favor of the management of the investment bank and to diminish the negotiating position of the SEC's staff. Whether or not Basel II's criteria were inherently flawed, it was a sophisticated tool that was beyond the capacity of the SEC's largely legal staff to administer effectively. The SEC's Inspector General's Report bears out this critique by describing a variety of instances surrounding the collapse of Bear Stearns in which the SEC's staff did not respond to red flags that the Inspector General, exercising 20/20 hindsight, considered to be obvious. The Report finds that although the SEC's staff was aware that Bear Stearns had a heavy and increasing concentration in mortgage securities, it ``did not make any efforts to limit Bear Stearns mortgage securities concentration.'' \52\ In its recommendations, the Report proposed both that the staff become ``more skeptical of CSE firms' risk models'' and that it ``develop additional stress scenarios that have not already been contemplated as part of the prudential regulation process.'' \53\--------------------------------------------------------------------------- \52\ SEC Inspector General Report at ix. \53\ SEC Inspector General Report at ix.--------------------------------------------------------------------------- Unfortunately, the SEC Inspector General Report does not seem realistic on this score. The SEC's staff cannot really hope to regulate through gentle persuasion. Unlike a prophylactic rule (such as the SEC's traditional net capital rule that placed a uniform ceiling on leverage for all broker-dealers), the identification of ``additional stress scenarios'' by the SEC's staff does not necessarily lead to specific actions by the CSE firms; rather, such attempts at persuasion are more likely to produce an extended dialogue, with the SEC's staff being confronted with counter-models and interpretations by the financial institution's managers. The unfortunate truth is that in an area where financial institutions have intense interests (such as over the question of their maximum permissible leverage), a government agency in the U.S. is unlikely to be able to obtain voluntary compliance. This conclusion is confirmed by a similar assessment from the individual with perhaps the most recent experience in this area. Testifying in September, 2008 testimony before the Senate Banking Committee, SEC Chairman Christopher Cox emphasized the infeasibility of voluntary compliance , expressing his frustration with attempts to negotiate issues such as leverage and risk management practices with the CSE firms. In a remarkable statement for a long-time proponent of deregulation, he testified: Beyond highlighting the inadequacy of the . . . CSE program's capital and liquidity requirements, the last six months--during which the SEC and the Federal Reserve worked collaboratively with each of the CSE firms . . . --have made abundantly clear that voluntary regulation doesn't work. \54\--------------------------------------------------------------------------- \54\ See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing, and Urban Affairs, United States Senate, September 23, 2008 (``Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions''), at p. 4 (available at www.sec.gov) (emphasis added). Chairman Cox has repeated this theme in a subsequent Op/Ed column in the Washington Post, in which he argued that ``Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed.'' See Christopher Cox, ``Reinventing A Market Watchdog,'' the Washington Post, November 4, 2008, at A-17. His point was that the SEC had no inherent authority to order a CSE firm to reduce its debt to equity ratio or to keep it in the CSE Program. \55\ If it objected, a potentially endless regulatory negotiation might only begin.--------------------------------------------------------------------------- \55\ Chairman Cox added in the next sentence of his Senate testimony: ``There is simply no provision in the law authorizes the CSE Program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage.'' Id. This is true, but if a CSE firm left the CSE program, it would presumably become subject to European regulation; thus, the system was not entirely voluntary and the SEC might have used the threat to expel a non-compliant CSE firm. The SEC's statements about the degree of control they had over participants in the CSE Program appear to have been inconsistent over time and possibly defensively self-serving. But clearly, the SEC did not achieve voluntary compliance.--------------------------------------------------------------------------- Ultimately, even if one absolves the SEC of ``selling out'' to the industry in adopting the CSE Program in 2004, it is still clear at a minimum that the SEC lacked both the power and the expertise to restrict leverage by the major investment banks, at least once the regulatory process began with each bank generating its own risk model. Motivated by stock market pressure and the incentives of a short-term oriented executive compensation system, senior management at these institutions affectively converted the process into self-regulation. One last factor also drove the rush to increased leverage and may best explain the apparent willingness of investment banks to relax their due diligence standards: competitive pressure and the need to establish a strong market share in a new and expanding market drove the investment banks to expand recklessly. For the major players in the asset-backed securitization market, the long-term risk was that they might be cut off from their source of supply, if loan originators were acquired by or entered into long-term relationships with their competitors, particularly the commercial banks. Needing an assured source of supply, some investment banks (most notably Lehman and Merrill, Lynch) invested heavily in acquiring loan originators and related real estate companies, thus in effect vertically integrating. \56\ In so doing, they assumed even greater risk by increasing their concentration in real estate and thus their undiversified exposure to a downturn in that market. This need to stay at least even with one's competitors best explains the now famous line uttered by Charles Prince, the then CEO of Citigroup in July, 2007, just as the debt market was beginning to collapse. Asked by the Financial Times if he saw a liquidity crisis looming, he answered:--------------------------------------------------------------------------- \56\ See Terry Pristin, ``Risky Real Estate Deals Helped Doom Lehman,'' N.Y. Times, September 17, 2008, at C-6 (discussing Lehman's expensive, multi-billion dollar acquisition of Archstone-Smith); Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' N.Y. Times, November 9, 2008, at B4-1 (analyzing Merrill Lynch's failure and emphasizing its acquisitions of loan originators). When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. \57\--------------------------------------------------------------------------- \57\ See Michiyo Nakamoto & David Wighton, ``Citigroup Chief Stays Bullish on Buy-Outs,'' Financial Times, July 9, 2007, available at http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html In short, competition among the major investment banks can periodically produce a mad momentum that sometimes leads to a lemmings-like race over the cliff. \58\ This in essence had happened in the period just prior to the 2000 dot.com bubble, and again during the accounting scandals of 2001-2002, and this process repeated itself during the subprime mortgage debacle. Once the market becomes hot, the threat of civil liability--either to the SEC or to private plaintiffs in securities class actions--seems only weakly to constrain this momentum. Rationalizations are always available: ``real estate prices never fall;'' ``the credit rating agencies gave this deal a `Triple A' rating,'' etc. Explosive growth and a decline in professional standards often go hand in hand. Here, after 2000, due diligence standards appear to have been relaxed, even as the threat of civil liability in private securities litigation was growing. \59\--------------------------------------------------------------------------- \58\ Although a commercial bank, Citigroup was no exception this race, impelled by the high fee income it involved. From 2003 to 2005, ``Citigroup more than tripled its issuing of C.D.O.s to more than $30 billion from $6.28 billion.'' See Eric Dash and Julie Creswell, ``Citigroup Pays for a Rush to Risk'' New York Times, November 22, 2008, at 1, 34. In 2005 alone, the New York Times estimates that Citigroup received over $500 million in fee income from these C.D.O. transactions. From being the sixth largest issuer of C.D.O.s in 2003, it rose to being the largest C.D.O. issuer worldwide by 2007, issuing in that year some $49.3 billion out of a worldwide total of $442.3 billion (or slightly over 11 percent of the world volume). Id. at 35. What motivated this extreme risk-taking? Certain of the managers running Citigroup's securitization business received compensation as high as $34 million per year (even though they were not among the most senior officers of the bank). Id. at 34. This is consistent with the earlier diagnosis that equity compensation inclines management to accept higher and arguably excessive risk. At the highest level of Citigroup's management, the New York Times reports that the primary concern was ``that Citigroup was falling behind rivals like Morgan Stanley and Goldman.'' Id. at 34 (discussing Robert Rubin and Charles Prince's concerns). Competitive pressure is, of course, enforced by the stock market and Wall Street's short-term system of bonus compensation. The irony then is that a rational strategy of deleveraging cannot be pursued by making boards and managements more sensitive to shareholder desires. \59\ From 1996 to 1999, the settlements in securities class actions totaled only $1.7 billion; thereafter, aggregate settlements rose exponentially, hitting a peak of $17.1 billion in 2006 alone. See Laura Simmons & Ellen Ryan, ``Securities Class Action Settlements: 2006, Review and Analysis'' (Cornerstone Research 2006) at 1. This decline of due diligence practices as liability correspondingly increased seems paradoxical, but may suggest that at least private civil liability does not effectively deter issuers or underwriters.--------------------------------------------------------------------------- As an explanation for an erosion in professional standards, competitive pressure applies with particular force to those investment banks that saw asset-back securitizations as the core of their future business model. In 2002, a critical milestone was reached, as in that year the total amount of debt securities issued in asset-backed securitizations equaled (and then exceeded in subsequent years) the total amount of debt securities issued by public corporations. \60\ Debt securitizations were not only becoming the leading business of Wall Street, as a global market of debt purchasers was ready to rely on investment grade ratings from the major credit rating agencies, but they were particularly important for the independent investment banks in the CSE Program.--------------------------------------------------------------------------- \60\ For a chart showing the growth of asset-backed securities in relation to conventional corporate debt issuances over recent years, see J. Coffee, J. Seligman, and H. Sale, SECURITIES REGULATION: Case and Materials (10th ed. 2006) at p. 10.--------------------------------------------------------------------------- Although all underwriters anticipated high rates of return from securitizations, the independent underwriters had gradually been squeezed out of their traditional line of business--underwriting corporate securities--in the wake of the step-by-step repeal of the Glass-Steagall Act. Beginning well before the formal repeal of that Act in 1999, the major commercial banks had been permitted to underwrite corporate debt securities and had increasingly exploited their larger scale and synergistic ability to offer both bank loans and underwriting services to gain an increasing share of this underwriting market. Especially for the smaller investment banks (e.g., Bear Stearns and Lehman), the future lay in new lines of business, where, as nimble and adaptive competitors, they could steal a march on the larger and slower commercial banks. To a degree, both did, and Merrill eagerly sought to follow in their wake. \61\ To stake out a dominant position, the CEOs of these firms adopted a ``Damn-the-torpedoes-full-speed-ahead'' approach that led them to make extremely risky acquisitions. Their common goal was to assure themselves a continuing source of supply of subprime mortgages to securitize, but in pursuit of this goal, both Merrill Lynch and Lehman made risky acquisitions, in effect vertically integrating into the mortgage loan origination field. These decisions, plus their willingness to acquire mortgage portfolios well in advance of the expected securitization transaction, left them undiversified and exposed to large writedowns when the real estate market soured.--------------------------------------------------------------------------- \61\ For a detailed description of Merrill, Lynch's late entry into the asset-backed securitization field and its sometimes frenzied attempt to catch up with Lehman by acquiring originators of mortgage loans, see Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' New York Times, November 9, 2008, at BU-1. Merrill eventually acquired an inventory of $71 billion in risky mortgages, in part through acquisitions of loan originators. By mid-2008, an initial writedown of $7.9 billion forced the resignation of its CEO. As discussed in this New York Times article, loan originators dealing with Merrill believed it did not accurately understand the risks of their field. For Lehman's similar approach to acquisitions of loan originators, see text and note, supra, at note 56.---------------------------------------------------------------------------Regulatory Modernization: What Should Be Done?An Overview of Recent Developments Financial regulation in the major capital markets today follows one of three basic organizational models: The Functional/Institutional Model: In 2008, before the financial crisis truly broke, the Treasury Department released a major study of financial regulation in the United States. \62\ This document (known as the ``Blueprint'') correctly characterized the United States as having a ``current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures.'' \63\ Unfortunately, even this critical assessment may understate the dimensions of this problem of fragmented authority. In fact, the U.S. falls considerably short of even a ``functional'' regulatory model. By design, ``functional'' regulation seeks to subject similar activities to regulation by the same regulator. Its premise is that no one regulator can have, or easily develop, expertise in regulating all aspects of financial services. Thus, the securities regulator understands securities, while the insurance regulator has expertise with respect to the very different world of insurance. In the Gramm-Leach-Bliley Act of 1999 (``GLBA''), which essentially repealed the Glass-Steagall Act, Congress endorsed such a system of functional regulation. \64\--------------------------------------------------------------------------- \62\ The Department of the Treasury, Blueprint for Modernized Financial Regulatory Structure (2008) (hereinafter, ``Blueprint''). \63\ Id. at 4 and 27. \64\ The Conference Report to the Gramm-Leach-Bliley Act clearly states this: Both the House and Senate bills generally adhere to the principle of functional regulation, which holds that similar activities should be regulated by the same regulator. Different regulators have expertise at supervising different activities. It is inefficient and impractical to expect a regulator to have or develop expertise in regulating all aspects of financial services. H.R. Rep. No. 106-434, at 157 (1999), reprinted in 1999 U.S.C.C.A.N. 1252.--------------------------------------------------------------------------- Nonetheless, the reality is that the United States actually has a hybrid system of functional and institutional regulation. \65\ The latter approach looks not to functional activity, but to institutional type. Institutional regulation is seldom the product of deliberate design, but rather of historical contingency, piecemeal reform, and gradual evolution.--------------------------------------------------------------------------- \65\ For this same assessment, see Heidi Mandanis Schooner & Michael Taylor, United Kingdom and United States Responses to the Regulatory Challenges of Modern Financial Markets, 38 Tex. Int'l L. J. 317, 328 (2003).--------------------------------------------------------------------------- To illustrate this difference between functional and institutional regulation, let us hypothesize that, under a truly functional system, the securities regulator would have jurisdiction over all sales of securities, regardless of the type of institution selling the security. Conversely, let us assume that under an institutional system, jurisdiction over sales would be allocated according to the type of institution doing the selling. Against that backdrop, what do we observe today about the allocation of jurisdiction? Revealingly, under a key compromise in GLBA, the SEC did not receive general authority to oversee or enforce the securities laws with respect to the sale of government securities by a bank. \66\ Instead, banking regulators retained that authority. Similarly, the drafters of the GLBA carefully crafted the definitions of ``broker'' and ``dealer'' in the Securities Exchange Act of 1934 to leave significant bank securities activities under the oversight of bank regulators and not the SEC. \67\ Predictably, even in the relatively brief time since the passage of GLBA in 1999, the SEC and bank regulators have engaged in a continuing turf war over the scope of the exemptions accorded to banks from the definition of ``broker'' and ``dealer.'' \68\--------------------------------------------------------------------------- \66\ See 15 U.S.C. 78o-5(a)(1)(B), 15 U.S.C. 78(c)(a)(34)(G), and 15 U.S.C. 78o-5(g)(2). \67\ See 15 U.S.C. 78(c)(a)(4),(5). \68\ See Kathleen Day, Regulators Battle Over Banks: 3 Agencies Say SEC Rules Overstep Securities-Trading Law, Wash. Post, July 3, 2001, at E3. Eventually, the SEC backed down in this particular skirmish and modified its original position. See Securities Exch. Act Release No. 34-44570 (July 18, 2001) and Securities Exchange Age Release No. 34-44291, 66 Fed. Reg. 27760 (2001).--------------------------------------------------------------------------- None of this should be surprising. The status quo is hard to change, and regulatory bodies do not surrender jurisdiction easily. As a result, the regulatory body historically established to regulate banks will predictably succeed in retaining much of its authority over banks, even when banks are engaged in securities activities that from a functional perspective should belong to the securities regulator. ``True'' functional regulation would also assign similar activities to one regulator, rather than divide them between regulators based on only nominal differences in the description of the product or the legal status of the institution. Yet, in the case of banking regulation, three different federal regulators oversee banks: the Office of the Controller of the Currency (``OCC'') supervises national banks; the Federal Reserve Board (``FRB'') oversees state-chartered banks that are members of the Federal Reserve System and the Federal Deposit Insurance Corporation (``FDIC'') supervises state-chartered banks that are not members of the Federal Reserve System but are federally insured. \69\ Balkanization does not stop there. The line between ``banks,'' with their three different regulators at the federal level, and ``thrifts,'' which the Office of Thrift Supervision (``OTS'') regulates, is again more formalistic than functional and reflects a political compromise more than a difference in activities.--------------------------------------------------------------------------- \69\ This is all well described in the Blueprint. See Blueprint, supra note 62, at 31-41.--------------------------------------------------------------------------- Turning to securities regulation, one encounters an even stranger anomaly: the United States has one agency (the SEC) to regulate securities and another (the Commodities Future Trading Commission (CFTC)) to regulate futures. The world of derivatives is thereby divided between the two, with the SEC having jurisdiction over options, while the CFTC has jurisdiction over most other derivatives. No other nation assigns futures and securities regulation to different regulators. For a time, the SEC and CFTC both asserted jurisdiction over a third category of derivatives--swaps--but in 2000 Congress resolved this dispute by placing their regulation largely beyond the reach of both agencies. Finally, some major financial sectors (for example, insurance and hedge funds) simply have no federal regulator. By any standard, the United States thus falls well short of a true system of functional regulation, because deregulation has placed much financial activity beyond the reach of any federal regulator. Sensibly, the Blueprint proposes to rationalize this patchwork-quilt structure of fragmented authority through the merger and consolidation of agencies. Specifically, it proposes both a merger of the SEC and CFTC and a merger of the OCC and the OTS. Alas, such mergers are rarely politically feasible, and to date, no commentator (to our knowledge) has predicted that these proposed mergers will actually occur. Thus, although the Blueprint proposes that we move beyond functional regulation, the reality is that we have not yet approached even a system of functional regulation, as our existing financial regulatory structure is organized at least as much by institutional category as by functional activity. Disdaining a merely ``functional'' reorganization under which banking, insurance, and securities would each be governed by their own federal regulator, the Blueprint instead envisions a far more comprehensive consolidation of all these specialized regulators. Why? In its view, the problems with functional regulation are considerable: A functional approach to regulation exhibits several inadequacies, the most significant being the fact that no single regulator possesses all the information and authority necessary to monitor systemic risk, or the potential that events associated with financial institutions may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected. \70\--------------------------------------------------------------------------- \70\ Blueprint, supra note 62, at 4.--------------------------------------------------------------------------- But beyond these concerns about systemic risk, the architects of the Blueprint were motivated by a deeper anxiety: regulatory reform is necessary to maintain the capital market competitiveness of the United States. \71\ In short, the Blueprint is designed around two objectives: (1) the need to better address systemic risk and the possibility of a cascading series of defaults, and (2) the need to enhance capital market competitiveness. As discussed later, the first concern is legitimate, but the second involves a more dubious logic.--------------------------------------------------------------------------- \71\ In particular, the Blueprint hypothesizes that the U.K. has enhanced its own competitiveness by regulatory reforms, adopted in 2000, that are principles-based and rely on self regulation for their implementation. Id. at 3.--------------------------------------------------------------------------- The Consolidated Financial Services Regulator: A clear trend is today evident towards the unification of supervisory responsibilities for the regulation of banks, securities markets and insurance. \72\ Beginning in Scandinavia in the late 1980s, \73\ this trend has recently led the United Kingdom, Japan, Korea, Germany and much of Eastern Europe to move to a single regulator model. \74\ Although there are now a number of precedents, the U.K. experience stands out as the most influential. It was the first major international market center to move to a unified regulator model, \75\ and the Financial Services and Markets Act, adopted in 2000, went significantly beyond earlier precedents towards a ``nearly universal regulator.'' \76\ The Blueprint focuses on the U.K.'s experience because it believes that the U.K.'s adoption of a consolidated regulatory structure ``enhanced the competitiveness of the U.K. economy.'' \77\--------------------------------------------------------------------------- \72\ For recent overviews, see Ellis Ferran, Symposium: Do Financial Supermarkets Need Super-Regulators? Examining the United Kingdom's Experience in Adopting the Single Financial Regulator Model, 28 Brook. J. Int'l L. 257, 257-59 (2003); Jerry W. Markham, A Comparative Analysis of Consolidated and Functional Regulation: Super Regulator: A Comparative Analysis of Securities and Derivative Regulation in the United States, the United Kingdom, and Japan, 28 Brook. J. Int'l L. 319, 319-20 (2003); Giorgio Di Giorgio & Carmine D. Noia, Financial Market Regulation and Supervision: How Many Peaks for the Euro Area?, 28 Brook. J. Int'l L. 463, 469-78 (2003). \73\ Norway moved to an integrated regulatory agency in 1986, followed by Denmark in 1988, and Sweden in 1991. See D. Giorgio & D. Noia, supra note 72, at 469-478. \74\ See Bryan D. Stirewalt & Gary A. Gegenheimer, Consolidated Supervision of Banking Groups in the Former Soviet Republics: A Comparative Examination of the Emerging Trend in Emerging Markets, 23 Ann. Rev. Banking & Fin. L. 533, 548-49 (2004). As discussed later, in some countries (most notably Japan), the change seems more one of form than of substance, with little in fact changing. See Markham, supra note 72, at 383-393, 396. \75\ See Ferran, supra note 72, at 258. \76\ See Schooner & Taylor, supra note 65, at 329. Schooner and Taylor also observe that the precursors to the U.K.'s centralized regulator, which were mainly in Scandinavia, had a ``predominantly prudential focus.'' Id. at 331. That is, the unified new regulator was more a guardian of ``safety and soundness'' and less oriented toward consumer protection. \77\ Blueprint, supra note 62 at 3.--------------------------------------------------------------------------- Yet it is unclear whether the U.K.'s recent reforms provide a legitimate prototype for the Blueprint's proposals. Here, the Blueprint may have doctored its history. By most accounts, the U.K.'s adoption of a single regulator model was ``driven by country-specific factors,'' \78\ including the dismal failure of a prior regulatory system that relied heavily on self-regulatory bodies but became a political liability because of its inability to cope with a succession of serious scandals. Ironically, the financial history of the U.K. in the 1990s parallels that of the United States over the last decade. On the banking side, the U.K. experienced two major banking failures--the Bank of Credit and Commerce International (``BCCI'') in 1991 and Barings in 1995. Each prompted an official inquiry that found lax supervision was at least a partial cause. \79\--------------------------------------------------------------------------- \78\ Ferran, supra note 72, at 259. \79\ Id. at 261-262.--------------------------------------------------------------------------- Securities regulation in the U.K. came under even sharper criticism during the 1990s because of a series of financial scandals that were generally attributed to an ``excessively fragmented regulatory infrastructure.'' \80\ Under the then applicable law (the Financial Services Act of 1986), most regulatory powers were delegated to the Securities and Investments Board (SIB), which was a private body financed through a levy on market participants. However, the SIB did not itself directly regulate. Rather, it ``set the overall framework of regulation,'' but delegated actual authority to second tier regulators, which consisted primarily of self-regulatory organizations (SROs). \81\ Persistent criticism focused on the inability or unwillingness of these SROs to protect consumers from fraud and misconduct. \82\ Ultimately, the then chairman of the SIB, the most important of the SROs, acknowledged that self-regulation had failed in the U.K. and seemed unable to restore investor confidence. \83\ This acknowledgement set the stage for reform, and when a new Labour Government came into power at the end of the decade, one of its first major legislative acts (as it had promised in its election campaign) was to dismantle the former structure of SROs and replace it with a new and more powerful body, the Financial Services Authority (FSA).--------------------------------------------------------------------------- \80\ Id. at 265. \81\ Id. at 266. The most important of these were the Securities and Futures Authority (SFA), the Investment Managers' Regulatory Organization (IMRO), and the Personal Investment Authority (PIA). \82\ Two scandals in particular stood out: the Robert Maxwell affair in which a prominent financier effectively embezzled the pension funds of his companies and a ``pension mis-selling'' controversy in which highly risky financial products were inappropriately sold to pension funds without adequate supervision or disclosure. Id. at 267-268. \83\ Id. at 268.--------------------------------------------------------------------------- Despite the Blueprint's enthusiasm for the U.K.'s model, the structure that the Blueprint proposes for the U.S. more closely resembles the former U.K. system than the current one. Under the Blueprint's proposals, the securities regulator would be restricted to adopting general ``principles-based'' policies, which would be implemented and enforced by SROs. \84\ Ironically, the Blueprint relies on the U.K. experience to endorse essentially the model that the U.K. concluded had failed.--------------------------------------------------------------------------- \84\ See infra notes--and accompanying text.--------------------------------------------------------------------------- The ``Twin Peaks'' Model: As the Blueprint recognizes, not all recent reforms have followed the U.K. model of a universal regulator. Some nations--most notably Australia and the Netherlands--instead have followed a ``twin peaks'' model that places responsibility for the ``prudential regulation of relevant financial institutions'' in one agency and supervision of ``business conduct and consumer protection'' in another. \85\ The term ``twin peaks'' derives from the work of Michael Taylor, a British academic and former Bank of England official. In 1995, just before regulatory reform became a hot political issue in the U.K., he argued that financial regulation had two separate basic aims (or ``twin peaks''): (1) ``to ensure the soundness of the financial system,'' and (2) ``to protect consumers from unscrupulous operators.'' \86\ Taylor's work was original less in its proposal to separate ``prudential'' regulation from ``business conduct'' regulation than in its insistence upon the need to consolidate ``responsibility for the financial soundness of all major financial institutions in a single agency.'' \87\ Taylor apparently feared that if the Bank of England remained responsible for the prudential supervision of banks, its independence in setting interest rates might be compromised by its fear that raising interest rates would cause bank failures for which it would be blamed. In part for this reason, the eventual legislation shifted responsibility for bank supervision from the Bank of England to the FSA.--------------------------------------------------------------------------- \85\ Blueprint, supra note 62, at 3. For a recent discussion of the Australian reorganization, which began in 1996 (and thus preceded the U.K.), see Schooner & Taylor, supra note65, at 340-341. The Australian Securities and Investments Commission (ASIC) is the ``consumer protection'' agency under this ``twin peaks'' approach, and the Australian Prudential Regulatory Authority (APRA) supervises bank ``safety and soundness.'' Still, the ``twin peaks'' model was not fully accepted in Australia as ASIC, the securities regulator, does retain supervisory jurisdiction over the ``financial soundness'' of investment banks. Thus, some element of functional regulation remains. \86\ Michael Taylor, Twin Peaks: A Regulatory Structure for the New Century i (Centre for the Study of Financial Institutions 1995). For a brief review of Taylor's work, see Cynthia Crawford Lichtenstein, The Fed's New Model of Supervision for ``Large Complex Banking Organizations'': Coordinated Risk-Based Supervision of Financial Multinationals for International Financial Stability, 18 Transnat'l Law. 283, 295-296 (2005). \87\ Lichtenstein, supra note 86, at 295; Taylor, supra note 86, at 4.--------------------------------------------------------------------------- The Blueprint, itself, preferred a ``twin peaks'' model, and that model is far more compatible with the U.S.'s current institutional structure for financial regulation. But beyond these obvious points, the best argument for a ``twin peaks'' model involves conflict of interests and the differing culture of banks and securities regulators. It approaches the self-evident to note that a conflict exists between the consumer protection role of a universal regulator and its role as a ``prudential'' regulator intent on protecting the safety and soundness of the financial institution. The goal of consumer protection is most obviously advanced through deterrence and financial sanctions, but these can deplete assets and ultimately threaten bank solvency. When only modest financial penalties are used, this conflict may sound more theoretical than real. But, the U.S. is distinctive in the severity of the penalties it imposes on financial institutions. In recent years, the SEC has imposed restitution and penalties exceeding $3 billion annually, and private plaintiffs received a record $17 billion in securities class action settlements in 2006. \88\ Over a recent ten year period, some 2,400 securities class actions were filed and resulted in settlements of over $27 billion, with much of this cost (as in the Enron and WorldCom cases) being borne by investment banks. \89\ If one agency were seeking both to protect consumers and guard the solvency of major financial institutions, it would face a difficult balancing act to achieve deterrence without threatening bank solvency, and it would risk a skeptical public concluding that it had been ``captured'' by its regulated firms.--------------------------------------------------------------------------- \88\ See Coffee, Law and the Market: The Impact of Enforcement, 156 U. of Pa. L. Rev. 299 (2007) (discussing average annual SEC penalties and class action settlements). \89\ See Richard Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L. J. 1, at 3 (2007).--------------------------------------------------------------------------- Even in jurisdictions adopting the universal regulator model, the need to contemporaneously strengthen enforcement has been part of the reform package. Although the 2000 legislation in the U.K. did not adopt the ``twin peaks'' format, it did significantly strengthen the consumer protection role of its centralized regulator. The U.K.'s Financial Services and Markets Act, enacted in 2000, sets out four statutory objectives, with the final objective being the ``reduction of financial crime.'' \90\ According to Heidi Schooner and Michael Taylor, this represented ``a major extension of the FSA's powers compared to the agencies it replaced,'' \91\ and it reflected a political response to the experience of weak enforcement by self-regulatory bodies, which had led to the creation of the FSA. \92\ With probably unintended irony, Schooner and Taylor described this new statutory objective of reducing ``financial crime'' as the ``one aspect of U.K. regulatory reform in which its proponents seem to have drawn direct inspiration from U.S. law and practice.'' \93\ Conspicuously, the Blueprint ignores that ``modernizing'' financial regulation in other countries has generally meant strengthening enforcement.--------------------------------------------------------------------------- \90\ See Financial Services and Markets Act, 2000, c. 8, pt. 1, 6, http://www.opsi.gov.uk/ACTS/acts2000/pdf/ukpga_20000008_en.pdf \91\ See Schooner & Taylor, supra note 65, at 335. \92\ Id. \93\ Id. at 335-36.--------------------------------------------------------------------------- A Preliminary Evaluation: Three preliminary conclusions merit emphasis: First, whether the existing financial regulatory structure in the United States is considered ``institutional'' or ``functional'' in design, its leading deficiency seems evident: it invites regulatory arbitrage. Financial institutions position themselves to fall within the jurisdiction of the most accommodating regulator, and investment banks design new financial products so as to encounter the least regulatory oversight. Such arbitrage can be defended as desirable if one believes that regulators inherently overregulate, but not if one believes increased systemic risk is a valid concern (as the Blueprint appears to believe). Second, the Blueprint's history of recent regulatory reform involves an element of historical fiction. The 2000 legislation in the U.K., which created the FSA as a nearly universal regulator, was not an attempt to introduce self-regulation by SROs, as the Blueprint seems to assume, but a sharp reaction by a Labour Government to the failures of self-regulation. Similarly, Japan's slow, back-and-forth movement in the direction of a single regulator seems to have been motivated by an unending series of scandals and a desire to give its regulator at least the appearance of being less industry dominated. \94\--------------------------------------------------------------------------- \94\ Japan has a history and a regulatory culture of economic management of its financial institutions through regulatory bodies that is entirely distinct from that of Europe or the United States. Although it has recently created a Financial Services Agency, observers contend that it remains committed to its traditional system of bureaucratic regulation that supports its large banks and discourages foreign competition. See Markham, supra note 72, at 383-92, 396. Nonetheless, scandals have been the primary force driving institutional change there too, and Japan's FSA was created at least in part because Japan's Ministry of Finance (MOF) had become embarrassed by recurrent scandals.--------------------------------------------------------------------------- Third, the debate between the ``universal'' regulator and the ``twin peaks'' alternative should not obscure the fact that both are ``superregulators'' that have moved beyond ``functional'' regulation on the premise that, as the lines between banks, securities dealers, and insurers blur, so regulators should similarly converge. That idea will and should remain at the heart of the U.S. debate, even after many of the Blueprint's proposals are forgotten.Defining the Roles of the ``Twin Peaks'' (Systemic Risk Regulator and Consumer Protector)--Who Should Do What? The foregoing discussion has suggested why the SEC would not be an effective risk regulator. It has neither the specialized competence nor the organizational culture for the role. Its comparative advantage is enforcement, and thus its focus should be on transparency and consumer protection. Some also argue that ``single purpose'' agencies, such as the SEC, are more subject to regulatory capture than are broader or ``general purpose'' agencies. \95\ To the extent that the Federal Reserve would have responsibility for all large financial institutions and would be expected to treat monitoring their capital adequacy and risk management practices as among its primary responsibilities, it does seem less subject to capture, because any failure would have high visibility and it would bear the blame. Still, this issue is largely academic because the SEC no longer has responsibility over any investment banks of substantial size.--------------------------------------------------------------------------- \95\ See Jonathan Macey, Organizational Design and Political Control of Administrative Agencies, 8 J. Law, Economics, and Organization 93 (1992). It can, of course, be argued which agency is more ``single purpose'' (the SEC or the Federal Reserve), but the latter does deal with a broader class of institutions in terms of their capital adequacy.--------------------------------------------------------------------------- The real issue then is defining the relationships between the two peaks so that neither overwhelms the other. The Systemic Risk Regulator (SRR): Systemic risk is most easily defined as the risk of an inter-connected financial breakdown in the financial system--much like the proverbial chain of falling dominoes. The closely linked insolvencies of Lehman, AIG, Fannie Mae and Freddie Mac in the Fall of 2008 present a paradigm case. Were they not bailed out, other financial institutions were likely to have also failed. The key idea here is not that one financial institution is too big to fail, but rather that some institutions are too interconnected to permit any of them to fail, because they will drag the others down. What should a system risk regulator be authorized to do? Among the obvious powers that it should have are the following: a. Authority To Limit the Leverage of Financial Institutions and Prescribe Mandatory Capital Adequacy Standards. This authority would empower the SRR to prescribe minimum levels of capital and ceilings on leverage for all categories of financial institutions, including banks, insurance companies, hedge funds, money market funds, pension plans, and quasi-financial institutions (such as, for example, G.E. Capital). The standards would not need to be identical for all institutions and should be risk adjusted. The SRS should be authorized to require reductions in debt to equity ratios below existing levels, to consider off-balance sheet liabilities (including those of partially owned subsidiaries and also contractual agreements to repurchase or guarantee) in computing these tests and ratios (even if generally accepted accounting principles would not require their inclusion). The SRR would focus its monitoring on the largest institutions in each financial class, leaving small institutions to be regulated and monitored by their primary regulator. For example, the SEC might require all hedge funds to register with it under the Investment Advisers Act of 1940, but hedge funds with a defined level of assets (say, $25 billion in assets) would be subject to the additional and overriding authority of the SSR. b. Authority To Approve, Restrict and Regulate Trading in New Financial Products. By now, it has escaped no one's attention that one particular class of over-the-counter derivative (the credit default swap) grew exponentially over the last decade and was outside the jurisdiction of any regulatory agency. This was not accidental, as the Commodities Futures Modernization Act of 2000 deliberately placed over-the-counter derivatives beyond the general jurisdiction of both the SEC and the CFTC. The SRR would be responsible for monitoring the growth of new financial products and would be authorized to regulate such practices as the collateral or margin that counter-parties were required to post. Arguably, the SRR should be authorized to limit those eligible to trade such instruments and could bar or restrict the purchase of ``naked'' credit default swaps (although the possession of this authority would not mean that the SRR would have to exercise it, unless it saw an emergency developing). c. Authority To Mandate Clearing Houses. Securities and options exchanges uniformly employ clearing houses to eliminate or mitigate credit risk. In contrast, when an investor trades in an over-the-counter derivative, it must accept both market risk (the risk that the investment will sour or price levels will change adversely) and credit risk (the risk that the counterparty will be unable to perform). Credit risk is the factor that necessitated the bailout of AIG, as its failure could have potentially led to a cascade of failures by other financial institutions if it defaulted on its swaps. Use of the clearing house should eliminate the need to bail out a future AIG because its responsibilities would fall on the clearing house to assume and the clearing house would monitor and limit the risk that its members assumed. At present, several clearinghouses are in the process of development in the United States and Europe. The SRR would be the obvious body to oversee such clearing houses (and indeed the Federal Reserve was already instrumental in their formation). Otherwise, some clearing houses are likely to be formed under the SEC's supervision and some under the CFTC's, thus again permitting regulatory arbitrage to develop. A final and complex question is whether competing clearing houses are desirable or whether they should be combined into a single centralized clearing house. This issue could also be given to the SRR. d. Authority To Mandate Writedowns for Risky Assets. A real estate bubble was the starting point for the 2008 crisis. When any class of assets appreciates meteorically, the danger arises that on the eventual collapse in that overvalued market, the equity of the financial institution will be wiped out (or at the least so eroded as to create a crisis in investor confidence that denies that institution necessary financing). This tendency was palpably evident in the failure of Bear Stearns, Lehman, Fannie Mae and Freddie Mac. If the SRR regulator relies only on debt/equity ratios to protect capital adequacy, they will do little good and possibly provide only illusory protections. Any financial institution that is forced to writedown its investment in overpriced mortgage and real estate assets by 50 percent will necessarily breach mandated debt to equity ratios. The best answer to this problem is to authorize the SRR to take a proactive and countercyclical stance by requiring writedowns in risky asset classes (at least for regulatory purposes) prior to the typically much later point at which accountants will require such a writedown. Candidly, it is an open question whether the SRS, the Federal Reserve, or any banking regulator would have the courage and political will to order such a writedown (or impose similar restraints on further acquisitions of such assets) while the bubble was still expanding. But Congress should at least arm its regulators with sufficient power and direct them to use it with vigor. e. Authority To Intervene To Prevent and Avert Liquidity Crises. Financial institutions often face a mismatch between their assets and liabilities. They may invest in illiquid assets or make long-term loans, but their liabilities consist of short-term debt (such as commercial paper). Thus, regulating leverage ratios is not alone adequate to avoid a financial crisis, because the institution may suddenly experience a ``run'' (as its depositors flee) or be unable to roll over its commercial paper or other short-term debt. This problem is not unique to banks and can be encountered by hedge funds and private equity funds (as the Long Term Capital Management crisis showed). The SRR thus needs the authority to monitor liquidity problems at large financial institutions and direct institutions in specific cases to address such imbalances (either by selling assets, raising capital, or not relying on short-term debt). From the foregoing description, it should be obvious that the only existing agency in a position to take on this assignment and act as an SRR is the Federal Reserve Board. But it is less politically accountable than most other federal agencies, and this could give rise to some problems discussed below. The Consumer Protection and Transparency Agency: The creation of an SSR would change little at the major Federal agencies having responsibilities for investor protection. Although it might be desirable to merge the SEC and the CFTC, this is not essential. Because no momentum has yet developed for such a merger, I will not discuss it further at this time. Currently, there are over 5,000 broker-dealers registered with the SEC. They would remain so registered, and the SRR would concern itself only with those few whose potential insolvency could destabilize the markets. The focus of the SEC's surveillance of broker-dealers is on consumer protection and market efficiency, and this would not be within the expertise of the Federal Reserve or any other potential SRR. The SEC is also an experienced enforcement agency, while the Federal Reserve has little, if any, experience in this area. Further, the SEC understands disclosure issues and is a champion of transparency, whereas banking regulators start from the unstated premise that disclosures of risks or problems at a financial institution is undesirable because it might provoke a ``run'' on the bank. The SEC and the Controller of the Currency have long disagreed about what banks should disclose in the Management Discussion and Analysis that banks file with the SEC. Necessarily, this tension will continue. Resolving the Conflicts: The SEC and the PCAOB have continued to favor ``mark to market'' accounting, while major banks have sought relief from the write-downs that it necessitates. Suppose then that in the future a SRR decided that ``mark to market'' accounting increased systemic risk. Could it determine that financial institutions should be spared from such an accounting regime on the ground that it was pro-cyclical? This is an issue that Congress should address in any legislation authorizing a SRR or enhancing the powers of the Federal Reserve. I would recommend that Congress maintain authority in the SEC to determine appropriate accounting policies, because, put simply, transparency has been the core value underlying our system of securities regulation. But there are other areas where a SRR might well be entitled to overrule the SEC. Take, for example, the problem of short selling the stocks of financial institutions during a period of market stress. Although the SEC did ban short selling in financial stocks briefly in 2008, one can still imagine an occasion on which the SRR and the SEC might disagree. Here, transparency would not be an issue. Short selling is pro-cyclical, and a SRR could determine that it had the potential to destabilize and increase systemic risk. If it did so, its judgment should control. These examples are given only by way of illustration, and the inevitability of conflicts between the two agencies is not assumed. The President's Working Group on Financial Markets has generally been able to work out disagreements through consultation and negotiation. Still, in any legislation, it would be desirable to identify those core policies (such as transparency and full disclosure) that the SRR could not override. The Failure of Quantitative Models: If one lesson should have been learned from the 2008 crisis, it is that quantitative models, based on historical data, eventually and inevitably fail. Rates of defaults on mortgages can change (and swiftly), and housing markets do not invariably rise. In the popular vernacular, ``black swans'' both can occur and even become predominant. This does not mean that quantitative models should not be used, but that they need to be subjected to qualitative and judgmental overrides. The weakness in quantitative models is particularly shown by the extraordinary disparity between the value at risk estimates (VaRs) reported by underwriters to the SEC and their eventual writedowns for mortgage-backed securities. Ferrell, Bethel and Hu report that for a selected group of major financial institutions the average ratio of asset writedowns as of August 20, 2008, to VaRs reported for 2006 was 291 to 1. \96\ If financial institutions cannot accurately estimate their exposure for derivatives and risky assets, this undermines many of the critical assumptions underlying the Basel II Accords, and suggests that regulators cannot defer to the institutions' own risk models. Instead, they must reach their own judgments, and Congress should so instruct them.--------------------------------------------------------------------------- \96\ See Farrell, Bethel, and Hu, supra note 15, at 47.---------------------------------------------------------------------------The Lessons of Madoff: Implications for the SEC, FINRA, and SIPC No time need be wasted pointing out that the SEC missed red flags and overlooked credible evidence in the Madoff scandal. Unfortunately, most Ponzi schemes do not get detected until it is too late. This implies that an ounce of prevention may be worth several pounds of penalties. More must be done to discourage and deter such schemes ex ante, and the focus cannot be only on catching them ex post. From this perspective focused on prevention, rather than detection, the most obvious lesson is that the SEC's recent strong tilt towards deregulation contributed to, and enabled, the Madoff fraud in two important respects. First, Bernard L. Madoff Investment Securities LLC (BMIS) was audited by a fly-by-night auditing firm with only one active accountant who had neither registered with the Public Company Accounting Oversight Board (``PCAOB'') nor even participated in New York State's peer review program for auditors. Yet, the Sarbanes-Oxley Act required broker-dealers to use a PCAOB-registered auditor. \97\ Nonetheless, until the Madoff scandal exploded, the SEC repeatedly exempted privately held broker-dealers from the obligation to use such a PCAOB-registered auditor and permitted any accountant to suffice. \98\ Others also exploited this exemption. For example, in the Bayou Hedge Fund fraud, which was the last major Ponzi scheme before Madoff, the promoters simply invented a fictitious auditing firm and forged certifications in its name. Had auditors been required to have been registered with PCAOB, this would not have been feasible because careful investors would have been able to detect that the fictitious firm was not registered.--------------------------------------------------------------------------- \97\ See Section 17(e)(1) of the Securities Exchange Act of 1934, 15 U.S.C. 78(q)(e)(1). \98\ See, e.g., Securities Exch. Act Rel. No. 34-54920 (Dec. 12, 2006).--------------------------------------------------------------------------- Presumably, the SEC's rationale for this overbroad exemption was that privately held broker-dealers did not have public shareholders who needed protection. True, but they did have customers who have now been repeatedly victimized. At the end of 2008, the SEC quietly closed the barn door by failing to renew this exemption--but only after $50 billion worth of horses had been stolen. A second and even more culpable SEC mistake continues to date. Under the Investment Advisers Act, investment advisers are required to maintain client funds or securities with a ``qualified custodian.'' \99\ In principle, this requirement should protect investors from Ponzi schemes, because an independent custodian would not permit the investment adviser to have access to the investors' funds. Indeed, for exactly this reason, mutual funds appear not to have experienced Ponzi-style frauds, which have occurred only in the case of hedge funds and investment advisers. Under Section 17(f) of the Investment Company Act, mutual funds must use a separate custodian. But in the case of investment advisors, the SEC permits the investment adviser to use an affiliated broker-dealer or bank as its qualified custodian. Thus, Madoff could and did use BMIS, his broker dealer firm, to serve as custodian for his investment adviser activities. The net result is that only a very tame watchdog monitors the investment adviser. Had an independent and honest custodian held the investors' funds, Madoff could not have recycled new investors' contributions to earlier investors, and the custodian would have noticed that Madoff was not actually trading. Other recent Ponzi schemes seem to have similarly sidestepped the need for an independent custodian. At Senate Banking Committee hearings on the Madoff debacle this January, the director of the SEC's Office of Compliance, Inspection and Examinations estimated that, out of the 11,300 investment advisers currently registered with the SEC, some 1,000 to 1,500 might similarly use an affiliated broker-dealer as their custodian. For investors, the SEC's tolerance for self-custodians makes the ``qualified custodian'' rule an illusory protection.--------------------------------------------------------------------------- \99\ See Rule 206(4)-2 (``Custody of Funds or Securities of Clients By Investment Advisers''), 17 CFR 275.206(4)-2.--------------------------------------------------------------------------- At present, the Madoff scandal has so shaken investor confidence in investment advisors that even the industry trade group for investment advisers (the Investment Advisers Association) has urged the SEC to adopt a rule requiring investment advisers to use an independent custodian. Unfortunately, one cannot therefore assume that the SEC will quickly produce such a rule. The SEC's staff knows that smaller investment advisers will oppose any rule that requires them to incur additional costs. Even if a reform rule is proposed, the staff may still overwhelm such a rule with exceptions (such as by permitting an independent custodian to use sub-custodians who are affiliated with the investment adviser). Congress should therefore direct it to require an independent custodian, across the board for mutual funds, hedge funds, and investment advisers. The Madoff scandal exposes shortcomings not only at the SEC but elsewhere in related agencies. Over the last 5 years, the number of investment advisers has grown from roughly 7,500 to 11,300--more than one third. Given this growth, it is becoming increasingly anomalous that there is no self-regulatory body (SRO) for investment advisers. Although FINRA may have overstated in its claim that it had no authority to investigate Madoff's investment adviser operations (because it could and should have examined BMIS's performance as the ``qualified custodian'' for Madoff's investment advisory activities), it still lacks authority to examine investment advisers. Some SRO (either FINRA or a new body) should have direct authority to oversee the investment adviser activities of an integrated broker-dealer firm. Similarly, the Securities Investor Protection Corporation (SIPC) continues to charge all broker-dealer firms the same nominal fee for insurance without any risk-adjustment. Were it to behave like a private insurer and charge more to riskier firms for insurance, these firms would have a greater incentive to adopt better internal controls against fraud. A broker-dealer that acted as a self-custodian for a related investment adviser would, for example, pay a higher insurance commission. Also, if higher fees were charged, more insurance (which is currently capped at $500,000 per account) could be provided to investors. When all broker-dealers are charged the same insurance premium, this subsidizes the riskier firms--i.e., the future Madoffs of the industry. Finally, one of the most perplexing problems in the Madoff story is why, when the SEC finally forced Madoff to register as an investment adviser in 2006, it did not conduct an early examination of BMIS's books and records. Red flags were flying, as Madoff (1) used an unknown accountant, (2) served as his own self-custodian, (3) had apparently billions of dollars in customer accounts, (4) had long resisted registration, and (5) was the subject of plausible allegations of fraud from credible whistle-blowers. Cost constrained as the SEC may have been, the only conclusion that can be reached here is that the SEC has poor criteria for evaluating the relative risk of investment advisers. At a minimum, Congress should require a report by the SEC as to the criteria used to determine the priority of examinations and how the SEC proposes to change those criteria in light of the Madoff scandal. Some have proposed eliminating the SEC's Office of Compliance, Inspection and Examinations and combining its activities with the Division of Investment Management. I do not see this as a panacea. Rather, it simply reshuffles the cards. The real problem is the criteria used to determine who should be examined. Credible allegations of fraud need to be directed to the compliance inspectors.Asset-Backed Securitizations: What Failed? Asset-backed securitizations represent a financial technology that failed. As outlined earlier, this failure seems principally attributable to a ``moral hazard'' problem that arose under which both loan originators and underwriters relaxed their lending standards and packaged non-creditworthy loans into portfolios, because both found that they could sell these portfolios at a high profit and on a global basis--at least so long as the debt securities carried an investment grade credit rating from an NRSRO credit rating agency. Broad deregulatory rules contributed to this problem, and the two most important such SEC rules are Rules 3a-7 under the Investment Company Act \100\ and Regulation AB. \101\ Asset-backed securities (including CDOs) are typically issued by a special purpose vehicle (SPV) controlled by the promoter (which often may be an investment or commercial bank). This SPV would under ordinary circumstances be deemed an ``investment company'' and thus subjected to the demanding requirements of the Investment Company Act--but for Rule 3a-7. That rule exempts fixed-income securities issued by an SPV if, at the time of sale, the securities are rated in one of the four highest categories of investment quality by a ``nationally recognized statistical rating organization'' (NRSRO). In essence, the SEC has delegated to the NRSROs (essentially, at the time at least, Moody's, S&P and Fitch) the ability exempt SPVs from the Investment Company Act. Similarly, Regulation AB governs the disclosure requirements for ``asset-backed securities'' (as such term is defined in Section 1101(c) of Regulation AB) in public offerings. Some have criticized Regulation AB for being more permissive than the federal housing agencies with respect to the need to document and verify the loans in a portfolio. \102\ Because Regulation AB requires that the issuer not be an investment company (see Item 101(c)(2)(i) of Regulation AB), its availability (and thus expedited registration) also depends on an NRSRO investment grade rating.--------------------------------------------------------------------------- \100\ 17 CFR 270.3a-7 (``Issuers of Asset-Backed Securities''). This exemption dates back to 1992. \101\ 17 CFR 229.1100 et seq. (``Asset-Backed Securities''). Regulation AB was adopted in 2005, but reflects an earlier pattern of exemptions in no-action letters. \102\ See Mendales, supra note 18.--------------------------------------------------------------------------- No suggestion is here intended that SPVs should be classified as ``investment companies,'' but the need for the exemption given by Rule 3a-7 shows that the SEC has considerable leverage and could condition this exemption on alternative or additional factors beyond an NRSRO investment grade rating. The key point is that exemptions like Rule 3a-7 give the SEC a tool that they could use even without Congressional legislation--if the SEC was willing to take action. What actions should be taken to respond to the deficiencies in asset-backed securitizations? I would suggest two basic steps: (1) curtail the ``originate-and-distribute'' model of lending that gave rise to the moral hazard problem, and (2) re-introduce due diligence into the securities offering process (both for public and Rule 144A offerings). Restricting the ``Originate-and-Distribute'' Model of Lending. In a bubble, everyone expects that they can pass the assets on to the next buyer in the chain--``before the music stops.'' Thus, all tend to economize on due diligence and ignore signs that the assets are not creditworthy. This is because none expect to bear the costs of holding the financial assets to maturity. Things were not always this way. When asset-backed securitizations began, the promoter usually issued various tranches of debt to finance its purchase of the mortgage assets, and these tranches differed in terms of seniority and maturity. The promoter would sell the senior most tranche in public offerings to risk averse public investors and retain some or all of the subordinated tranche, itself, as a signal of its confidence in the creditworthiness of the underlying assets. Over time, this practice of retaining the subordinated tranche withered away. In part, this was because hedge funds would take the risk of buying this riskier debt; in part, it was because the subordinated tranche could be included in more complex CDOs (where overcollateralization was the investor's principal protection), and finally it was because in a bubbly market, investors no longer looked for commitments or signals from the promoter. Given this definition of the problem, the answer seems obvious: require the promoter to retain some portion of the subordinated tranche. This would incentivize it to buy only creditworthy financial assets and end the ``moral hazard'' problem. To make this proposal truly effective, however, more must be done. The promoter would have to be denied the ability to hedge the risk on the subordinated tranche that it retained. Otherwise it might hedge that risk by buying a credit default swap on its own offering through an intermediary. But this is feasible. Even in the absence of legislation, the SEC could revise Rule 3a-7 to require, as a price of its exemption, that the promoter (either through the SPV or an affiliate) retain a specified percentage of the bottom, subordinated tranche (or, if there were no subordinated tranche, of the offering as a whole). Still, the cleaner, simpler way would be a direct legislative requirement of a minimum retention. 2. Mandating Due Diligence. One of the less noticed but more important developments associated with asset-backed securitization is the rapid decline in due diligence after 2000. Once investment banks did considerable due diligence on asset-backed securitizations, but they outsourced the work to specialized ``due diligence'' firms. These firms (of which Clayton Holdings, Inc. was the best known) would send squads of ten to fifteen loan reviewers to sample the loans in a securitized portfolio, checking credit scores and documentation. But the intensity of this due diligence review declined over recent years. The Los Angeles Times quotes the CEO of Clayton Holdings to the effect that: Early in the decade, a securities firm might have asked Clayton to review 25 percent to 40 percent of the sub-prime loans in a pool, compared with typically 10 percent in 2006 \103\ \103\ See E. Scott Reckard, ``Sub-Prime mortgage watchdogs kept on leash; loan checkers say their warnings of risk were met with indifference,'' Los Angeles Times, March 17, 2008, at C-1.--------------------------------------------------------------------------- The President of a leading rival due diligence firm, the Bohan Group, made an even more revealing comparison: By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50 percent to 100 percent of the loans examined, Bohan President Mark Hughes said. \104\--------------------------------------------------------------------------- \104\ Id. In short, lenders who retained the loans checked the borrowers carefully, but the investment banks decreased their investment in due diligence, making only a cursory effort by 2006. Again, this seems the natural consequence of an originate-and-distribute model. The actual loan reviewers employed by these firms also told the above-quoted Los Angeles Times reporter that supervisors in these firms would often change documentation in order to avoid ``red-flagging mortgages.'' These employees also report regularly encountering inflated documentation and ``liar's loans,'' but, even when they rejected loans, ``loan buyers often bought the rejected mortgages anyway.'' \105\--------------------------------------------------------------------------- \105\ Id.--------------------------------------------------------------------------- In short, even when the watchdog barked, no one at the investment banks truly listened. Over the last several years, due diligence practices long followed in the industry seemed to have been relaxed, ignored, or treated as a largely optional formality. That was also the conclusion of the President's Working Group on Financial Markets, which in early 2008 identified ``a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors.'' \106\--------------------------------------------------------------------------- \106\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments at 1 (March, 2008). (emphasis added). This report expressly notes that underwriters had the incentive to perform due diligence, but did not do so adequately.--------------------------------------------------------------------------- Still, in the case of the investments bank, this erosion in due diligence may seem surprising. At least over the long-term, it seems contrary to their own self-interest. Four factors may explain their indifference: (1) an industry-wide decline in due diligence as the result of deregulatory reforms that have induced many underwriters to treat legal liability as simply a cost of doing business; (2) heightened conflicts of interest attributable to the underwriters' position as more a principal than an agent in structured finance offerings; (3) executive compensation formulas that reward short-term performance (coupled with increased lateral mobility in investment banking so that actors have less reason to consider the long-term); and (4) competitive pressure. Each is briefly examined below, and then I suggest some proposed reforms to address these problems. i. The Decline of Due Diligence: A Short History: The Securities Act of 1933 adopted a ``gatekeeper'' theory of protection, in the belief that by imposing high potential liability on underwriters (and others), this would activate them to search for fraud and thereby protect investors. As the SEC wrote in 1998: Congress recognized that underwriters occupied a unique position that enabled them to discover and compel disclosure of essential facts about the offering. Congress believed that subjecting underwriters to the liability provisions would provide the necessary incentive to ensure their careful investigations of the offering.'' \107\--------------------------------------------------------------------------- \107\ See SEC Release No. 7606A (``The Regulation of Securities Offerings''), 63 Fed. Reg. 67174, 67230 (Dec. 4 1998). Specifically, Section 11 of the Securities Act of 1933 holds the underwriters (and certain other persons) liable for any material misrepresentation or omission in the registration statement, without requiring proof of scienter on the part of the underwriter or reliance by the plaintiff. This is a cause of action uniquely tilted in favor of the plaintiff, but then Section 11(b) creates a powerful incentive by establishing an affirmative defense under which any defendant (other ---------------------------------------------------------------------------than the issuer) will not be held liable if: he had, after a reasonable investigation, reasonable ground to believe and did believe, at the time such registration statement became effective, that the statements made therein were true and that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading. 15 U.S.C. 77k (b)(3)(A). (emphasis added) Interpreting this provision, the case law has long held that an underwriter must ``exercise a high degree of care in investigation and independent verification of the company's representations.'' Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 554, 582 (E.D.N.Y. 1971). Overall, the Second Circuit has observed that ``no greater reliance in our self-regulatory system is placed on any single participant in the issuance of securities than upon the underwriter.'' Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F. 2d 341, 370 (2d Cir. 1973). Each underwriter need not personally perform this investigation. It can be delegated to the managing underwriters and to counsel, and, more recently, the task has been outsourced to specialized experts, such as the ``due diligence firms.'' The use of these firms was in fact strong evidence of the powerful economic incentive that Section 11(b) of the Securities Act created to exercise ``due diligence.'' But what then changed? Two different answers make sense and are complementary: First, many and probably most CDO debt offerings are sold pursuant to Rule 144A, and Section 11 does not apply to these exempt and unregistered offerings. Second, the SEC expedited the processing of registration statements to the point that due diligence has become infeasible. The latter development goes back nearly thirty years to the advent of ``shelf registration'' in the early 1980s. In order to expedite the ability of issuers to access the market and capitalize on advantageous market conditions, the SEC permitted issuers to register securities ``for the shelf''--i.e., to permit the securities to be sold from time to time in the future, originally over a two year period (but today extended to a three year period). \108\ Under this system, ``takedowns''--i.e., actual sales under a shelf registration statement--can occur at any time without any need to return to the SEC for any further regulatory permission. Effectively, this telescoped a period that was often three or four months in the case of the traditional equity underwriting (i.e., the period between the filing of the registration statement and its ``effectiveness,'' while the SEC reviewed the registration statement) to a period that might be a day or two, but could be only a matter of hours.--------------------------------------------------------------------------- \108\ See Rule 415 (17 C.F.R. 230.415)(2007).--------------------------------------------------------------------------- Today, because there is no longer any delay for SEC review in the case of an issuer eligible for shelf registration, an eligible issuer could determine to make an offering of debt or equity securities and in fact do so within a day's time. The original premise of this new approach was that eligible issuers would be ``reporting entities'' that filed continuous periodic disclosures (known as Form 10-Ks and Form 10-Qs) under the Securities Exchange Act of 1934. Underwriters, the SEC hoped, could do ``continuing due diligence'' on these issuers at the time they filed their periodic quarterly reports in preparation for a later, eventual public offering. This hope was probably never fully realized, but, more importantly, this premise never truly applied to debt offerings by issuers of asset-backed securities. For bankruptcy and related reasons, the issuers of asset-backed issuers (such as CDOs backed by a pool of residential mortgages) are almost always ``special purpose vehicles'' (SPVs), created for the single offering; they thus have no prior operating history and are not ``reporting companies'' under the Securities Exchange Act of 1934. To enable issuers of asset-backed securities to use shelf-registration and thus obtain immediate access to the capital markets, the SEC had to develop an alternative rationale. And it did! To use Form S-3 (which is a precondition for eligibility for shelf-regulation), an issuer of asset-backed securities must receive an ``investment grade'' rating from an ``NRSRO'' credit-rating agency. \109\ Unfortunately, this requirement intensified the pressure that underwriters brought to bear on credit-ratings agencies, because unless the offering received an investment grade rating from at least one rating agency, the offering could not qualify for Form S-3 (and so might be delayed for an indefinite period of several months while its registration statement received full-scale SEC review). An obvious alternative to the use of an NRSRO investment grade rating as a condition for Form S-3 eligibility would be certification by ``gatekeepers'' to the SEC (i.e., attorneys and due diligence firms) of the work they performed. Form S-3 could still require an ``investment grade'' rating, but that it come from an NRSRO rating agency should not be mandatory.--------------------------------------------------------------------------- \109\ See Form S-3, General Instructions, IB5 (``Transaction Requirements--Offerings of Investment Grade Asset-Backed Securities'').--------------------------------------------------------------------------- After 2000, developments in litigation largely convinced underwriters that it was infeasible to expect to establish their due diligence defense. The key event was the WorldCom decision in 2004. \110\ In WorldCom, the court effectively required the same degree of investigation for shelf-registered offerings as for traditional offerings, despite the compressed time frame and lack of underwriter involvement in the drafting of the registration statement. The Court asserted that its reading of the rule should not be onerous for underwriters because they could still perform due diligence prior to the offering by means of ``continuous due diligence'' (i.e., through participation by the underwriter in the drafting of the various Form 10-Ks and Form 10-Qs that are incorporated by reference into the shelf-registration).--------------------------------------------------------------------------- \110\ In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004). The WorldCom decision denied the underwriters' motion for summary judgment based on their asserted due diligence defense, but never decided whether the defense could be successfully asserted at trial. The case settled before trial for approximately $6.2 billion.--------------------------------------------------------------------------- For underwriters, the WorldCom decision was largely seen as a disaster. Their hopes--probably illusory in retrospect--were dashed that courts would soften Securities Act 11's requirements in light of the near impossibility of complying with due diligence responsibilities during the shortened time frames imposed by shelf registration. Some commentators had long (and properly) observed that the industry had essentially played ``ostrich,'' hoping unrealistically that Rule 176 would protect them. \111\ In WorldCom's wake, the SEC did propose some amendments to strengthen Rule 176 that would make it something closer to a safe harbor. But the SEC ultimately withdrew and did not adopt this proposal.--------------------------------------------------------------------------- \111\ See Donald Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, 63 Law and Contemporary Problems, U.S. 62-63 (2000).--------------------------------------------------------------------------- As the industry now found (as of late 2004) that token or formalistic efforts to satisfy Section 11 would not work, it faced a bleak choice. It could accept the risk of liability on shelf offerings or it could seek to slow them down to engage in full scale due diligence. Of course, different law firms and different investment banks could respond differently, but I am aware of no firms attempting truly substantial due diligence on asset-backed securitizations. Particularly in the case of structured finance, the business risk of Section 11 liability seemed acceptable. After all, investment grade bonds did not typically default or result in class action litigation, and Section 11 has a short statute of limitations (one year from the date that the plaintiffs are placed on ``inquiry notice''). Hence, investment banks could rationally decide to proceed with structured finance offerings knowing that they would be legally exposed if the debt defaulted, in part because the period of their exposure would be brief. In the wake of the WorldCom decision, the dichotomy widened between the still extensive due diligence conducted in IPOs, and the minimal due diligence in shelf offerings. As discussed below, important business risks may have also motivated investment banks to decide not to slow down structured finance offerings for extended due diligence. The bottom line here then is that, at least in the case of asset-backed shelf offerings, investment banks ceased to perform the due diligence intended by Congress, but instead accepted the risk of liability as a cost of doing business in this context. But that is only the beginning of the story. Conflicts of Interest: Traditionally, the investment bank in a public offering played a gatekeeping role, vetting the company and serving as an agent both for the prospective investors (who are also its clients) and the corporate issuer. Because it had clients on both sides of the offering, the underwriter's relationship with the issuer was somewhat adversarial, as its counsel scrutinized and tested the issuer's draft registration statement. But structured finance is different. In these offerings, there is no corporate issuer, but only a ``special purpose vehicle'' (SPV) typically established by the investment bank. The product--residential home mortgages--is purchased by the investment bank from loan originators and may be held in inventory by the investment bank for some period until the offering can be effected. In part for this reason, the investment bank will logically want to expedite the offering in order to minimize the period that it must hold the purchased mortgages in its own inventory and at its own risk. Whereas in an IPO the underwriter (at least in theory) is acting as a watchdog testing the quality of the issuer's disclosures, the situation is obviously different in an assets-backed securities offering that the underwriter is structuring itself. It can hardly be its own watchdog. Thus, the quality of disclosure may suffer. Reports have circulated that some due diligence firms advised their underwriters that the majority of mortgages loans in some securitized portfolio were ``exception'' loans--i.e., loans outside the bank's normal guidelines. \112\ But the registration statement disclosed only that the portfolio included a ``significant'' or ``substantial'' number of such loans, not that it was predominantly composed of such loans. This is inferior and materially deficient disclosure, and it seems attributable to the built-in conflicts in this process.--------------------------------------------------------------------------- \112\ See, e.g., Vikas Bajaj and Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' New York Times, January 12, 2008, at A-1.--------------------------------------------------------------------------- Executive Compensation: Investment bankers are typically paid year-end bonuses that are a multiple of their salaries. These bonuses are based on successful completion of fee-generating deals during the year. But a deal that generates significant income in Year One could eventually generate significant liability in Year Two or Three. In this light, the year-end bonus system may result in a short-term focus that ignores or overly discounts longer-term risks. Moreover, high lateral mobility characterizes investment banking firms, meaning that the individual investment banker may not identify with the firm's longer-term interests. In short, investment banks may face serious agency costs problems, which may partly explain their willingness to acquire risky mortgage portfolios without adequate investigation of the collateral. Competitive Pressure: Citigroup CEO Charles Prince's now famous observation that ``when the music is playing, you've got to get up and dance'' is principally a recognition of the impact of competitive pressure. If investors are clamoring for ``investment grade'' CDOs (as they were in 2004-2006), an investment bank understands that if it does not offer a steady supply of transactions, its investors will go elsewhere--and possibly not return. Thus, to hold onto a profitable franchise, investment banks sought to maintain a steady pipeline of transactions; this in turn lead them to seek to lock in sources of supply. Accordingly, they made clear to loan originators their willingness to buy all the ``product'' that the latter could supply. Some investment banks even sought billion dollar promises from loan originators of a minimum amount of product. Loan originators quickly realized that due diligence was now a charade (even if it had not been in the past) because the ``securitizing'' investment banks were competing fiercely for supply. In a market where the demand seemed inexhaustible, the real issue was obtaining supply, and investment banks spent little time worrying about due diligence or rejecting a supply that was already too scarce for their anticipated needs. Providing Time for Due Diligence: The business model for structured finance is today broken. Underwriters and credit rating agencies have lost much of their credibility. Until structured finance can regain credibility, housing finance in the United States will remain in scarce supply. The first lesson to be learned is that underwriters cannot be trusted to perform serious due diligence when they are in effect selling their own inventory and are under severe time pressure. The second lesson is that because expedited shelf registration is inconsistent with meaningful due diligence, the process of underwriting structured finance offerings needs to be slowed down to permit more serious due diligence. Shelf registration and abbreviated time schedules may be appropriate for seasoned corporate issuers whose periodic filings are incorporated by reference into the registration statement, but it makes less sense in the case of a ``special purpose vehicle'' that has been created by the underwriter solely as a vehicle by which to sell asset-backed securities. Offerings by seasoned issuers and by special purpose entities are very different and need not march to the same drummer (or the same timetable). An offering process for structured finance that was credible would look very different than the process we have recently observed. First, a key role would be played by the due diligence firms, but their reports would not go only to the underwriter (who appears to have at time ignored them). Instead, without editing or filtering, their reports would also go directly to the credit-rating agency. Indeed, the rating agency would specify what it would want to see covered by the due diligence firm's report. Some dialogue between the rating agency and the due diligence firm would be built into the process, and ideally their exchange would be outside the presence of the underwriter (who would still pay for the due diligence firm's services). At a minimum, the NRSRO rating agencies should require full access to such due diligence reports as a condition of providing a rating (this is a principle with which these firms agree, but may find it difficult to enforce in the absence of a binding rule). To enable serious due diligence to take place, one approach would be to provide that structured finance offerings should not qualify for Form S-3 (or for any similar form of expedited SEC review). If the process can occur in a day, the pressures on all the participants to meet an impossible schedule will ensure that little serious investigation of the collateral's quality will occur. An alternative (or complementary approach) would be to direct the SEC to revise Regulation AB to incorporate greater verification by the underwriter (and thus its agents) of the quality of the underlying financial assets. Does this sound unrealistic? Interestingly, the key element in this proposal--that that due diligence firm's report go to the credit rating agency--is an important element in the settlement negotiated in 2008 by New York State Attorney General Cuomo and the credit rating agencies. \113\--------------------------------------------------------------------------- \113\ See Aaron Lucchetti, ``Big Credit-Rating Firms Agree to Reforms,'' The Wall Street Journal, June 6, 2008 at p. C-3.--------------------------------------------------------------------------- The second element of this proposal--i.e., that the process be slowed to permit some dialogue and questioning of the due diligence firm's findings--will be more controversial. It will be argued that delay will place American underwriters at a competitive disadvantage to European rivals and that offerings will migrate to Europe. But today, structured finance is moribund on both sides of the Atlantic. To revive it, credibility must be restored to the due diligence process. Instantaneous due diligence is in the last analysis simply a contradiction in terms. Time and effort are necessary if the quality of the collateral is to be verified--and if investors are to perceive that a serious effort to protect their interests is occurring.Rehabilitating the Gatekeepers Credit rating agencies remain the critical gatekeeper whose performance must be improved if structured finance through private offerings (i.e., without government guarantees) is to become viable again. As already noted, credit rating agencies face a concentrated market in which they are vulnerable to pressure from underwriters and active competition for the rating business. At present, credit rating agencies face little liability and perform little verification. Rather, they state explicitly that they are assuming the accuracy of the issuer's representations. The only force that can feasibly induce them to conduct or obtain verification is the threat of securities law liability. Although that threat has been historically non-existent, it can be legislatively augmented. The credit rating agency does make a statement (i.e., its rating) on which the purchasers of debt securities do typically rely. Thus, potential liability does exist under Rule 10b-5 to the extent that it makes a statement in connection with a purchase or sale of a security. The difficult problem is that a defendant is only liable under Rule 10b-5 if it makes a material misrepresentation or omission with scienter. In my judgment, there are few cases, if any, in which the rating agencies actually know of the fraud. But, under Rule 10b-5, a rating agency can be held liable if it acted ``recklessly.'' Accordingly, I would proposed that Congress expressly define the standard of ``recklessness'' that creates liability under Rule 10b-5 for a credit rating agency to be the issuance of a rating when the rating agency knowingly or recklessly is aware of facts indicating that reasonable efforts have not been conducted to verify the essential facts relied upon by its ratings methodology. A safe harbor could be created for circumstances in which the ratings agency receives written certification from a ``due diligence'' firm, independent of the promoter, indicating that it has conducted sampling procedures that lead it to believe in the accuracy of the facts or estimates asserted by the promoter. The goal of this strategy is not to impose massive liabilities on rating agencies, but to make it unavoidable that someone (either the rating agency or the due diligence firm) conduct reasonable verification. To be sure, this proposal would involve increased costs to conduct such due diligence (which either the issuer or the underwriter would be compelled to assume). But these costs are several orders of magnitude below the costs that the collapse of the structured finance market has imposed on the American taxpayer.Conclusions 1. The current financial crisis--including the collapse of the U.S. real estate market, the insolvency of the major U.S. investment banks, and the record decline in the stock market--was not the product of investor mania or the classic demand-driven bubble, but rather was the product of the excesses of an ``originate-and-distribute'' business model that both loan originators and investment banks followed to the brink of disaster--and beyond. Under this business model, financial institutions abandoned discipline and knowingly made non-creditworthy loans because they did not expect to hold the resulting financial assets for long enough to matter. 2. The ``moral hazard'' problem that resulted was compounded by deregulatory policies at the SEC (and elsewhere) that permitted investment banks to increase their leverage rapidly between 2004 and 2006, while also reducing their level of diversification. Under the Consolidated Supervised Entity (CSE) Program, the SEC essentially deferred to self-regulation by the five largest investment banks, who woefully underestimated their exposure to risk. 3. This episode shows (if there ever was doubt) that in an environment of intense competition and under the pressure of equity-based executive compensation systems that are extraordinarily short-term oriented, self-regulation does not work. 4. As a result, all financial institutions that are ``too big to fail'' need to be subjected to prudential financial supervision and a common (although risk-adjusted) standard. This can only be done by the Federal Reserve Board, which should be given authority to regulate the capital adequacy, safety and soundness, and risk management practices of all large financial institutions. 5. Incident to making the Federal Reserve the systemic risk regulator for the U.S. economy, it should receive legislative authority to: (1) establish ceilings on debt/equity ratios and otherwise restrict leverage at all major financial institutions (including banks, hedge funds, money market funds, insurance companies, and pension plans, as well as financial subsidiaries of industrial corporations); (2) supervise and restrict the design, and trading of new financial products (particularly including over-the-counter derivatives); (3) mandate the use of clearinghouses, to supervise them, and in its discretion to require their consolidation; (4) require the writedown of risky assets by financial institutions, regardless of whether required by accounting rule; and (5) to prevent liquidate crises by restricting the issuance of short-term debt. 6. Under the ``twin peaks'' model, the systemic risk regulatory agency would have broad powers, but not the power to override the consumer protection and transparency policies of the SEC. Too often bank regulators and banks have engaged in a conspiracy of silence to hide problems, lest they alarm investors. For that reason, some SEC responsibilities should not be subordinated to the authority of the Federal Reserve. 7. As a financial technology, asset-backed securitizations have decisively failed. To restore credibility to this marketplace, sponsors must abandon their ``originate-and-distribute'' business model and instead commit to retain a significant portion of the most subordinated tranche. Only if the promoter, itself, holds a share of the weakest class of debt that it is issuing (and on an unhedged basis) will there be a sufficient signal of commitment to restore credibility. 8. Credit rating agencies must be compelled either to conduct reasonable verification of the key facts that they are assuming in their ratings methodology or to obtain such verification from professionals independent of the issuer. For this obligation to be meaningful, it must be backstopped by a standard of liability specifically designed to apply to credit-rating agencies. ______ CHRG-111shrg53085--65 Mr. Attridge," I don't know exactly how much the fee would be, but basically, right now, I disagree with the statement that the FDIC has failed in picking up systemic risk. I don't think that was their job. I am not sure their definition--they have done an excellent job in administering and regulating and resolving problems with the banks. I don't know what the details of their charter is, but I don't think that they were given the responsibility of regulating systemic risk. " fcic_final_report_full--302 Molinaro, Alix, and others spent the weekend in due diligence meetings with JP Morgan and other potential buyers, including the private equity firm J.C. Flowers and Co. According to Schwartz, the participants determined JP Morgan was the only candidate with the size and stature to make a credible offer within  hours.  As Bear Stearns’s clearing bank for repo trades, JP Morgan held much of Bear Stearns’s assets as collateral and had been assessing their value daily.  This knowl- edge let JP Morgan move more quickly. On Sunday, March , JP Morgan informed the New York Fed and the Treasury that it was interested in a deal if it included financial support from the Fed.  The Federal Reserve Board, again finding “unusual and exigent circumstances” as re- quired under section () of the Federal Reserve Act, agreed to purchase . bil- lion of Bear’s assets to get them off the firm’s books through a new entity called Maiden Lane LLC (named for a street alongside the New York Fed). Those assets— mostly mortgage-related securities, other assets, and hedges from Bear’s mortgage trading desk—would be under New York Fed management. To finance the purchases, JP Morgan made a . billion subordinated loan and the New York Fed lent . billion. Because of its loan, JP Morgan bore the risk of the first . billion of losses; the Fed would bear any further losses up to . billion.  The Fed’s loan would be repaid as Maiden Lane sold the collateral. On Sunday night, with Maiden Lane in place, JP Morgan publicly announced a deal to buy Bear Stearns for  a share. Minutes of Bear’s board meeting indicate that JP Morgan had considered  but cut it to  “because the government would not permit a higher number. . . . The Fed and the Treasury Department would not sup- port a transaction where [Bear Stearns] equity holders received any significant con- sideration because of the ‘moral hazard’ of the federal government using taxpayer money to ‘bail out’ the investment bank’s stockholders.”  Eight days later, on March , Bear Stearns and JP Morgan agreed to increase the price to . John Chrin, co-head of the financial institutions mergers and acquisi- tions group at JP Morgan, told the FCIC they increased the price to make Bear share- holders’ approval more likely.  Bear CEO Schwartz told the FCIC the increase let Bear preserve the company’s value “to the greatest extent possible under the circum- stances for our shareholders, our , employees, and our creditors.”  “IT WAS HEADING TO A BLACK HOLE ” The SEC regulators Macchiaroli and Eichner were as stunned as everyone else by the speed of Bear’s collapse. Macchiaroli had had doubts as far back as August, he told the FCIC, but he and his colleagues expected Bear would be able to fund itself through the repo market, albeit at higher margins.  Fed Chairman Ben Bernanke later called the Bear Stearns decision the toughest of the financial crisis. The . trillion tri-party repo market had “really [begun] to break down,” Bernanke said. “As the fear increased,” short-term lenders began de- manding more collateral, “which was making it more and more difficult for the fi- nancial firms to finance themselves and creating more and more liquidity pressure on them. And, it was heading sort of to a black hole.” He saw the collapse of Bear Stearns as threatening to freeze the tri-party repo market, leaving the short-term lenders with collateral they would try to “dump on the market. You would have a big crunch in asset prices.”  “Bear Stearns, which is not that big a firm, our view on why it was important to save it—you may disagree—but our view was that because it was so essentially in- volved in this critical repo financing market, that its failure would have brought down that market, which would have had implications for other firms,” Bernanke told the FCIC.  CHRG-111hhrg52400--164 Mr. Scott," Thank you, Mr. Chairman. Let me ask--we are here, debating this largely because of actions that stemmed from the problems at AIG, with excessive trading and credit default swaps out of their Financial Products unit in London that was not regulated by State commissioners, but by the Federal Government, the Office of Thrift Supervision. However, some are using the collapse of AIG to argue for the creation of an optional Federal charter for the insurance industry. And, as I said in my opening statement, this is somewhat problematic, because here we have an entity that had the Federal oversight. So, the question has to be asked, would an optional Federal charter, had it been in place, would it have prevented the collapse of AIG, which, again, is already federally regulated? May I get your point? " CHRG-111hhrg55814--264 Mr. Dugan," Mr. Moore, Mr. Bachus, and members of the committee, thank you for the opportunity to discuss the discussion draft of the Financial Stability and Improvement Act. We support many of its key initiatives but also have significant concerns about certain provisions; and we are continuing to review the draft in detail to provide additional comments to the committee. Let me briefly comment here on four key parts of the draft. First, we believe the Financial Services Oversight Council established by the draft has appropriate roles and responsibilities. The Council would be well-positioned to monitor and address developments that threaten the financial system, identify regulatory gaps in arbitrage opportunities, and make formal recommendations to individual regulators. The Council would also have the responsibility, which is appropriate, for identifying those financial companies and financial activities that require heightened prudential supervision and stricter prudential standards. Second, the discussion draft expands the role of the Federal Reserve in two fundamental ways: as consolidated supervisor and standard-setter for all systemically significant financial firms; and as the standard-setter for financial activities that pose systemic risk. We support extending the Federal Reserve's consolidated supervisor authority beyond bank holding companies to any other type of financial company that the council identifies as posing systemic risk. The lack of such authority over such non-banking companies as AIG, Bear Stearns, and Lehman Brothers was a key contributor to the financial crisis, and is imperative to eliminate this supervisory gap. In terms of setting and implementing standards for these companies, the discussion draft is an improvement over the Administration's bill in terms of the role played by primary supervisors in the process. While the Federal Reserve would have authority to establish such standards for holding companies and their subsidiaries, the primary supervisors of regulated banks, if they disagreed with such standards, they would have the authority not to impose them if they explained in writing why they believed imposing them would be inappropriate. As a practical matter, this will provide banking supervisors with the opportunity to provide meaningful input into the design of the standards. This is appropriate given that in many cases, primary supervisors will have more expertise with respect to the impact of particular standards on the firms they directly supervise than will the Federal Reserve. We are very concerned, however, about the separate authority provided to the Federal Reserve to establish standards for any financial activity that the council deems to present systemic risk. There, the Board's authority is much broader in that the banking supervisor could in essence be compelled to apply the standard to the bank even if it objected in writing. As a practical matter, this would significantly diminish the banking supervisor's ability to provide that meaningful input to the standards. We believe this expansion of authority is too broad. And, more generally, we believe that there should be a meaningful consultation requirement with all primary supervisors before the Federal Reserve adopts any heightened standard for identified financial firms that meaningfully affects institutions regulated by primary supervisors. We also have concerns about Fed authority to act on divestitures or acquisitions affecting the bank and about continuing gaps in supervision of non-bank holding company affiliates. Third, we support the agency consolidation provisions of the discussion draft. These would transfer the bulk of the functions of the Office of Thrift Supervision to the OCC, while providing a framework in which the Federal Thrift Charter is preserved. The mechanics of the proposed transfer appear to be sensible and workable, and fair and equitable to employees of both agencies. There are, however, important technical areas, including assessments, transfer of property and personnel, and clarification of the agency's independence where we will have additional comments. Finally, the discussion draft includes important new measures to address the so-called ``too-big-to-fail'' problem. It would establish a new regime primarily administered by the FDIC to facilitate the orderly resolution of failing systemically important financial firms. As it has with failing banks, the FDIC would have the authority to operate the financial firm, enforce or repudiate its contracts, and pay its claims. It could also provide the firm with emergency assistance in the form of loans, guarantees or asset purchases but only with the concurrence of the Secretary and only after determining such assistance is necessary to preserve financial stability. And in doing so, however, there would be a strong presumption that the FDIC as receiver would remove senior management. Even more important, shareholders, subordinated creditors, and any other provider of regulatory capital to the firm could never be protected. Instead, they would always absorb first losses in the resolution to the same extent as such stakeholders would in an ordinary bankruptcy. This mandatory exposure to first loss by shareholders and creditors is a substantial change from the Administration's original proposal. We believe it is an appropriate and effective way to maintain market discipline and address the ``too-big-to-fail'' problem while protecting systemic stability. Thank you very much. Mr. Moore of Kansas. Thank you very much, Mr. Dugan. Governor Tarullo, please. STATEMENT OF THE HONORABLE DANIEL K. TARULLO, GOVERNOR, BOARD CHRG-111shrg52619--184 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM JOHN C. DUGANQ.1. Two approaches to systemic risk seem to be identified, (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse?A.1. The functions and authorities of a systemic risk regulator may need to differ depending on the nature of the systemically significant entity. Some types of firms, including banks, already are subject to federally imposed capital requirements, federal constraints on their activities, and the enforcement jurisdiction of a federal prudential regulator. These oversight functions should not be duplicated in the systemic supervisor. Doing so increases the potential for uncertainty about the standards to which firms will be held and for inconsistency between requirements administered by the primary and the systemic regulator. In practice, the role of a systemic risk overseer may vary at different points in time depending on whether financial markets are functioning normally, or are instead experiencing unusual stress or disruption. For example, in a stable economic environment, the systemic risk regulator might focus most on obtaining and analyzing information about risks. Such additional information and analysis would be valuable not only for the systemic risk regulator, but also for prudential supervisors in terms of their understanding of firms' exposure to risks occurring in other parts of the financial services system to which they have no direct access. And it could facilitate the implementation of supervisory strategies to address and contain such risk before it increased to unmanageable levels. On the other hand, in times of stress or disruption it may be desirable for the systemic regulator to take actions to stabilize a firm or apply stricter than normal standards to aspects of its operations.Q.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. At the federal level, no barriers to information sharing exist between federal banking regulators because the Federal Deposit Insurance Act, at 12 U.S.C. 1821t, provides that ``a covered agency'' does not waive any privilege when it transfers information or permits information to be used by a covered agency or any other agency of the federal government. A ``covered agency'' includes a federal banking agency, but not a state authority. This would also protect privilege when the OCC shares information with other federal agencies, such as the SEC, with which the OCC shares information pursuant to letter agreements in connection with the SEC's enforcement investigations and inspection functions. In 1984, a joint statement of policy was issued by the OCC, FRB, FDIC, and the FHLBB that contained agreements relating to confidentiality safeguards that would be observed in connection with the sharing of certain categories of confidential supervisory information between those agencies. Presently, these and other protocols are observed in connection with the sharing of broader and other categories of supervisory information with other federal agencies that occurs pursuant to OCC's regulations or, as indicated above with respect to the SEC, written agreements or memoranda of understanding. It is crucial that the confidentiality of any information shared between federal and state authorities concerning bank condition or personal consumer information be assured. The OCC has therefore entered into a number of agreements with various state regulators that govern the sharing, and protect the confidentiality, of information held by federal and state regulators: The OCC has entered into written sharing agreements or memoranda with 48 of the 50 states, the District of Columbia, and Puerto Rico. These documents, most of which were executed between 1987 and 1992, generally provide for the sharing of broad categories of information when needed for supervisory purposes. The OCC has executed a model Memorandum of Understanding with the Conference of State Bank Supervisors (CSBS) that is intended to facilitate the referral of customer complaints between the OCC and individual states, and to share information about the disposition of these complaints. As of December, 2008, this model agreement has served as the basis for information sharing agreements between the OCC and 44 states and Puerto Rico. In addition, the OCC has insurance information- sharing agreements with 49 States and the District of Columbia. The OCC has entered into many case specific agreements with states attorneys general in order to obtain information relevant to misconduct within the national banking system. We also encourage states attorneys general to refer complaints of misconduct by OCC regulated entities directly to the OCC's Customer Assistance Group. Finally, the OCC Customer Assistance Group refers consumer complaints that it receives with respect to State regulated entities to the appropriate state officials. The OCC exchanges information with state securities regulators on a case-by-case basis pursuant to letter agreements. Moreover, the OCC has worked cooperatively with the states to address specific supervisory and consumer protection issues. For example, in the area of supervisory guidance, federal and state regulators have worked constructively in connection with implementation of the nontraditional mortgage and subprime mortgage guidance issued initially by the federal banking agencies. More generally, under the auspices of the Federal Financial Institutions Examination Council (FFIEC), the OCC actively participates in the development and implementation of uniform principles, standards, and report forms for the examination of financial institutions by the federal agencies who are members of the FFIEC, which include (in addition to the OCC) the Federal Reserve Board, the FDIC, the OTS, and the NCUA. In 2006, the Chair of the State Liaison Committee (SLC) was added to the FFIEC as a voting member. The SLC includes representatives of the Conference of State Bank Supervisors (CSBS), the American Council of State Savings Supervisors (ACSSS), and the National Association of State Credit Union Supervisors (NASCUS). Working through its Task Forces (such as the Task Force on Supervision and the Task Force on Compliance), the FFIEC also develops recommendations to promote uniformity in the supervision of financial institutions. The OCC also participates in the President's Working Group on Financial Markets, a group composed of the Treasury Department, the Federal Reserve Board, the SEC, and the CFTC, which considers significant financial institutions' policy issues on an ongoing basis. ------ CHRG-111hhrg53245--47 The Chairman," But you say here, ``The Systemic Risk Council could be authorized to establish an acceptable limit of bank growth and impose appropriate limits on growth that are not consistent with the limits.'' By that, do you mean capital requirements? There's no actual limit? " CHRG-109shrg24852--63 Chairman Greenspan," Well, unless they are using the arguments that I am using. We have to distinguish between the mortgage market and the securitized market. In the securitized market, yes, the commercial banks will probably pick up some advantages because indeed that will be one of the purposes of changing the system. I think, however, that the nature of the argument misses the really fundamental point, which is that we are creating a potential very serious systemic risk. And to have arguments that are going on about whose market share or whose potential profits will change in somewhat different ways, I think, is missing the much larger point. Let me respond in writing to you about how I think the specific changes might occur in these markets. There are changes. I do not want to deny that there will be changes. But I think people extraordinarily exaggerate what the implications are. And for the self-interest of all parties, in my judgment, making certain that we do not have a systemic problem occurring because there is a very large accumulation created by incentives to hold ever-increasing portfolios to get ever-increasing incomes, in the long-run will redound to nobody's benefit, because we will all lose. " CHRG-111shrg53176--47 Mr. Breeden," Thank you very much, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for the opportunity to offer my views on enhancing investor protection and improving financial regulation. These are really, really critical subjects and it is a great pleasure to have a chance to be back before this important Committee. I was privileged to serve as SEC Chairman from 1989 to 1993. My views here today reflect that experience at the SEC as well as my White House service in 1989, when we had to craft legislation to deal with an earlier banking crisis, that involving the savings and loans. In subsequent years, my firm has worked on the restructuring of many, many companies that encountered financial difficulties, most notably WorldCom in the 2002 to 2005 range. Today, I am an investor and my fund manages approximately $1.5 billion in equity investments in the United States and Europe on behalf of some of the Nation's largest pension plans. By any conceivable yardstick, our Nation's financial regulatory programs have not worked adequately to protect our economy, our investors, or our taxpayers. In little more than a year, U.S. equities have lost more than $7 trillion in value. Investors in financial firms that either failed or needed a government rescue have alone lost about $1 trillion in equity. These are colossal losses without any precedent since the Great Depression. After the greatest investor losses in history, I believe passionately that we need to refocus and rededicate ourselves to putting investor interests at the top of the public policy priority list. We have badly shattered investor confidence at a time when we have never needed private savings and capital formation more. There is much work to be done to restore trust, and I must say, in the public policy debates, we seem to worry endlessly about the banks that created this mess and I believe we need to focus a little more on the investors who are key for the future to get us out of it. Many people today are pointing at gaps in the regulatory structure, including systemic regulatory authority. But the Fed has always worried about systemic risk. I remember back in the Bush task force back in 1982 to 1985, the Fed talking about its role as the lender of last resort and that it worried about systemic risk. And they have been doing that and we still had a global banking crisis. The problems like the housing bubble, the massive leverage in the banks, the shaky lending practices and subprime mortgages, those things weren't hidden. They were in plain sight, except for the swaps market, where I agree with the previous witnesses that there is a need for extending oversight and jurisdiction. But for the most part, the banking and securities regulators did have tools to address many of the abusive practices but often didn't use their powers forcefully enough. Creating a systemic or super-regulator, in my view, is a giant camel's nose under the tent. It is a big, big step toward industrial planning, toward central planning of the economy, and I think the very first thing that creating a systemic regulator will do is to create systemic risk. I fear very much that if you are not extremely helpful, we will have more ``too big to fail,'' more moral hazard, and more bailouts, and that is not a healthy path for us to move forward. I am very concerned that we not shift the burden of running regulated businesses in a sound and healthy manner from management and the boards of directors that are supposed to do that. Unfortunately, in the wake of this crisis, we have seen boards of directors that failed miserably to control risk taking, excessive leverage, compensation without correlation to performance, misleading accounting and disclosure, overstated asset values, failure to perform due diligence before giant acquisitions. These and other factors are things that boards are supposed to control. But over and over again in the big failures, the boards at AIG, Fannie Mae, Lehman Brothers, CitiGroup, Bank of America, Wachovia, WAMU, in those cases, boards were not doing an adequate job. So my view is that we need to step back as part of this process and look and say, why are boards not doing what we need them to do? I think one of the important answers is that we have too much entrenchment of board members, too many staggered boards, too many super voting shares, too many self-perpetuating nominating committees, and a very, very high cost to run a proxy contest to try and replace directors who are not doing their jobs. So I think one of the important things that Congress can look at, and I hope you will look at in the future, is to enact a shareholder voting rights and proxy access act that would deal with proxy access, uninstructed votes by brokers, which is corporate ballot stuffing, majority vote for all directors every year, one share, one vote. There are a number of things where if we give a little more democracy to corporate shareholders, we can bring a little more discipline to misbehavior in corporations and not put quite so much on the idea that some super uber-regulator somewhere is going to save us from all these problems. Thank you very much. " CHRG-111shrg54675--90 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM JACK HOPKINSQ.1. Many of my constituents in Wisconsin are expressing frustration in getting a loan from their bank. The complaints have the same theme: they have been banking with the institution for a long time, and they have good credit and financial standing. Yet they still cannot refinance their loan or get a new line of credit. Can you please explain to the committee how the ICBA is working with their member banks to remedy this problem? Every weekend the FDIC is closing the doors of banks across the country at a record pace. I am concerned about the failure of small rural banks in areas where there is not another bank. The customers in the area might be left unbanked if a larger institution buys the deposits without opening a branch in the community. What are the options for these customers, and how are your members working to keep rural customers connected to the banking system?A.1. Answer not received by time of publication. ------ FinancialCrisisInquiry--73 CHAIRMAN ANGELIDES: If everyone in the audience can please take your seats. Mr. Vice Chairman, we’re going to roll forward now. OK. Mr. Thompson? THOMPSON: Thank you, Mr. Chairman. I’d like to take the discussion, if I might, back to the causes of the financial crisis. And as I reviewed the written testimony of several of you, particularly, Mr. Blankfein, in your testimony, you said that there were products that were created that served no purpose. What were those products? Why did they get created? Why weren’t they regulated better? To what extent did those products that had no purpose contribute to this problem? BLANKFEIN: I’m not sure I—I think—at that point, I think I was talking—maybe I was talking about SIVs or those off-balance sheet. I think that there was regarded as a kind of an arbitrage, if you will, to have a company or a trust that invested in longer-term assets and financed itself short in the commercial paper markets. And that is a—that is a mistake that is as old as financial markets to make that that liquidity would be there and, ultimately, those risks contained in the assets that were acquired weren’t—the vehicle was structured in a way to keep the risks off the balance sheet, but when they blew up, they suddenly came onto the balance sheet of institutions and created a lot of uncertainty as to the solvency of the institutions that sponsored them. THOMPSON: So we saw a collapse a few years ago of an organization that took down an awful lot of people and collapsed two companies, Enron and Anderson, where underneath that were a set of instruments that were off-balance-sheet financed items. BLANKFEIN: CHRG-111hhrg53245--155 Mr. Zandi," Well, I think one of the root causes of the bubble in the housing market was that the process of securitization was fundamentally broken, that no one in the chain of the process had a clear understanding of all the risks in its entirety. The lenders made the loan. They sold it to the investment banks. The investment bank's package got the rating. The rating agencies then put their stamp on it. And then it was sold to Goldman investors. And no one was really looking at the entire system, making sure that the structure was properly working, that the loans that were ultimately being made were good loans. So the process of securitization fell apart. It just was not functioning well because in my view there was not a systemic risk regulator looking at it holistically and saying, does this make sense, and will it work if it is stressed under a bad economy, under a bad housing market? " FOMC20080724confcall--100 98,MR. KOHN.," Thank you, Mr. Chairman. I think this has been a really good discussion that has raised a lot of interesting points. I agree with President Geithner that these are adjustments around the edges that were intended to make the facilities a little more useful in potential periods of stress. I, myself, was favorably disposed toward the options for the reasons you said, Mr. Chairman, of focusing our balance sheet. If we're a little worried about our balance sheet, let's focus on putting it to work where the stress points in the system are likely to be, which is quarterend and year-end. I didn't see it as promising a further extension. We would be voting on one through the end of January--that's what it says, and that's what it would be. On the TAF extension, I do think that the financial system and the depository system, regional banks in particular, are coming under increasing pressure. I think we ought to keep the maximum flexibility to deal with these liquidity pressures. I would hesitate to go to just 84 days if I thought that meant there was going to be a material tightening of the standards that the Reserve Banks use to grant these loans because of nervousness about the shifting of a bank's rating over the 84 days. So I would ask Bill to think again about whether we could run 28-day and 84-day auctions at the same time. I don't think it's that confusing, to tell the truth. We run schedule 1 and schedule 2 auctions for the dealers, so I think we ought to give that a little thought so that we're not forcing the Reserve Banks to make even more difficult judgments about long-term viability than they do now. So on balance, I'm favorably disposed, but I think we need to take on board the discussion we've heard here today and think carefully about whether we have these proposals adjusted in the right way. " fcic_final_report_full--319 The Treasury’s inspector general would later criticize OTS’s supervision of Wash- ington Mutual: “We concluded that OTS should have lowered WaMu’s composite rat- ing sooner and taken stronger enforcement action sooner to force WaMu’s management to correct the problems identified by OTS. Specifically, given WaMu management’s persistent lack of progress in correcting OTS-identified weaknesses, we believe OTS should have followed its own policies and taken formal enforcement action rather than informal enforcement action.”  Regulators: “A lot of that pushback” In these examples and others that the Commission studied, regulators either failed or were late to identify the mistakes and problems of commercial banks and thrifts or did not react strongly enough when they were identified. In part, this failure reflects the nature of bank examinations conducted during periods of apparent financial calm when institutions were reporting profits. In addition to their role as enforcers of regu- lation, regulators acted something like consultants, working with banks to assess the adequacy of their systems. This function was, to a degree, a reflection of the supervi- sors’ “risk-focused” approach. The OCC Large Bank Supervision Handbook published in January  explains, “Under this approach, examiners do not attempt to restrict risk-taking but rather determine whether banks identify, understand, and control the risks they assume.”  As the crisis developed, bank regulators were slow to shift gears. Senior supervisors told the FCIC it was difficult to express their concerns force- fully when financial institutions were generating record-level profits. The Fed’s Roger Cole told the FCIC that supervisors did discuss issues such as whether banks were growing too fast and taking too much risk, but ran into pushback. “Frankly a lot of that pushback was given credence on the part of the firms by the fact that—like a Citigroup was earning  to  billion a quarter. And that is really hard for a supervi- sor to successfully challenge. When that kind of money is flowing out quarter after quarter after quarter, and their capital ratios are way above the minimums, it’s very hard to challenge.”  Supervisors also told the FCIC that they feared aggravating a bank’s already-exist- ing problems. For the large banks, the issuance of a formal, public supervisory action taken under the federal banking statutes marked a severe regulatory assessment of the bank’s risk practices, and it was rarely employed for banks that were determined to be going concerns. Richard Spillenkothen, the Fed’s head of supervision until early , attributed supervisory reluctance to “a belief that the traditional, nonpublic (behind-the-scenes) approach to supervision was less confrontational and more likely to induce bank management to cooperate; a desire not to inject an element of contentiousness into what was felt to be a constructive or equable relationship with management; and a fear that financial markets would overreact to public actions, possibly causing a run.” Spillenkothen argued that these concerns were relevant but that “at times they can impede effective supervision and delay the implementation of needed corrective action. One of the lessons of this crisis . . . is that the working pre- sumption should be earlier and stronger supervisory follow up.”  FOMC20080130meeting--148 146,MR. PLOSSER.," So are these ""extra channels""-- if you want to call them that--typically part of the forecast change and how you evaluate? That is to say, in the fall, when the stock market booms 10 percent, are we going to get another kicker upward in r* due to these same factors? " CHRG-111shrg61651--137 PREPARED STATEMENT OF HAL S. SCOTT Nomura Professor of International Financial Systems at Harvard Law School; and Director of the Committee on Capital Markets Regulation February 4, 2010 Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee for permitting me to testify before you on the implications of the Volcker Rules for Financial Stability (Volcker Rules), as well as President Obama's proposed size limitations on banks. I am testifying today in my own capacity and do not purport to represent the views of the Committee on Capital Markets Regulation. Let me preface my testimony by stressing the urgent need for broad regulatory reform in light of the financial crisis on matters ranging from the structure of our regulatory system, to the reduction of systemic risk in the derivatives market, to improving resolution procedures for insolvent financial companies, to increasing consumer protection, and to revamping the GSEs. The Committee on Capital Markets Regulation dealt with these issues in its May 2009 Report titled ``The Global Financial Crisis: A Plan for Regulatory Reform''. \1\ These issues were also fully laid out in the Treasury Department's June 2009 proposal on financial regulatory reform, \2\ and have been vigorously debated in public meetings, the press, and Congressional hearings for months. These efforts have so far culminated in the Wall Street Reform and Consumer Protection Act (H.R. 4173) as well as in Senator Dodd's thoughtful Discussion Draft. And I applaud the ongoing efforts of this Committee to reach bipartisan consensus on these issues. In my judgment, we should not hold up these important reforms while we debate activity and size limitations.--------------------------------------------------------------------------- \1\ This report contains 57 recommendations for making the U.S. financial regulatory structure more integrated, more effective and more protective of investors. Comm. on Capital Mkts. Reg., The Global Financial Crisis: A Plan For Regulatory Reform (May 2009). \2\ U.S. Dep't of the Treasury, Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision And Regulation (June 2009) [hereinafter Treasury White Paper], http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.--------------------------------------------------------------------------- The Volcker Rules would limit the ability of banks \3\ to own, invest in, or sponsor a hedge fund or private equity fund, or to engage in ``proprietary trading.'' The size limitation would limit the market share of all financial institution liabilities beyond the current 10 percent market share cap applied to bank deposits.--------------------------------------------------------------------------- \3\ We use the term ``banks'' to refer generally to bank holding companies and their subsidiaries.--------------------------------------------------------------------------- At the outset, it is important to focus on the stated objective of these new proposals--to reduce bank risk so as to minimize the necessity of public rescue of banks that are ``Too Big to Fail.'' There is no question that we need to address the ``Too Big to Fail'' issue. We need to understand whether the conventional wisdom--that we cannot let large financial institutions fail, in the sense of imposing a full measure of losses on the private sector, whether they be equity or unsecured debt holders or counterparties--is actually true. The concern rests on an assumption that we cannot permit certain large and interconnected financial institutions to fail because such failure would trigger a chain reaction of other financial institution failures, with disruption to the entire economy. In the notable $85 billion Federal bailout of AIG, however, some question whether the asserted prospect of severe counterparty losses actually existed. Goldman Sachs, one of AIG's major counterparties, has stated that it had adequate cash collateral to survive an AIG default. \4\ We need to be careful that ``Too Big to Fail'' does not become a self-fulfilling prophecy.--------------------------------------------------------------------------- \4\ Transcript of F3Q09 Earnings Call (David Viniar, Chief Fin. Officer, Goldman Sachs Group, Inc.) (Oct. 15, 2009).--------------------------------------------------------------------------- Clearly, the absolute size of an institution is not the predicate for systemic risk; it is rather the size of its debt, its derivatives positions, and the scope and complexity of many other financial relationships running between the firm, other institutions, and the wider financial system. As Senator Schumer's example at Tuesday's hearing illustrates, 50 small but highly correlated hedge funds might combine to create systemic risk. In short, the proper focus is on a bank's interconnectedness with other financial institutions, and we have only a primitive understanding of the nature and extent of these connections. To the extent interconnectedness is a problem, the most fundamental way to attack it is to reduce the interconnections so that we can allow institutions to fail safely. This will also require that Federal regulators be given enhanced resolution authority, as set forth in H.R. 4173 and Senator Dodd's Discussion Draft. \5\ And as Secretary Geithner recently acknowledged, ``the Bankruptcy Code is not an effective tool for resolving the failure of a global financial services firm in times of severe economic stress.'' \6\--------------------------------------------------------------------------- \5\ H.R. 4173, 111th Cong. Subtitle G (2009); Restoring American Financial Stability Act, 111th Cong. Title II (2009) (mark by the Chairman of the S. Comm. on Banking, Housing and Urban Affairs). \6\ Systemic Regulation, Prudential Matters, Resolution Authority and Securitization: Hearing Before the H. Comm. On Financial Services, 111th Cong. 2 (2009) (written testimony of Timothy F. Geithner).--------------------------------------------------------------------------- To address our ``Too Big to Fail Problem,'' we need to modernize financial regulation to address the problems of today, not of the past. Let me now turn in more depth to the Volcker Rules.I. Proposed Restrictions on the Scope of Bank OperationsA. Proprietary Trading and ``Too Big to Fail'' The Volcker Rules would prohibit banks and bank holding companies from engaging in proprietary trading ``unrelated to serving customers for [their] own profit,'' as well as from investing in or sponsoring hedge fund and private equity fund operations. \7\ Given that Mr. Volcker is the Chairman of the Trustees as well as the Chairman of the Steering Committee of the Group of 30 (G-30), it is worth noting that the Volcker Rules are significantly more aggressive than the G-30's recent proposal to merely limit proprietary trading by ``strict capital and liquidity requirements.'' \8\--------------------------------------------------------------------------- \7\ Press Release, The White House, Remarks by the President on Financial Reform (Jan. 21, 2010), available at http://www.whitehouse.gov/the-press-office/remarks-president-financial-reform. \8\ Group of 30, Financial Reform: A Framework for Financial Stability 8 (Jan. 15, 2009), http://www.group30.org/pubs/recommendations.pdf. --------------------------------------------------------------------------- The objective embodied in the Volcker Rules is to restrict banks that are ``Too Big to Fail'' from participating in nontraditional risky investment activity, thus minimizing the chance they might fail and have to be rescued to avoid endangering uninsured depositors or the FDIC insurance fund. This might have been the concern in the past but it misses the mark today. The reason for the rescues during the crisis, such as AIG, or the TARP injections to forestall failures, was not to protect depositors of banks or the FDIC insurance fund. The reason was rather to avoid a chain reaction of failures set off by interconnectedness. Furthermore, this need for rescue does not depend on what activity gives rise to the potential bank failure. We will have to rescue banks whose failure will endanger other banks even if these failing banks are engaging in traditional activities. Mr. Volcker seems to imply that it is acceptable to rescue banks engaging in traditional activities. I disagree. Quite frankly, I do not think a taxpayer would feel better about rescuing a bank that made risky loans than he would rescuing a bank that engaged in less traditional risky activity. As a solution to the problem of ``Too Big to Fail,'' the Volcker Rules are over-inclusive because not all banks, and not even all large banks, pose chain-reaction risks to the financial system. The Rules are also potentially under-inclusive, because many interconnected financial institutions which do pose systemic risks are not deposit-taking banks. Goldman Sachs--which is the only U.S. bank with significant revenue exposure to proprietary trading \9\--could avoid falling under the Volcker Rules by divesting itself of its small deposit-taking operations, which account for only 5.19 percent of its liabilities. \10\ Similarly, Morgan Stanley would lose only 8.70 percent of its liability base by giving up bank holding company status. \11\ None of the most prominent failures of the financial crisis--Fannie Mae, Freddie Mac, AIG, Bear Stearns, or Lehman Brothers--were deposit-taking banks.--------------------------------------------------------------------------- \9\ Goldman's management has stated that proprietary trading accounts for 10 percent of its total revenues. Transcript of F4Q09 Earnings Call (David Viniar, Chief Fin. Officer, Goldman Sachs Group, Inc.) (Jan. 21, 2010). Citigroup reportedly maintains proprietary trading operations accounting for 5 percent of revenues. Jonathan Weisman, Damian Paletta and Robin Sidel, New Bank Rules Sink Stocks--Obama Proposal Would Restrict Risk-Taking by Biggest Firms as Battle Looms, Wall St. J., Jan. 21, 2010, available at http://online.wsj.com/article/SB10001424052748703699204575016983630045768.html; Citigroup Inc., Quarterly Report (Form 10-Q), at 88 (Nov. 7, 2009). \10\ See, Goldman Sachs Group, Inc., Quarterly Report (Form 10-Q), at 5 (Nov. 4, 2009). \11\ Morgan Stanley, Quarterly Report (Form 10-Q), at 2 (Nov. 9, 2009).--------------------------------------------------------------------------- Furthermore, major U.S. banks that do have high levels of deposits relative to total liabilities derive only a marginal fraction of their revenues from walled off proprietary trading activities, if ``proprietary trading'' is understood as trading activity carried out on internal trading desks purely for a bank's own account. Wells Fargo and Bank of America, two of the largest deposit-funded banks, report deposits accounting for approximately 72 percent and 49 percent of their total liabilities, respectively, but are both estimated to earn less than 1 percent of revenues from proprietary trading. \12\ These data show that U.S. banks with significant deposit bases assume little to no balance sheet risk from proprietary trading. Riskier institutions that do have exposure, if forced to choose between proprietary trading and deposits, may opt to ``de-bank.'' But because banks are highly regulated entities, regulators are in a good position to respond to bank failures. By encouraging banks to take themselves off the regulatory radar, the Volcker Rules could actually increase systemic risk. The regulatory and supervisory system is much better able to deal with controlling the risky activity of regulated banks than of unregulated investment banks, insurance companies, hedge funds, or commercial companies with large financial operations. The migration of risky bank activities to other large firms that may be ``Too Big to Fail'' would compound, rather than reduce, the systemic risk problem. The Administration's earlier proposals envision some level of regulation of systemically important institutions other than banks, but such regulation will be much less comprehensive than it is for banks.--------------------------------------------------------------------------- \12\ See, Bank of America Corp., Quarterly Report (Form 10-Q), at 4 (Nov. 7, 2009); Wells Fargo and Co., Quarterly Report (Form 10-Q), at 63 (Nov. 7, 2009); Brooke Masters, ``Alert Over Proprietary Trading Clamp'', Fin. Times, Jan. 28, 2010, available at http://www.ft.com/cms/s/0/0293b842-0bab-11df-9f03-00144feabdc0.html.--------------------------------------------------------------------------- The original proposal was somewhat ambiguous as to the level of the banking organization at which the Rules would apply. Unless the Rules limit the activities of bank holding companies and all holding company subsidiaries, banks could evade the restrictions by shifting hedge fund or private equity investments and proprietary trading activities to nonbank subsidiaries. This would, perhaps, protect bank depositors, but it would not solve the need to rescue bank holding companies to avoid the chain-reaction-of-failures problem. Because proprietary trading, hedge fund, and private equity investments could pose the same threat to other financial institutions because of connectedness, regardless of whether they occur in a bank or its holding company, the Volcker Rules only make sense if they apply to bank holding companies and all of their subsidiaries (including banks and nonbanks).B. What Is Proprietary Trading? Mr. Volcker is confident that he as well as bankers know proprietary trading when they see it. Yet it is notable that neither Mr. Volcker nor the Treasury Department has presented a workable definition of this term. The suggestion that it can be measured by a pattern of large gains and losses is unclear. Hedges or positions taken for customers can exhibit the same pattern. Defining ``proprietary trading'' presents tremendous difficulties. Too narrow a definition, limited to discrete internal hedge fund and private equity activity undertaken by banks for their own accounts, is unlikely to lead to material reduction of risk, since these activities account for only a small fraction of most banks' operations. Defining proprietary trading too broadly, meanwhile, might seriously impair the basic function of modern banks as market-makers in Government and nongovernment securities, and as securitizers of consumer debt. Neither of these options is very attractive. 1. Proprietary Trading as ``Internal Hedge Funds'' Is Insignificant to Banks.--Strictly construed, proprietary trading ``unrelated to serving customers'' encompasses any trading activity carried out on internal trading desks for a bank's own account, but not on behalf of clients. \13\ Writing in the New York Times on Sunday, Mr. Volcker echoed this definition, identifying proprietary trading as ``the search [for] speculative profit rather than in response to customer need.'' \14\ Generally speaking, there are at least two reasons why this narrow definition of the activity is unlikely to reduce systemic risk. First, in absolute terms, the scale of such internal, noncustomer, proprietary trading is too negligible to drastically impact banks that engage in it. As outlined above, most U.S. banks, with the exception of Goldman Sachs, report minimal proprietary trading activity so defined.--------------------------------------------------------------------------- \13\ Bernstein Research, Quick Take--Thoughts About Proposed Trading Constraints and Investment Prohibitions 1 (Jan. 22, 2010). \14\ Paul Volcker, ``Op-Ed, How To Reform Our Financial System'', N.Y. Times, Jan. 31, 2010, available at http://www.nytimes.com/2010/01/31/opinion/31volcker.html?hp. (This article was attached to Mr. Volcker's testimony on Feb. 2, 2010.)--------------------------------------------------------------------------- Second, proprietary trading through internal hedge funds and other non-customer-related trading desks was not the source of the damaging losses that fatally impaired many of the banks at the center of the financial crisis. According to one Wall Street analyst's estimate, of the approximately $1.67 trillion of cumulative credit losses reported by U.S. banks, losses taken on trading activities and derivatives accounted for less than $33 billion, or 2 percent, of this total. \15\ And as Bernstein Research notes in a recently published analysis, a construction of the Volcker Rules confined exclusively to internal hedge fund activity would not, for example, have reached the significant mortgage positions and unsecuritized loans held by Lehman Brothers that plummeted in value as liquidity drained from the market during the crisis. These positions, while proprietary, were not trading positions assumed by an internal trading desk for Lehman's own account. \16\ Instead, they were accumulated as part of Lehman's mortgage-underwriting and securitization businesses.--------------------------------------------------------------------------- \15\ Goldman Sachs Group, Inc., Goldman Investment Research, United States: Banks 6 (Nov. 30, 2009). \16\ Bernstein Research, supra note 13, at 1.--------------------------------------------------------------------------- 2. Loan and Securitization Losses Were at the Heart of the Financial Crisis.--The losses at the center of the financial crisis mainly resulted from the credit, lending, and securitization functions of U.S. banks. To date, the vast majority of overall credit losses--approximately 80 percent--have been linked to lending and securitization operations. \17\ Goldman Sachs estimates that approximately $577 billion, or 34 percent, of cumulative losses were incurred by banks on direct real-estate-related lending, including mortgages, commercial real-estate loans, and construction lending. An additional $338 billion of losses on non-real-estate loans accounted for 20 percent of cumulative losses. A further $519 billion, or 31 percent, represented losses on indirect real-estate-backed securitizations, including RMBS, CMBS, and CDOs. The loss experiences of smaller regional banks, where poor-quality mortgage and construction loans drove the largest failures, confirm the centrality of credit and lending to bank losses. For example, option ARMs represented 65 percent of total loans at Downey Savings, 59 percent at BankUnited, 29 percent at Indymac, and 22 percent at Washington Mutual. Construction loans accounted for 88 percent of Corus Bank's loan book. \18\ At regional U.S. banks, just as at the national and global levels, under-priced credit risk embedded in loans and securitized debt, and not speculative internal hedge funds, generated the lion's share of the losses that led to financial collapse.--------------------------------------------------------------------------- \17\ Goldman Sachs Group, Inc., supra note 15. \18\ Id. at 7.--------------------------------------------------------------------------- To be clear, portfolios of securitized debt instruments held on- and off-balance sheet by banks were responsible for roughly one-third of total credit losses. Broadening the definition of ``proprietary trading'' to restrict banks from holding securitized debt instruments might address one of the central risks banks were exposed to in the financial crisis. But do we really want to prevent banks from investing in securitized debt altogether? The question is complicated by the fact that owning securitized assets typically serves several purposes for banks, including making markets in securitized assets and assuring clients that the banks that structured their deals will have ``skin in the game,'' particularly by holding junior tranches of securitized debt. \19\ Indeed, recently adopted legislation in the European Union requires banks to retain a 5 percent interest in securitizations. \20\ While it was also true that banks held securitized debt for speculative reasons, it would be difficult to separate such positions from those needed to engage in the securitization business. A blanket rule preventing banks from holding securitized debt might interfere with the revival of our already moribund securitized debt markets, \21\ since it would deprive banks of an important way of signaling the quality of issuances. Because restoring these markets is crucial to fueling new lending and economic growth \22\--Mr. Volcker himself, in his opinion piece, cited the ``large challenge in rebuilding an efficient, competitive private mortgage market, an area in which commercial bank participation is needed'' \23\--regulators must bear this risk in mind when implementing reforms.--------------------------------------------------------------------------- \19\ Morgan Stanley, Annual Report (Form 10-K), at 54 (Jan. 29, 2008) (for a discussion of these different roles of VIEs/SPVs in owning securitized assets). \20\ Regulations in the European Union permit ``credit institutions'' to have securitization exposures only if the ``originator, sponsor or original lender'' (a) retains no less than 5 percent of the nominal value of each of the tranches sold or transferred; (b) in the case of securitization of revolving exposures, retains of the originator's interest no less than 5 percent of the nominal value of the securitized exposures; (c) retains randomly selected exposures, equivalent to less than 5 percent of the securitized exposures, where such exposures would otherwise have been securitized in the securitization, provided that the number of potentially securitized exposures is no less than 100 at origination; or (d) retains the first loss tranche, and if necessary, other tranches having the same or more severe risk profile than those transferred or sold to investors and not maturing any earlier than those transferred or sold to investors, so that retention equals in total no less than 5 percent of the nominal value of the securitized exposures. European Parliament and Council Directive 2009/111/EC, Sept. 16, 2009, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0097:0119:EN:PDF. \21\ Data from the Securities Industry and Financial Markets Association show that there were approximately $146 billion of asset backed securities issued in the U.S. in 2009, as compared to about $754 billion when issuance of asset backed securities was at its peak in 2006. See, Sec. Indus. and Fin. Mkt. Ass'n, U.S. ABS Issuance, http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf. \22\ Int'l Monetary Fund, Global Financial Stability Report 78 (Oct. 2009), available at http://www.imf.org/external/pubs/ft/gfsr/2009/02/index.htm. \23\ Volcker, supra note 14 (emphasis added).--------------------------------------------------------------------------- 3. Market-Making in Securities Is a Core Function of Banks.--In its most expansive formulation, proprietary trading could include any activity that places principal at risk, including the longstanding role that banks have played in modern capital markets as market-makers in U.S. Government, agency, and nongovernment securities. A rule which restricts the scope of this function by classifying market-making as a form of proprietary trading would reduce liquidity and increase borrowing costs throughout a wide range of securities markets, including the market for GSE and U.S. Treasury securities. This activity cannot easily be performed by other institutions--it requires the large balance sheets of banks. According to Federal Reserve data cumulating securities ownership across all bank securities portfolios (including held-to-maturity, available for sale, and trading), over 60 percent of the securities held by banks are agency MBS and Treasuries. \24\ Forced reductions in this inventory under the Volcker Rules would drain liquidity from important Government funding markets and entail higher borrowing costs for the U.S. Government and its sponsored entities, negatively impacting economic recovery. \25\ Mr. Volcker likewise recognizes what he has called the ``essential intermediating function'' banks serve in meeting the ``need for reliable sources of credit for businesses, individuals, and governments.'' \26\ And Glass-Steagall itself recognized the linkage between liquidity in Government debt markets and proprietary trading by banks in Government securities, providing for an exception authorizing banks to deal in, underwrite, and purchase for their own account securities issued by the U.S. Government. \27\ So the area which comprises the largest portion of bank trading, U.S. Government securities, would have to be preserved.--------------------------------------------------------------------------- \24\ Fed. Res. Bd., Assets and Liabilities of Commercial Banks in the United States (Jan. 29, 2010), http://www.federalreserve.gov/releases/h8/current/h8.pdf. \25\ These portfolio breakdowns illustrate how banks manage cash through treasury operations on an ongoing basis by investing it in U.S. Treasuries, GSE securities, and other fixed-income securities in order to manage risk and improve their financial position. While treasury operations are largely fungible with running an ``internal hedge fund,'' they are an inevitable part of running a bank. This suggests that trying to prevent banks from running internal hedge funds may be an exercise in futility. \26\ Volcker, supra note 14 (emphasis added). \27\ 12 U.S.C. 24 (Seventh) provides that ``[t]he limitations and restrictions herein contained as to dealing in, underwriting, and purchasing for its own account, investment securities shall not apply to obligations of the United States, or general obligations of any State or of any political subdivision thereof.''--------------------------------------------------------------------------- 4. Proprietary Trading Is a Source of Diversification for Banks.--Portfolio diversification reduces risk. All else being equal, more concentrated portfolios are more volatile than portfolios containing an array of uncorrelated earnings streams, even when parts of the uncorrelated income are volatile. As the breakdowns discussed earlier illustrate, a substantial portion of bank losses sustained in the 2007-2008 financial crisis emanated from highly concentrated exposures to direct real-estate loans. And past financial crises, like the sovereign debt and thrift crises of the 1980s and the Asian crises of the 1990s, also involved lending operations. Proprietary trading (excluding securitization, as discussed earlier), which barely contributed to losses in these earlier periods, is a source of diversification that may help to mitigate, not aggravate, the risk profile of U.S. banks in the future. During the financial crisis, firms with significant proprietary trading operations like Goldman Sachs, or those that ran complex, interconnected books of business, including Goldman, Morgan Stanley, and JPMorgan, survived. Indeed, this diversification helped protect them in the crisis. By contrast, firms that concentrated their exposures in real-estate, like Lehman, or isolated these exposures in large, undercapitalized, off-balance sheet silos either did not survive, or needed Government capital injections to keep them afloat.C. Limitations on Private Equity and Hedge Fund Investing by Banks The Volcker Rules, in addition to limiting proprietary trading activity, would also restrict banks from owning, investing in, or sponsoring private equity funds (including venture capital funds whose activity is crucial to small business) and hedge funds. Worldwide, banks and investment banks account for $115 billion, or 12 percent, of the $1.1 trillion of investment by limited partners including coinvestments in private equity funds involved in corporate finance and buyouts. \28\ Indeed, banks are a larger source of capital as private equity limited partners than endowments or sovereign wealth funds. \29\ Historically, banks have also represented an important source of direct proprietary involvement in private equity as general partners, raising an estimated $80 billion in committed capital from investors over the past 5 years. \30\ Mandating the exit of banks from involvement in these activities could force the withdrawal of a substantial fraction of the private equity industry's available investment capital. This would deal a disruptive blow to the recovery of the private equity industry on the heels of serious setbacks in terms of both fundraising and transaction activity which the industry sustained from 2007 to 2008. U.S. and global private equity fundraising activity remains at or below 2004 levels, with less than $10 billion raised by U.S. funds in Q4 2009 as compared to an excess of $100 billion raised in the same period in 2007. \31\ Nonetheless, private equity is still an important financing source for the U.S. economy, providing needed investment to undercapitalized or recapitalizing U.S. industries, including the financial sector. In Q4 2009, as investment activity began to recover, private equity funds invested $8 billion in U.S. buyouts (executing $48 billion in M and A transaction volume). \32\ At a moment when private equity activity is starting to rebound, rules that would force a withdrawal or reconfiguration of significant capital in the industry could chill investment in U.S. industry.--------------------------------------------------------------------------- \28\ Private Equity Council, Private Equity and Banks 1, Jan. 22, 2010; see also Press Release, Preqin, Effects of Obama's Proposal on Alternatives Industry Significant (Jan. 22, 2010), http://www.preqin.com/docs/press/Preqin-PR-Potential-effects-of-Obamas-proposals-on-alternatives.pdf. \29\ Private Equity Council, supra note 28, at 1. \30\ Id. \31\ Private Equity Council, 2009 Year End Update 5-6, Jan. 4, 2010. \32\ Id. at 2.--------------------------------------------------------------------------- These prospective costs to the economy might be acceptable if they were offset by a commensurate reduction in bank balance sheet risk. But while bank investment is an important source of capital to private equity, it is not a meaningful proportion of bank assets. \33\ As of September 30, 2009, investment in private equity accounted for less than 3 percent of the aggregate reported trading and/or ``other'' assets of the six largest U.S. banks. As a percentage of total bank assets, private equity investments accounted for less than 1 percent of the total consolidated balance sheet of Bank of America, JPMorgan, Wells Fargo, and Citigroup, and less than 2 percent of the total balance sheet assets of Goldman Sachs and Morgan Stanley. \34\ While relatively little bank capital is at risk in the private equity business, private equity nevertheless represents an important source of advisory, syndication, and underwriting revenues for banks which sponsor private equity funds. \35\ Mandating the spin-off or closure of these funds would not improve the composition of bank balance sheets or the profile of bank riskiness, but would terminate a lucrative source of earnings at a time when banks are focused on recapitalizing.--------------------------------------------------------------------------- \33\ Indeed, of the 10 largest private equity firms worldwide, only one--Goldman Sachs--is a U.S. bank. Bernstein Research, supra note 13, at 3. \34\ Private Equity Council, supra note 28, at 1-8. \35\ Bernstein Research, supra note 13, at 3. Proprietary Investment in Private Equity as a Percentage of Trading and Other Assets (Q3 2009)\36\ ($ millions)---------------------------------------------------------------------------------------------------------------- Proprietary PE Investment % Investment in Trading and Other of Trading and Private Equity Assets Other Assets----------------------------------------------------------------------------------------------------------------Bank of America.......................................... $13,500 $280,000 4.8%Goldman Sachs............................................ $12,480 $381,000 3.3%Morgan Stanley........................................... $8,500 $340,000 2.5%JPMorgan................................................. $6,836 $351,000 1.9%Wells Fargo.............................................. $2,771 $98,827 2.8%Citigroup................................................ $359 $118,000 0.3%---------------------------------------------------------------------------------------------------------------- Total................................................ $44,446 $1,568,827 2.8%---------------------------------------------------------------------------------------------------------------- Although we have not been able to gather much data regarding bank exposure to the hedge fund industry, \37\ the information we do have suggests that eliminating these activities will not significantly reduce bank risk profiles either. Analysis by Preqin shows that banks directly invest only $10 billion (or 0.9 percent) of the total capital invested by U.S. investors in hedge funds. \38\ In addition, banks have fund-of-funds units that are responsible for channeling $180 billion (or 16 percent) of all U.S. capital flowing to hedge funds. \39\ It is unclear what percentage of this $180 billion represents banks' own capital. But even on the implausible assumption that all of $180 billion comes from banks, it likely represents a negligible portion of bank risk. \40\ It is far more likely that a significant portion of the $180 billion is money that banks are managing on behalf of clients. Managing client funds (apart from the use of seed money) generally does not place bank capital at risk, and therefore does not implicate the underlying rationale of the Volcker Rules. \41\--------------------------------------------------------------------------- \36\ Private Equity Council, supra note 28. \37\ This is a distinct topic from what we referred to in section I.B.1 as ``internal hedge fund activity'' at banks. The focus there was on trading activity carried out on internal trading desks that are for a bank's own account. Here, the focus is investments banks make directly, as limited or general partners, or indirectly, through funds of funds products, to hedge funds established as distinct legal entities. Some such hedge funds are managed by third-parties, while others are managed by bank affiliates. \38\ Preqin, supra note 28. \39\ Id. \40\ To provide a very rough sense of scale, as of September 2009, Goldman Sachs and JPMorgan held assets worth approximately $882 billion and $2.04 trillion, respectively. Goldman Sachs Group, Inc., Quarterly Report (Form 10-Q) (Nov. 4, 2009); JPMorgan Chase and Co., Quarterly Report (Form 10-Q) (Nov. 10, 2009). \41\ Industry sources indicate that banks make small contributions of ``seed money'' to new funds to get them off the ground. Even if the Volcker Rules are enacted, the ability to make such contributions should be preserved through de minimus carveouts.--------------------------------------------------------------------------- In his written testimony, Deputy Secretary Wolin seemed to refer to Bear Stearns when he wrote that ``[m]ajor firms saw their hedge funds and proprietary trading operations suffer large losses in the financial crisis. Some of these firms `bailed out' their troubled hedge funds, depleting the firm's capital at precisely the moment it was most needed.'' \42\ Although Bear Stearns later pledged $3.2 billion to bailout Bear Stearns High-Grade Structured Credit Fund and Bear Stearns High-Grade Structured Enhanced Leverage Fund, Bear's original principal exposure was only $40 million. Clearly, Bear's real exposure, on a reputational basis, exceeded its investment. The same was true for many banks' SIVs and conduits. This problem is best addressed by FASB's new consolidation accounting rules, FAS 166 and 167, \43\ which effectively require banks to hold capital against these exposures. There is no need to ban these sponsorships entirely.--------------------------------------------------------------------------- \42\ Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies: Hearing Before the S. Comm. on Banking, Housing and Urban Affairs, 111th Cong. 3 (Feb. 2, 2010) (statement of Neal S. Wolin, Deputy Secretary, U.S. Dep't of the Treasury) [hereinafter Wolin Testimony]. \43\ Fin. Accounting Standards Bd., Statement of Financial Accounting Standard 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 and Fin. Accounting Standards Bd., Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R).--------------------------------------------------------------------------- As the above analysis suggests, bank involvement with private equity and hedge funds can benefit bank customers in significant ways. Banks that sponsor or invest in private equity funds and hedge funds are better positioned to serve their global clients, who increasingly look to banks for ``one-stop shopping'' in financial products and services. Given the dramatic rise in assets under management in the private equity and hedge fund industry, \44\ it is fair to infer that clients are particularly interested in these offerings. In addition, to the extent that banks are permitted to continue managing funds or fund-of-funds, allowing them to invest their own money alongside customers' is an important way to align interests.--------------------------------------------------------------------------- \44\ Private Equity Council, supra note 31, at 1-8; Hedge Funds 2009 (Int'l Fin. Serv. London Research), Apr. 2009, http://www.thehedgefundjournal.com/research/ifsl/cbs-hedge-funds-2009-2-.pdf.--------------------------------------------------------------------------- Taking a more skeptical view of the implications for customers of bank involvement in proprietary trading as well as private equity funds and hedge funds, Mr. Volcker recently argued that these activities ``present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called `Chinese walls' between different divisions of an institution.'' \45\ Mr. Volcker elaborated on this point in his testimony before the Committee:--------------------------------------------------------------------------- \45\ Volcker, supra note 14. I want to note the strong conflicts of interest inherent in the participation of commercial banking organizations in proprietary or private investment activity. That is especially evident for banks conducting substantial investment management activities, in which they are acting explicitly or implicitly in a fiduciary capacity. When the bank itself is a ``customer'', i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank. ``Inside'' hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same ``inside'' funds may be favored over outside competition in placing funds for clients. More generally, proprietary trading activity should not be able to profit from knowledge of customer trades. \46\--------------------------------------------------------------------------- \46\ Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies: Hearing Before the S. Comm. on Banking, Housing and Urban Affairs, 111th Cong. (Feb. 2, 2010) (statement of Paul A. Volcker, Chairman, President's Economic Recovery Advisory Board) [hereinafter Volcker Testimony]. If there is a sound justification for the Volcker Rules, it is that they would limit systemic risk, not that they would prevent conflicts of interest. Moreover, the issue of conflicts of interest was considered and rejected during the repeal of Glass-Steagall. If Mr. Volcker's contention were correct, it would be equally applicable to a much wider range of bank activities than proprietary trading and investment in hedge funds and private equity. It would extend to bank involvement in the underwriting of securities, for example, where the argument has long been made that a banker underwriting a faltering securities offering would encourage clients to invest in the securities. \47\ Given that there is no proposal to limit bank underwriting, or other securities services that raise potential conflicts, \48\ it is unclear why conflict of interest concerns justify restricting bank investments.--------------------------------------------------------------------------- \47\ Joseph Michael Heppt, ``An Alternative to Throwing Stones: A Proposal for the Reform of Glass-Steagall'', 52 Brook. L. Rev. 281, 289 (1986). \48\ In, Investment Company Institute v. Camp, 401 U.S. 617 (1971), the Supreme Court discussed several additional conflicts that arise when commercial banking and securities services are combined. These include that banks involved in securities activities would: (a) lose the confidence of the public if their securities affiliates experienced business difficulties; (b) fail to act as ``impartial sources of credit,'' giving preference to their securities affiliates or to borrowers that use securities services; (c) make unsound loans to their securities affiliates or to borrowers who use their securities services; (d) become unable to act as disinterested advisors to their commercial banking clients; and (e) divert talent and resources to their securities businesses.---------------------------------------------------------------------------II. Proposed Restrictions on the Size of Banks and other Financial InstitutionsA. Proposed Limitations on the Size of Banks The actual operation of the size limitations is even less clear than the meaning of the Volcker Rules on bank activity. The Administration has referred to ``limits on the excessive growth of the market share of liabilities at the largest firms, to supplement existing caps on the market share of deposits.'' \49\ This appears to mean that the size limit would apply to banks' market share of nondeposit liabilities.--------------------------------------------------------------------------- \49\ The White House, supra note 7.--------------------------------------------------------------------------- Deputy Secretary Wolin's recent testimony that the ``size limit should not require existing firms to divest operations,'' but will instead ``serve as a constraint on future excessive consolidation among our major financial firms,'' would appear to be addressed to market concentration and antitrust concerns since they carry the striking implication that no firm is currently ``Too Big to Fail.'' \50\ If market concentration is the concern, we need to understand why existing antitrust law is not up to the task of dealing with this problem, while if systemic risk is the issue, it is puzzling why the size caps should apply only to firms that grow by acquisition. Presumably we should be concerned about the size (or the interconnectedness) of firms, whether the result of acquisition, organic growth, or otherwise.--------------------------------------------------------------------------- \50\ Wolin Testimony, supra note 42, at 4.--------------------------------------------------------------------------- To the extent systemic risk is the issue, the central questions are: (a) whether larger banks are more or less likely to fail than smaller banks; (b) whether the failure of large banks generates higher levels of systemic risk; and (c) whether the Administration's proposal to cap each banks' market share of liabilities is a plausible remedy for the problem. If larger banks are riskier than smaller ones, the differences are likely to be relatively minor. \51\ Studies have found that large banks hold more diversified portfolios and are engaged in a wider range of business, and that such diversification serves as a source of strength. \52\ Scholars have also found that size promotes stability since it is easier for large banks to obtain funding in the capital markets. \53\ On the other hand, larger banks tend to use size advantages to make riskier loans, conduct more off-balance sheet activities, and maintain more aggressive leverage ratios. \54\ As banks grow larger, they may take on additional risk by becoming reliant on noninterest income and nondeposit funding. \55\ On net, this combination of considerations may roughly balance out.--------------------------------------------------------------------------- \51\ Rebecca Demsetz and Philip Strahan, ``Historical Patterns and Recent Changes in the Relationship Between Bank Holding Company Size and Risk'', 1 Econ. Pol. Rev. 13 (July 1995); see also Rebecca Demsetz and Philip Strahan, ``Diversification, Size, and Risk at Bank Holding Companies'', 29 J. Money, Credit, and Banking 300, 308 (1997). \52\ See, e.g., Rebecca Demsetz and Philip Strahan, ``Diversification, Size, and Risk at Bank Holding Companies'', 29 J. Money, Credit, and Banking 300 (1997). \53\ Jith Jayaratne and Donald P. Morgan, ``Capital Market Frictions and Deposit Constraints at Banks'', 32 J. Money, Credit, and Banking 74 (2000). \54\ See, e.g., Demsetz and Strahan, supra note 52, at 312. \55\ Asli Demirguc-Kunt and Harry Huizinga, ``Bank Activity and Funding Strategies: The Impact on Risk and Return'' 29 (European Banking Center Discussion Paper No. 2009-01, 2009).--------------------------------------------------------------------------- Turning to the second question, the surprising fact is that we do not know whether larger institutions pose greater systemic risk and, if so, whether that increase is significant. As discussed above, this question requires more data and discussion. The issue is whether larger banks are more interconnected in such a way that their failure would set off a chain reaction of failures. This should not be accepted on faith. To the extent that systemic risk does increase with ``size,'' it is unclear that broad-brush restrictions on nondeposit liabilities are the solution. First, the focus on liabilities ignores the fact that a bank's riskiness is determined in large part by the assets it holds. Some of the most prominent victims of the financial crisis failed because of the interactions between different parts of their balance sheets (e.g., funding risky assets with overnight loans). Second, a bank could comply with the general liability restrictions while maintaining risky assets. The Volcker Rules would not limit the ability of banks to make risky loans. Thus, the somewhat smaller bank, faced with Volcker Rules and size caps, may shift its activity to overall higher levels of risk in search of return. As Raghuram Rajan, Professor of Finance at the University of Chicago and author of a prescient paper anticipating the financial crisis, \56\ recently wrote:--------------------------------------------------------------------------- \56\ See, Raghuram G. Rajan, Fed. Res. Brd. of K.C., ``Has Financial Development Made The World Riskier?'' (2005), http://www.kc.frb.org/publicat/SYMPOS/2005/PDF/Rajan2005.pdf. Crude asset size limits, for example, would probably ensure a lot of financial activity is hidden from the regulator, only to come back to light (and to the balance sheets) at the worst of times. There are many legal ways to mask size. Banks can offer guarantees to assets placed in off-balance sheet vehicles, much like the conduits of the recent crisis. If, instead, capital is the measure, then we will be pushing banks to economize on it as much as possible, hardly a recipe for safety. \57\--------------------------------------------------------------------------- \57\ Raghuram Rajan, Op-Ed., ``A better way to reduce financial sector risk'', Fin. Times, Jan. 25, 2010. Finally, we should consider if overall size limitations are preferable to an approach targeted at individual institutions. It appears that, at most, only six banking institutions would be impacted. Assuming, for example, that a 10 percent of domestic wholesale funding market share ceiling is imposed on U.S. banks--analogous to the deposit market share limits already in place--Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, and Morgan Stanley are the only institutions that appear to approach this ceiling level. \58\ If a higher ceiling than 10 percent wholesale funding market share is imposed, it is possible that only the very largest domestic users of wholesale funding--Bank of America and JPMorgan Chase, the only two institutions with wholesale funding market shares significantly greater than 10 percent--would be impacted. We note that beyond these six institutions, the U.S. bank wholesale funding market is highly fragmented; no other institution has more than a 3 percent market share. Given that the size limitations might affect only a handful of banks, a better policy would be to address issues at those banks individually through better and more intense supervision.--------------------------------------------------------------------------- \58\ This judgment is subject to some measurement error due to the difficulty of determining the precise domicile of particular wholesale funding sources. Apart from defining what types of nondeposit liabilities count as wholesale funding, the specific data issue that arises in determining U.S. wholesale funding market shares relates to determining sources of wholesale funding. While the Federal Reserve reports wholesale funding data for the U.S. banking system as a whole (see, Bd. of Gov. of the Fed. Res., Assets and Liabilities of Commercial Banks in the United States (Jan. 29, 2010), available at http://www.federalreserve.gov/releases/h8/current/default.htm#fn21), individual banks with significant international operations (i.e., the six institutions mentioned above) generally do not disclose what portions of their nondeposit funding come from U.S. versus international sources. Thus determining the U.S.-only wholesale funding market shares for these institutions requires making some estimates about the proportion of wholesale funding that comes from the United States.--------------------------------------------------------------------------- We must also take into account that size limitations on our biggest banks will negatively affect their global competitiveness. \59\ Size limitations could cause U.S. banks to lose the business of their largest and most important customers, who will prefer to work with banks that have the capacity to address their global needs. Larger banks and their customers also benefit from the economies of size and scope that exist when banks are large enough to offer a wider range of products, such as lending and derivatives. One study by an economist at the New York Federal Reserve found that bank productivity grew more than 0.4 percent per year during the bank merger wave of the early 1990s, \60\ while Charles Calomiris of Columbia Business School suggests that the increasing size of banks has lowered underwriting costs associated with accessing public equity markets by as much as 20 percent. \61\ As it is, as of the end of 2008, the United States only had two of the 10 largest banks in the world, Bank of America (6th) and JPMorgan Chase (9th). \62\ The world's five biggest banks are BNP Paribas (France), Royal Bank of Scotland (U.K.), Barclays (U.K.), Deutsche Bank (Germany), and HSBC (U.K.).--------------------------------------------------------------------------- \59\ Charles Calomiris, Op-Ed., ``In the World of Banks, Bigger Can Be Better'', Wall St. J., Oct. 19, 2009. \60\ Kevin J. Stiroh, ``How did bank holding companies prosper in the 1990s?'', 24 J. Banking and Fin. 1703 (Nov. 2000). \61\ Calomiris, supra note 59. \62\ Data from Capital IQ as reported in Damian Paletta and Alessandra Galloni, Europe, U.S. Spar on Cure for Banks, Wall St. J., Sept. 23, 2009, available at http://online.wsj.com/article/SB125366282157932323.html.--------------------------------------------------------------------------- In this connection, it is worth recalling that a major motivation for the decision to repeal Glass-Steagall was the need to increase the competitiveness of U.S. financial institutions. \63\ At the time, Senator Proxmire noted that Glass Steagall's ``restrictions inhibit a U.S.-based firm from offering the entire range of financial services to both domestic and foreign customers in the United States.'' \64\ Therefore, many U.S. and foreign financial institutions were choosing to locate offshore, where they could provide such products to foreign clients. \65\ Furthermore, although U.S. banks had expertise as underwriters through offshore activity, they could not achieve the economies of scale attainable through underwriting domestically. \66\ Any limitation on U.S. bank activities that did not extend to foreign banks would be damaging to their future profitability.--------------------------------------------------------------------------- \63\ Comm. on Capital Mkts. Reg., supra note 1. \64\ 134 Cong. Rec. S3,382 (1988) (statement of Sen. Proxmire). \65\ Id. at S3,385 and S3,382. \66\ Id. at S3,382.---------------------------------------------------------------------------B. Proposed Limitations on the Size of Other Financial Institutions To the extent that the proposed rules regarding nondeposit liability market share addresses financial institutions other than bank holding companies, it is important to consider the potential impact on four additional groups. First, there are a number of U.S. wholesale-funded lending businesses--most notably credit card lenders and nonbank commercial lenders--that are not typically grouped with banks in regulatory discussions. Many of the largest of these lending businesses are subsidiaries of bank holding companies. Of those that are not bank holding company subsidiaries, although some are large within the context of their narrowly defined business segments (credit carding lending, etc.), even the largest have modestly sized wholesale funding bases compared to the largest bank holding companies. In credit cards, for example, American Express and Capital One Financial (the largest pure-play card lenders by wholesale liabilities) have only 3 percent and 1 percent wholesale funding market shares, respectively. \67\ Similarly, GMAC and CIT, the largest wholesale-funded commercial lending businesses have only 4.5 percent and 2.2 percent nondeposit liability market shares, respectively. \68\ Though the precise details on the proposed wholesale funding limits are not yet available, it is hard to imagine that the market share ceiling would be set low enough to impact even the largest of these lenders.--------------------------------------------------------------------------- \67\ See, American Express, Financial Supplements (Q4 2009) and Capital One, Financial Supplements (Q4 2009). \68\ See, GMAC, Quarterly Report (Form 10-Q) (Nov. 4, 2009) and CIT, Quarterly Report (Form 10-Q) (Nov. 7, 2009). Note that even before its bankruptcy, at the end of 2008, CIT's nondeposit liability market share was only slightly higher, at 2.5 percent.--------------------------------------------------------------------------- Second, a number of U.S. insurance companies also have sizable balance sheets, with ostensibly sizable nondeposit liability bases. Although these large liability bases may seem to place insurers within the purview of the proposed liability size restrictions, the size caps are unlikely to apply to these institutions for two reasons: (1) insurers in general simply do not rely heavily on wholesale funding as part of their business models--the majority of the large funding bases of these institutions consists of expected future benefits or actuarial estimates of unpaid claims (classic insurance ``float'' funding that appears to fall outside the definition of the funding targets) \69\ and (2) as the last crisis has shown, the riskiest insurance institutions, like AIG, suffered primarily from underwriting risk--much of which was opaquely held in off-balance sheet vehicles--not from funding risk per se.--------------------------------------------------------------------------- \69\ As examples, consider leading insurer Metlife's balance sheet--though its liability base is roughly 70 percent of Morgan Stanley's, its wholesale funding base is only 10 percent of Morgan Stanley's. Put differently, if Metlife were a bank holding company it would have a U.S. nondeposit liability funding market share of only about 2 percent. See, Metlife, Quarterly Report (Form 10-Q) (Nov. 4, 2009) and Morgan Stanley, Financial Supplement (Q4 2009).--------------------------------------------------------------------------- Third, there are money market mutual funds that as of the week ended January 27, had assets totaling $3.218 trillion. \70\ The five largest money market fund families managed roughly 15 percent (Fidelity), 11 percent (JPMorgan), 8 percent (Federated), 7 percent (Blackrock) and 6 percent (Dreyfus) of this amount. \71\ Since even the largest money market fund family does not have a dominant share of the market, and there are numerous fund families with substantial levels of assets under management, the case for capping the size of money market mutual funds based purely on market concentration of liabilities appears weak.--------------------------------------------------------------------------- \70\ Inv. Co. Inst., Money Market Mutual Fund Assets (Jan. 28, 2010), available at http://www.ici.org/research/stats/mmf/mm_01_28_10. \71\ Crane Data, Largest Money Fund Managers, Dec. 21, 2009, available at http://www.cranedata.us.--------------------------------------------------------------------------- Fourth, though GSEs are not bank holding companies, the largest GSEs use sufficient wholesale funding to make them worth discussing here. Freddie Mac and Fannie Mae each have roughly $800 billion in wholesale funding, an amount that dwarfs the domestic wholesale funding requirements of all bank holding companies, except that of Bank of America whose wholesale funding is slightly over $1 trillion. \72\ Given these very large nondeposit liability requirements--together these two GSEs use more wholesale funding than half of the entire U.S. bank holding company total--excluding them from any new size restrictions would seem highly inconsistent with the treatment of banks.--------------------------------------------------------------------------- \72\ See, Freddie Mac, Quarterly Report (Form 10-Q) (Nov. 6, 2009); Fannie Mae, Quarterly Report (Form 10-Q) (Nov. 5, 2009); Bank of America Corp., Quarterly Report (Form 10-Q), at 4 (Nov. 7, 2009).--------------------------------------------------------------------------- In concluding the discussion of liability size restrictions, it is important to keep in mind that regardless of the liability size of any bank or nonbank financial institution, the proposed rules fail to address the more fundamental issue that nondeposit liability market share is not a good proxy for an institution's broader systemic risk. Even if a commercial lender or an insurer does not rely on systemically large amounts of wholesale funding, the interconnectedness of these and similar institutions could ultimately make them ``Too Big to Fail.'' Any set of new regulations designed to reduce systemic risk must focus not just on the size of institutions' wholesale liabilities, but also on institutions' connections with the broader financial system.III. There Has Been a Lack of International Coordination in the Newest Proposals Up to this point, the Obama administration wisely and appropriately has been careful to coordinate its regulatory reform recommendations with international efforts. In the Treasury White Paper, the Administration stressed the importance of international coordination stating, ``The United States is playing a strong leadership role in efforts to coordinate international financial policy through the G-20, the Financial Stability Board, and the Basel Committee on Banking Supervision. We will use our leadership position in the international community to promote initiatives compatible with . . . [U.S.] domestic regulatory reforms.'' \73\ Regrettably, this has not been the case with the Volcker Rules or size limitations.--------------------------------------------------------------------------- \73\ Treasury White Paper, supra note 2, at 80.--------------------------------------------------------------------------- Based on the initial reaction from international financial and regulatory bodies, we are far from reaching consensus on this issue. Speaking at the Davos economic summit, Dominique Strauss-Kahn--head of the International Monetary Fund--highlighted the lack of international cooperation behind President Obama's proposed banking reforms saying, ``The question of coordinating the financial reform is key and I'm afraid we're not going in that direction.'' \74\ The Financial Stability Board says that the proposals are ``amongst the range of options and approaches under consideration'' and that a ``mix of approaches will be necessary to address the [`Too Big to Fail'] problem,'' \75\ hardly an endorsement. And earlier this week, the Deputy Director-General of the European Commission's internal market and services division, David Wright, said he was surprised the U.S. had taken a radical line on the structure of banking without first consulting European leaders--especially in light of U.S. discontent last year when the European Commission took the lead on securitization and credit rating agency reforms. \76\ Wright added that it might be difficult to find the right definition of ``proprietary trading'' to satisfy the Obama administration's goals without inflicting unintended consequences on the industry, emphasizing that Europe traditionally prefers to reform processes rather than change bank structure. \77\--------------------------------------------------------------------------- \74\ Simon Carswell, ``IMF Head Calls for Financial Reform'', Irish Times, Jan. 30, 2010, available at http://www.irishtimes.com/newspaper/breaking/2010/0130/breaking13.htm. \75\ Press Release, Fin. Stability Bd., ``FSB Welcomes U.S. Proposals for Reducing Moral Hazard Risks'' (Jan. 22, 2010), http://www.financialstabilityboard.org/press/pr_100122.pdf. \76\ Joel Clark, ``EC Says Obama Prop Trading Plans Would Be `Difficult' to Implement'', Risk Magazine, Feb. 1, 2010, available at http://www.risk.net/risk-magazine/news/1589763/ec-obama-prop-trading-plans-difficult-implement. \77\ Id.--------------------------------------------------------------------------- National leaders have also emphasized the need for a coordinated approach. French President Nicolas Sarkozy stressed that all regulation concerning banks should be dealt with at an international level, coordinated by the G-20. \78\ Sarkozy called the current crisis a ``crisis of globalization itself,'' urging broad coordination of regulation and accounting rules. \79\ In Germany, the Finance Ministry merely referred to the President's proposals as ``helpful suggestions,'' with Chancellor Angela Merkel stating that her Government will offer its own proposal to prevent G-20 banks from getting too big or interconnected. \80\--------------------------------------------------------------------------- \78\ Katrin Benhold, At Davos, Sarkozy Calls for Global Finance Rules, N.Y. Times, Jan. 27, 2010, available at http://www.nytimes.com/2010/01/28/business/global/28davos.html. \79\ Id. \80\ Andrea Thomas, 2nd Update: Germany: Need International Review of Obama Plan, Wall St. J., Jan. 22, 2010, available at http://online.wsj.com/article/BT-CO-20100122705666.html?mod=WSJ-World-MIDDLEHeadlinesEurope.--------------------------------------------------------------------------- As Mr. Volcker asserted in his testimony before this Committee on Tuesday: A strong international consensus on the proposed approach would be appropriate, particularly across those few nations hosting large multinational banks and active financial markets. The needed consensus remains to be tested. However, judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood. \81\--------------------------------------------------------------------------- \81\ Volcker Testimony, supra note 46. In his appearance before the Committee, Mr. Volcker added that London was the other financial center whose acceptance of the Volcker Rules would be critical. Yet Prime Minister Gordon Brown of the United Kingdom, while welcoming the suggestion, stated the U.K. should consider similar rules only if there is an international agreement. \82\ The U.K.'s Chancellor of the Exchequer, Alistair Darling, expressed concerns that separating banks does not solve the problem posed by interconnectivity. \83\ To the extent there is a solution, he noted that ``everything we do has to be a global solution otherwise we will get arbitrage.'' \84\ Such comments are anything but an endorsement.--------------------------------------------------------------------------- \82\ Terence Roth and Laurence Norman, Europe Divided of U.S. Bank Proposal, Seeks global Pact, Wall St. J., Jan. 22, 2010, available at http://online.wsj.com/article/SB10001424052748704509704575018622712047044.html?mod=WSJ-Markets-LEFTTopNews. \83\ Philip Aldrick, Alistair Darling Dismisses Obama's Plan to Break Up Banks as Ineffective, Telegraph, Jan. 28, 2010, available at http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/7093796/Alistair-Darling-dismisses-Obama-plan-to-break-up-banks-as-ineffective.html. \84\ Id.---------------------------------------------------------------------------IV. The Perlmutter-Miller and Kanjorski Amendments Suggest a Preferable Approach If Congress were to conclude that bank activities and the size of financial companies were a problem, the Perlmutter-Miller and the Kanjorski Amendments to the House Bill are better solutions than the Volcker Rules and size limitations. The Perlmutter-Miller Amendment would allow the Federal Reserve Board (Board) to prohibit a systemically important financial holding company that is subject to stricter prudential supervision from engaging in all proprietary trading activities when the Board finds that trading activities threaten the safety and soundness of such company or of the U.S. financial system. \85\ The Amendment defines ``proprietary trading'' broadly, as ``trading of stocks, bonds, options, commodities, derivatives, or other financial instruments with the company's own money and for the company's own account.'' \86\ However, the Board has the flexibility to ban certain forms of proprietary trading at a company without putting an end to all of company's proprietary trading activities. Instead, the Board can exempt proprietary trading activities that are ``ancillary to other operations of the company'' and do not pose a threat to the company or U.S. financial stability, provided they are carried on for the purpose of making a market in securities issued by the company, hedging or managing risk or other purposes permitted by the Board. \87\ While it would be preferable to extend this exemption to market making in a broader range of securities, allowing the Board to address proprietary trading at individual institutions and to distinguish between different trading activities is a better approach than the Volcker Rules.--------------------------------------------------------------------------- \85\ H.R. 4173, 111th Cong. 1117(a) (2009). \86\ Id. 1117(e). \87\ Id. 1117(b).--------------------------------------------------------------------------- If the Perlmutter-Miller Amendment is a better way of addressing proprietary trading, the Kanjorski Amendment is a better solution to the broader problem of all activities and size. \88\ The Kanjorski Amendment would allow a new Financial Services Oversight Council to require ``mitigatory actions'' whenever an individual firm that has been subject to stricter prudential supervision is deemed to pose a ``grave threat to the financial stability or economy of the United States.'' \89\ The Amendment anticipates that such a threat could arise from a wide range of sources--including the amount and nature of a company's financial assets and liabilities, off-balance sheet exposures, reliance on leverage, interconnectedness with other firms, the company's importance as a source of credit for households and businesses and the scope of its activities. \90\ It considers a wide range of remedies: requiring the institutions to terminate one or more of its activities; restricting its ability to offer financial products; and requiring the firm to sell, divest or otherwise transfer business units, branches, assets or off balance sheet items. \91\ Firms that are subject to mitigatory actions have the right to a hearing \92\ and can seek judicial review if such actions are imposed on an arbitrary or capricious basis. \93\--------------------------------------------------------------------------- \88\ Id. 1105. \89\ Id. 1105(a). \90\ Id. 1105(c). \91\ Id. 1105(d)(1). \92\ Id. 1105(e)(1). \93\ Id. 1105(h).--------------------------------------------------------------------------- I am not endorsing these amendments but do believe they are preferable to the Volcker Rules and size limitations. Thank you and I look forward to your questions. ______ CHRG-111hhrg51591--75 Mr. Harrington," I would like to see a really detailed analysis of the securities lending issue and exactly what happened, why it happened, what the nature of the breakdown was, to what extent New York's Insurance Department and various other State regulators may have been asleep at the switch. Securities lending had gone on for so long and had been a major part of so many operations, I think it was regarded as routine business with no mischief involved. Clearly, it now appears there might have been some real mischief. So there could seriously have been some State regulatory failure there. I would want to really look into the specifics of the securities lending. But I have to go back and say everybody failed here. The OTS failed. Foreign bank regulators failed. They were letting foreign banks load up on AIG paper, CDS paper. Presumably, if they were doing their job, they would have said, how can we have so much of our banking system dependent on the promise of a single United States institution? Bank regulators failed. I don't know about the Comptroller, but the Fed in many respects must have failed to allow so many banks to contract with AIG given that it was running amok, so to speak, on these dimensions. So the Fed was partially to blame. The FDIC seems to have been to blame. The SEC, you can lay a lot of blame at their feet. And then also the Federal Reserve in general. I mean, I won't go--we don't want to go to low interest rates and what that did to the incentives in the entire system. But my point would just be you may well be correct that there is blame to go around. " CHRG-111hhrg48867--161 Mr. Yingling," Mr. Castle, I think as I listen to this panel and a lot of the concerns of the members, we have to define what systemic regulation means. And I think a lot of us are talking not about detailed in-depth regulation, we are talking about looking out and seeing where the problems are and then using the regulatory system as it exists to solve those problems and then supplementing the regulatory system where we have gaps. So that we would not get into all the problems of having some super, super regulator out there. That is not what we are talking about. Again, I think it is critical to look at that resolution process because that is going work backward and affect who is considered too big to fail. And I think I have heard everybody here say we shouldn't have a list that identifies people as too big to fail. One thing I do think the Fed could give up is the holding company regulation of small banks. It really makes no sense to have the Fed regulate the holding company of a $100 million bank that is regulated by the FDIC, the State, or even the Comptroller. A lot of times they go in and that holding company is nothing more than a shell. So as they get the new authority I think they can give up the holding company authority over smaller institutions. " CHRG-111hhrg48875--3 Mr. Bachus," Secretary Geithner, earlier this week, we had a hearing on AIG's bailout, and at that hearing, you acknowledged that AIG fully met its obligations to foreign banks and certain U.S. banks, our financial companies. In fact, at that time, you said that throughout this period of time, and this is critically important to the stability of the system, we wanted to make sure AIG was able to meet its commitments. I said to you--pensioners and retirees--and your response was also to municipalities and banks, and that you considered they had met the full range of their obligations. Since that time, I have been informed that AIG is now attempting to force many of its U.S. bank creditors to accept severe haircuts of more than 70 percent on the total debt owed to them. This disparity and the treatment of foreign banks, which, as you said in your response to my question, were paid dollar-for-dollar within hours of the bailout, and U.S. banks have yet to receive any payment and are being asked to accept 70 and 80 percent haircuts. This disparity in treatment between foreign banks and U.S. banks is very concerning to me. This morning, I sent a letter to the chairman regarding this development and a hearing will be scheduled so that the committee can get to the bottom of this. And he has assured me that he will fully cooperate and I think agrees with my concern. Now, let me talk about this hearing. In the last year we have witnessed unprecedented interventions by the government to commit trillions of taxpayer dollars to save too-big-to-fail institutions. The taxpayer continues to be given the bill as the government continues a cycle of bailouts. One way to end the cycle would be to allow for an orderly liquidation of complex financial institutions that are not subject to the statutory regime for resolving banks administered by the FDIC. At a hearing last July, I stated that our regulators must strive for a system where financial firms can succeed or fail without threatening the whole financial system and placing taxpayers at risk. By creating this process of which non-banks whose failures would have systemic consequences could be unwound in an orderly fashion, we would restore balance and force firms to face the consequences of their actions. It is essential that any new regime for resolving or liquidating non-banks not rely on taxpayer funding. However, the Treasury legislative proposal released yesterday suggests the Administration is considering using taxpayer funding to pay the cost of resolving these failed financial firms. This to me is unacceptable and would serve only to promote moral hazard and perpetrate a too-big-to-fail doctrine that the American people have squarely rejected. The proposal also leaves it to the Secretary and the FDIC to decide whether the firm will receive financial assistance or be placed in conservatorship. This empowers Federal regulators with incredible discretion. And some of the past experience that I have witnessed in the case that this discretion is not always administered fairly or evenhandedly. If the goal of the resolution process is to end the too-big-to-fail premise, why is the potential taxpayer subsidy part of the Administration's solution? Mr. Chairman, there are many more unanswered questions, like which firms will be designated as systemically important, and why? When will a liquidation be triggered? What happens if there is a disagreement between regulators on the need for a conservatorship? How will the regulators determine whether to provide financial assistance or place a firm in conservatorship? The details are important, even more important is that we develop the right solution and not rush poorly vetted legislation. I do commend you and agree with you that we do need a resolution process. The modernization of our regulatory structure will be the most important task this committee undertakes this Congress. The complex and interconnected nature of our financial markets require us to engage in thorough analysis with all the major stakeholders. I conclude by saying I hope that the committee will have additional hearings on this proposal so that we can hear from the stakeholders and regulators on their views, identify any unintended consequences in advance, and take a look at some past resolutions which have caused real questions and issues, which I think have not been resolved. So I appreciate your attendance today. " CHRG-111shrg51303--169 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you, Mr. Chairman. The collapse of the American International Group is the greatest corporate failure in American history. Once a premiere global insurance and financial services company with more than one trillion dollars in assets, AIG lost nearly $100 billion last year. Over the past 5 months it has been the recipient of four bailouts. To date, the Federal Government has committed to provide approximately $170 billion in loans and equity to AIG. Given the taxpayer dollars at stake and impact on our financial system, this Committee has an obligation to throughly examine the reasons for AIG's collapse and how Federal regulators have responded. I also hope that today's hearing will shed new light on the origins of our financial crisis, as well as inform our upcoming discussions on financial regulatory reform. In reviewing our witnesses' testimony and AIG's public filings, it appears that the origins of AIG's demise were two-fold. First, as has been widely reported, AIG suffered huge losses on credit default swaps written by its Financial Products subsidiary on collateralized debt obligations. AIG's problems, however, were not isolated to its credit default swap business. Significant losses at AIG's State-regulated life insurance companies also contributed to the company's collapse. Approximately a dozen of AIG's life insurance subsidiaries operated a securities lending program, whereby they loaned out securities in exchange for cash collateral. Typically, an insurance company or bank will lend securities and reinvest the cash collateral in very safe, short-term instruments. AIG's insurance companies, however, invested their collateral in riskier long-term mortgage-backed securities. Although they were highly rated securities, approximately half of them were backed by subprime and alt-a mortgage loans. When the prices for mortgage-backed securities declined sharply last year, the value of AIG's collateral plummeted. The company was rapidly becoming unable to meet the demands of borrowers returning securities to AIG. By September, it became clear that AIG's life insurance companies would not be able to repay collateral to their borrowers. Market participants quickly discovered these problems and rushed to return borrowed securities and get back their collateral. Because AIG was unable to cover its obligations to both its securities lending and derivatives operations, it ultimately had to seek Federal assistance. In total, AIG's life insurance companies suffered approximately $21 billion in losses related to securities lending in 2008. More than $20 billion dollars in Federal assistance has been used to recapitalize the State-regulated insurance companies to ensure that they are able to pay their policyholders' claims. In addition, the Federal Reserve had to establish a special facility to help unwind AIG's securities lending program. I am submitting for the record a document from AIG that shows the losses from securities lending suffered by each AIG subsidiary that participated in AIG's securities lending program and the impact those losses had on its statutory capital. (See Exhibit A, below.) The causes of AIG's collapse raise profound questions about the adequacy of our existing State and Federal financial regulatory regimes. With respect to AIG's derivatives operations, the Office of Thrift Supervision was AIG's holding company regulator. It appears, however, that the OTS was not adequately aware of the risks presented by the company's credit default swap positions. Since AIG's Financial Products subsidiary had operations in London and Hong Kong, as well as in the U.S., it is unclear whether the OTS even had the authority to oversee all of AIG's operations. It is also unclear whether OTS had the expertise necessary to properly supervise what was primarily an insurance company. According to the National Association of Insurance Commissioners, a life insurance company may participate in securities lending only after it obtains the approval of its State insurance regulator. If so, why did State insurance regulators allow AIG to invest such a high percentage of the collateral from its securities lending program in longer-term mortgage-backed securities? Also, how did insurance regulators coordinate their oversight of AIG's securities lending since it involved life insurers regulated by at least five different States? While I hope we can get answers to these and many other questions today, I believe we are just beginning to scratch the surface of what is an incredibly complex and, on many levels, a very disturbing story of malfeasance, incompetence, and greed. Thank you, Mr. Chairman. CHRG-109shrg26643--124 Chairman Bernanke," We consider it a very important issue, and we are putting a lot of resources into it. Our approach is again to assess information management systems that banks have to make sure that they know their customer or they know the source of a transaction. That is the best way we have to approach this and again we will continue to work hard to make sure that the Anti-Money Laundering and Bank Secrecy Act rules are obeyed. Senator Sarbanes. Is there a special unit at the Fed that focuses on this? " CHRG-111shrg57709--53 Mr. Volcker," A huge institution. Senator Shelby. Dr. Volcker, my second question along those lines would be, could you tell me, or tell the Committee, actually, what limits will be on a firm's share of similar liabilities in the U.S. banking system in the global market or in a market in each country in which a U.S. firm operates? Or, let us say it is a foreign firm operates in this country. We have a lot of banks domiciled overseas that operate here. " CHRG-111shrg56376--203 Mr. Carnell," I don't think we need to eliminate them, but I do think our system has put much too much emphasis on them. I think our focus in banking policy should be on what can banks do and how should they go about doing it. I wouldn't want to leave the impression that bank holding companies had this role as letting do something nefarious. I mean, we are talking about things like opening an office in the next county, opening a bank in the next State. These were things that restrictive laws of 50 years ago didn't allow. And then getting into nonbanking activities, many of which are not allowed in the bank or Congress has passed a law saying they could be in the same corporate family. So it is not that the activities were inherently problematic, but it is that we have this enormous growth of holding company regulation that is really unrelated to any real need other than the fact that we sort of built it up in these loophole-based ways. " CHRG-111shrg56376--119 PREPARED STATEMENT OF SENATOR JACK REED Today's hearing addresses a critical part of this Committee's work to modernize the financial regulatory system--strengthening regulatory oversight of the safety and soundness of banks, thrifts, and holding companies. These institutions are the engine of our economy, providing loans to small businesses and helping families buy homes and cars, and save for retirement. But in recent years, an outdated regulatory structure, poor supervision, and misaligned incentives have caused great turmoil and uncertainty in our financial markets. Bank regulators failed to use the authority they had to mitigate the financial crisis. In particular, they failed to appreciate and take action to address risks in the subprime mortgage market, and they failed to implement robust capital requirements that would have helped soften the impact of the recession on millions of Americans. Regulators such as the Federal Reserve also failed to use their rulemaking authority to ban abusive lending practices until it was much too late. I will work with my colleagues to ensure that any changes to the financial system are focused on these failings in order to prevent them from reoccurring (including by enhancing capital, liquidity, and risk management requirements). Just as importantly, however, we have to reform a fragmented and inefficient regulatory structure for prudential oversight. Today we have an inefficient system of five Federal regulators and State regulators that share prudential oversight of banks, thrifts, and holding companies. This oversight has fallen short in many significant ways. We can no longer ignore the overwhelming evidence that our system has led to problematic charter shopping among institutions looking to find the most lenient regulator, and has allowed critical market activities to go virtually unregulated. Regulators under the existing system acted too slowly to stem the risks in the subprime mortgage market, in large part because of the need to coordinate a response among so many supervisors. The Federal Reserve itself has acknowledged that the different regulatory and supervisory regimes for lending institutions and mortgage brokers made monitoring such institutions difficult for both regulators and investors. It is time to reduce the number of agencies that share responsibility for bank oversight. I support the Administration's plan to merge the Office of the Comptroller of the Currency and the Office of Thrift Supervision, but I think we should also seriously consider consolidating all Federal prudential bank and holding company oversight. Right now, a typical large holding company is overseen by the Federal Reserve or the Office of Thrift Supervision at the holding company level, and then the banks and thrifts within the company can be overseen by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and often many others. Creating a new consolidated prudential regulator would bring all such oversight under one agency, streamlining regulation and reducing duplication and gaps between regulators. It would also bring all large complex holding companies and other systemically significant firms under one regulator, allowing supervisors to finally oversee institutions at the same level as the companies do to manage their own risks. I appreciate the testimony of the witnesses today and I look forward to discussing these important issues. ______ CHRG-111hhrg48867--166 Mr. Meeks," Thank you, Mr. Chairman. And I want to thank all of you for testifying today. I think that your testimony lends to the fact that we really need to think this thing through. It has been very thought-provoking for me. And I think that everyone will probably agree to, at least, surely the way I look at it, that our regulatory system did work. We now have a problem because we have a new train running on old tracks. And so it worked for a period of time until now, and then that train ran off the track. And what we are talking about now, when we are talking about a systemic risk regulator or however we are doing it, to create new tracks for the train. I don't want to get rid of the train, because capitalism ultimately evolves, and I think that we are evolving. But we need some type of regulation to make sure that the train doesn't go off the track, which then causes damage to society in general. And so we have to figure out who do we need and what do we need. Whether it is someone in the Fed or whether it is an entirely new regulator, a systemic risk regulator, combining others. You know, I don't know. That is why I find some of your testimony intriguing, and I want to consider to listen and learn and move forward. But, also, I think that--and I think that Mr. Silvers spoke on this a little bit, and of course Mr. Bartlett also--we are in this new world that we currently live in. It is global; it is indeed global. And the question that comes to my mind is, are there areas--unless we can fix our own system, you know, create these tracks for our own train, will we be running right off the track again if we don't have some kind of a global regulator? Because I keep hearing consistently how everything is now intertwined, they are all running into one another at some point. You are selling one thing to another bank. My colleague, Carolyn Maloney, was talking about banks across the ocean. And one of the answers was, well, when you help an American bank, you are helping a foreign bank, because they are all interrelated. Well, if that be the case, then isn't there an urgent need for also talking either simultaneously or trying to figure out what a global regulator would be? Do you think that we need to have one? I guess I will direct that question initially to Mr. Silvers and then to Mr. Bartlett and then to Mr. Ryan. " CHRG-111hhrg52406--28 HARVARD UNIVERSITY Ms. Warren. Thank you, Chairman Frank, for inviting me here. Thank you, Ranking Member Bachus. I also want to thank Congressman Delahunt and Congressman Miller who were able to put together the first version of this and introduce it in this House. I appreciate the invitation to appear. I should note, I speak only for myself, not on behalf of any other group or as a lobbyist for anyone. I am here to deal with a problem that can be explained in blunt words: the consumer credit market is broken. This is not about people who went to the mall and charged up what they couldn't afford to pay, and this is not about people who bought five bedroom houses that they can't make the payments on. Those people should deal with the consequences. This is about people who get trapped by credit agreements themselves. Everyone in this room recognizes the problem. Consumers cannot compare financial products because the products have become too complicated. Make a comparison between four credit cards, put the papers on the table, and you would have more than 100 pages of dense, fine-print text to work through. And, quite frankly, even if you invested the hours to do it, I don't know if you would be able to understand it. I say that only because I teach contract law at Harvard Law School, and I can't understand many of the terms. You can't tell which card is cheaper, which card is safer. That is not choice. Companies compete today by offering nominal interest rates and free gifts and then loading tricks and traps in the fine print where nobody else can see them. The result is that bad cards produce more profits than good cards and the market can't drive consumers toward cheaper, lower-risk products. Healthy markets thrive with information and level playing fields, not with tricks and traps. Broken credit markets also tilt the playing fields between big and small lenders. Local banks and credit unions may offer better products, but when the customers can't make easy comparisons the smaller banks, the ones with the smaller advertising budgets lose out. Broken credit markets also feed excessive risk into the system. Bad products carry very high default rates. And this is true across-the-board. Aggregated together, this can bring down families, bring down banks, bring down retirement funds, and ultimately bring down our whole economy. Systemic risk regulation starts by not feeding high risk products into the system. A Consumer Financial Protection Agency can fix a broken market. An agency that focuses on transparency can promote, for example, a plain vanilla product. Consider if we had a Consumer Financial Protection Agency, 2-page plain vanilla, credit card agreement. You could put four of them on the table, the differences between them, the interest rates, the penalties, what causes the penalties, even the free gifts can be put out there in bold. That means that in less than a minute, you can tell which one is cheaper, which one is riskier and how much those free gifts actually cost you. That is choice, that is a meaningful choice made possible by regulation that repairs a broken market. Agencies can also reduce overall regulatory burdens for lenders. I think everyone in here agrees we should remove the layers of contradictory and inefficient regulation. By putting things in a single place and by promoting plain vanilla safe harbor mortgages, credit cards and other products that automatically pass regulatory muster, we make it very cheap for issuers to issue these products. They are already through the regulatory process. Banks can offer something else, but they have to show that what they offer meets basic safety standards, which in this case means a customer can read it and understand it in 5 minutes or less. Regulatory agencies are not perfect, but they can do a lot of good. In the 1920's, anyone with a bathtub and some bottles of chemicals could sell drugs in America. The FDA put a stop to that. Dirty meat could be sold to families. The Department of Agriculture put a stop to that. In the 1960's, babies' car seats collapsed on impact, 8-year old boys shot out their cousins' eyes with BB guns, and infants chewed on toys covered in lead paint. The Consumer Protection Safety Commission put a stop to that. We have tried for 70 years to combine consumer protection with other financial service regulatory functions. This structure has not worked. To talk about keeping these two together is to say we are satisfied with the system and want it to go on as it has before. I think it is time for change. We need someone in Washington who cares primarily about families, who cares about consumers, who looks at the products not from the point of view exclusively of bank profitability but who looks at these products in a much larger sense about what they mean to the family, what they mean to communities, what they mean to the economy as a whole. This is an historic moment. You can repair a broken market, you can take the first steps in preventing the next financial crisis, and most of all, you can put a Consumer Financial Protection Agency in place to stop the tricks and traps that are robbing American families every day. Thank you, Chairman Frank. [The prepared statement of Professor Warren can be found on page 199 of the appendix. ] " CHRG-111hhrg56766--334 Mr. Bernanke," There are general ideas about setting up a system that would allow capital requirements to vary over the business cycle, during weak periods, that you could run down some capital, for example. Those so-called countercyclical capital requirements, and those are being discussed. They might be actually a useful innovation. There is quite a bit of danger, I think, with the forbearance idea because if you begin to allow capital to fall arbitrarily, according to short-run objectives, you might find yourself with the government having to pay a lot of money to bail out banks that have failed because they did not have enough capital. It is a very delicate issue. I think you are better off if you are going to go that way having a system in place that allows for circumscribed variation over the business cycle and the amount of capital the banks have to hold. A buffer during the good times, they can run it down during the bad times. " CHRG-111shrg57709--167 Chairman Dodd," Thank you, Senator Crapo. Senator Schumer. Senator Schumer. Thank you, Mr. Chairman. Thank you for holding the hearing. I thank the witnesses. Sorry--I have been busy with a million different things--that I came in at the very end. Better late than never, I hope. I want to thank you, Mr. Volcker, for your thoughtful proposals, particularly relating to the too big to fail issue. I remain convinced that the steps the government took to save the financial system were absolutely necessary, but I suppose like everyone in the room would prefer we never be in that situation again and agree with the premise at the heart of your proposal: The safety net provided by the government put in place over the last century in response to multiple banking panics not be put at risk by financial activities that are outside the core function of the banking system. That would be a summation of what you---- " CHRG-111shrg56262--7 UNIVERSITY OF CONNECTICUT SCHOOL OF LAW Ms. McCoy. Thank you. Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee, thank you for inviting me here today. In the run-up to the crisis, Wall Street financed over half of subprime mortgages through private label securitization. When defaults spiked on those loans and housing prices fell, securitization collapsed in August 2007. It has been on life support ever since. When private label securitization comes back, it is critical to put it on sound footing so that it does not bring down the financial system again. The private label system had basic flaws that fueled the crisis. First, under the originate-to-distribute model, lenders made loans for immediate sale to investors. In addition, lenders made their money on up-front fees. Both features encouraged lenders to ``pass the trash.'' Lenders cared less about underwriting because they knew that investors would bear the brunt if the loans went belly up. In addition, to boost volume and fees, lenders made loans to weaker and weaker borrowers. In fact, when I have examined the internal records of some of the largest nonprime lenders in the United States, I have often found two sets of underwriting standards: lower standards for securitized loans and higher ones for loans held in portfolio. Second, securitizations spread contagion by allowing the same bad loan to serve as collateral for a mortgage-backed security, a collateralized debt obligation, and even the CDO of CDOs. It further spread contagion because investors used tainted subprime bonds as collateral for other types of credit, such as commercial paper and interbank loans. This shook confidence in the entire financial system because investors did not know where the toxic assets were located. Last, securitization resulted in a servicing system that creates thorny barriers to constructive workouts of distressed loans. We have had too many foreclosures as a result. In this, there were three victims: borrowers, who were steered into bafflingly risky mortgages, often at inflated interest rates; investors, who were forced to rely on ratings because securities disclosures were deficient and securitizations were so complex; and, finally, the public, who had to pay to clean up the mess. So how do we fix these problems going forward? There are two aspects: lax underwriting and loan workouts. First, fixing underwriting. One group of proposals seeks to realign incentives indirectly so that mortgage actors do careful underwriting. These include requiring securitizers to retain risk, higher capital requirements, better compensation methods, and stronger representations and warranties along with stiff recourse. I applaud these measures, but they are not enough to ensure good underwriting. I doubt, for example, whether prohibiting issuers from hedging their retained risk is really enforceable. Banks are adept at evading capital standards, and the Basel II standards are badly frayed. And stronger reps and warranties are only as good as the issuer's solvency. Consider the fact that most nonbank subprime lenders are out of business and 128 banks and thrifts have failed since the crisis began. Another group of proposals focuses on better due diligence by investors and rating agency reform. This, too, is badly needed. However, memories of this crisis eventually will grow dim. When that happens, query whether investors will really take the time to do careful due diligence when a high-yield investment is dangled out in front of them. For these reasons, we need to finish the work the Federal Reserve Board began last year and adopt uniform Federal underwriting standards for mortgages that apply to all mortgage actors across the board. A brand-new study by researchers at UNC-Chapel Hill just found that States with similar laws had lower foreclosure rates than States without those laws. And a 2008 study found that State assignee liability laws did not reduce access to credit. Then one last thought: facilitating loan workouts. Here I propose amending Federal tax laws to tax securitized trusts unless they provide ironclad incentives to do loan workouts when cost effective. Thank you, and I welcome any questions. " CHRG-111shrg52966--21 Mr. Sirri," I think we all--I won't speak for others. I think we understood, and my impression was all of these regulators understood, that we were limited in part. We had dialog amongst ourselves. Staff on the ground talked to staff from other regulators. In addition, the firm--it is not like the firms drew up walls and said, we won't give you information on that bank, or we won't give you information on that thrift. They would provide such information. But in the sense of integrated enterprise risk management, I think it was not what it could be. Senator Reed. Senator Bunning, and take as much time as you want. Senator Bunning. Thank you, Mr. Chairman. Welcome back from your vacations that you have been on for the last 5 years, and I say that not kiddingly. I say that as meaningful as I can, because if we would have had good regulators, we wouldn't be in the crisis we are in right now. Ms. Williams, at the bottom of page 24, you said the Fed did not identify many of the issues that led to the failure of some large institutions. Can you tell us what some of these issues that they are, what they missed? Ms. Williams. Absolutely. I would direct your attention to a couple of pages later, on page 26. We note that the Fed began to issue risk committee reports, and in February of 2007 they issued perspectives on risk, and we list a number of issues that we pulled from that report. For example--the report stated that there were no substantial issues of supervisory concern for large financial institutions; that asset quality across the systemically important institutions remains strong; in spite of predictions of a market crash, the housing market correction has been relatively mild and while price appreciation and home sales have slowed, inventories remain high and most analysts expect the housing boom to bottom out in mid-2007. Overall, the impact on a national level will likely be moderate. However, in certain areas, housing prices have dropped significantly. They also noted that the volume of mortgages being held by institutions or warehouse pipelines had grown rapidly to support collateralized mortgage-backed securities and CDOs and noted that the surging investor demand for high-yield bonds and leveraged loans, largely through structured products such as CDOs, was providing a continuing strong liquidity that resulted in continued access to funding for lower-rated firms at relatively modest borrowing costs. So those are some of the---- Senator Bunning. Would you like to comment on counterparty exposures, particularly to hedge funds? Ms. Williams. This was another area that was identified. The regulators had focused on counterparty exposures, particularly to hedge funds. Senator Bunning. Mr. Cole, would you like to respond? " CHRG-110hhrg46593--95 Secretary Paulson," Let me then make two other points here, because you are dealing with consolidations. I have heard a lot about using capital from the TARP for mergers. And, again--and I am just not going to deal with this--I will make the general point that, if there is a bank that is in distress and it is acquired by a well-capitalized bank, there is more capital in the system, more available for lending, better for communities, better for everyone. No doubt about that in my mind. And so, when we get--and the applications which come to Treasury, when it will come to Treasury--we have not received an application for capital from either of the banks you have mentioned--when it comes to Treasury, we will look at it and act on it. But, again, I just can't emphasize enough that this program, to me, it was very, very important on this program that--this is general; I am not speaking--that it not be used to prop up failing banks or banks that might fail, that this be used for healthy banks. And I looked to the regulators. As a matter of fact, we designed a process with the regulators. They would look at the applications as they would come in. And there is even a peer-review board with the regulators. And they submit them to us, and we make a decision. " CHRG-111hhrg55809--201 Mr. Bernanke," Well, it is first certainly true that we are better off than we were with the system in crisis. It is also true that the banks have not returned to normal lending by any means. I think the low interest rates do have positive effects on the economy, for example, operating through other markets, like the mortgage market or the corporate bond market. But getting the banking system back into a lending mode is very important. We continue to work with the banks to encourage them to raise equity so they have sufficient capital to support their lending. We have provided them with an enormous amount of liquidity so they are able to have the funds to lend. We are encouraging them to lend, in that going back to November, the bank regulators had a joint statement encouraging banks to lend to creditworthy borrowers as being in the interest both of the banks and of the economy. And we continue to try to follow up on all those things. In addition, as you may know, we have some programs, including the Term Asset-Backed Securities Loan Facility, which is trying to open up sources of funding from the capital markets, for example, for consumer loans and small business loans. I would add, I guess, that there are also some efforts taking place from the Treasury to support small-business lending. It is a difficult problem, but we are trying it attack it in a number of fronts. Just to conclude, I would say that it is true that as long as the banks are as reluctant to lend as they are, to some extent, it weakens the effect of our stimulative policies. Mr. Miller of California. You recall last September, we were having a very lengthy debate, and you and I had some conversations requiring the $700 billion to going to buy mortgage-backed securities, which we approved the first $350 billion. But it seems like we went through a tremendous amount of debate to make that decision; yet the Federal Reserve last week decided to buy a trillion and quarter dollars of mortgage-backed securities. And your previous comments, we have talked about the Fed's role in injecting liquidity in the marketplace and being able to fight inflation as needed, but you can't do that with assets you are buying. They are not liquid. Unless you are going to have a barn sale and just get rid of them for liquidity, how can you justify those two? They seem to be-- " CHRG-111hhrg48873--21 Mr. Bernanke," Thank you, Mr. Chairman. The Federal Reserve and the Treasury agreed that AIG's failure under the conditions then prevailing would have posed unacceptable risks for the global financial system and for our economy. Some of AIG's insurance subsidiaries, which are among the largest in the United States and in the world, would have likely been put into rehabilitation by their regulators, leaving policyholders facing considerable uncertainty about the status of their claims. State and local government entities that had lent more than $10 billion to AIG would have suffered losses. Workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable value funds would decline in value would have seen that insurance disappear. Global banks and investment banks would have suffered losses on loans and lines of credit to AIG and on derivatives with AIG FP. The banks' combined exposure exceeded $50 billion. Money market mutual funds and others that held AIG's roughly $20 billion of commercial paper would also have taken losses. In addition, AIG's insurance subsidiaries have substantial derivatives exposure to AIG FP that could have weakened them in the event of the parent company's failure. Moreover, as the Lehman case clearly demonstrates, focusing on the direct effects of a default on AIG's counterparties understates the risk to the financial system as a whole. Once begun, a financial crisis can spread unpredictably. For example, Lehman's default on its commercial paper caused a prominent money market mutual fund to break the buck and suspend withdrawals, which in turn ignited a general run on prime money market mutual funds, with resulting severe stresses in the commercial paper market. As I mentioned, AIG had about $20 billion in commercial paper outstanding, so its failure would have exacerbated the problems of the money market mutual funds. Another worrisome possibility was that uncertainties about the safety of insurance products could have led to a run on the broader insurance industry by policyholders and creditors. Moreover, it was well-known in the market that many major financial institutions had large exposures to AIG. Its failure would likely have led financial market participants to pull back even more from commercial and investment banks, and those institutions perceived as weaker would have faced escalating pressure. Recall that these events took place before the passage of the Emergency Economic Stabilization Act, which provided the funds that the Treasury used to help stem a global banking panic in October. Subsequently, it is unlikely that the failure of additional major firms could have been prevented in the wake of a failure of AIG. At best, the consequences of AIG's failure would have been a significant intensification of an already severe financial crisis and a further worsening of global economic conditions. Conceivably, its failure could have resulted in a 1930's-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs. The decision by the Federal Reserve on September 16, 2008, with the full support of the Treasury, to lend up to $85 billion to AIG should be viewed with this background in mind. At that time, no Federal entity could provide capital to stabilize AIG, and no Federal or State entity outside of a bankruptcy court could wind down AIG. Unfortunately, Federal bankruptcy laws do not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure could pose substantial systemic risks, which is why I have called on the Congress to develop new emergency resolution procedures. However, the Federal Reserve did have the authority to lend on a fully secured basis consistent with our emergency lending authority provided by the Congress and our responsibility as the Central Bank to maintain financial stability. We took as collateral for our loan AIG's pledge of a substantial portion of its assets, including its ownership interest in its domestic and foreign insurance subsidiaries. This decision bought time for subsequent actions by the Congress, the Treasury, the FDIC, and the Federal Reserve that have avoided further failures of systemically important institutions and have supported improvements in key credit markets. Having lent AIG money to avert the risk of a global financial meltdown, we found ourselves in the uncomfortable situation of overseeing both the preservation of its value and its dismantling--a role quite different from our usual activities. We have devoted considerable resources to this effort and have engaged outside advisors. Using our rights as creditor, we have worked with AIG's new management team to begin the difficult process of winding down AIG FP and to oversee the company's restructuring and divestiture strategy. Progress is being made on both fronts. However, financial turmoil and a worsening economy since September have contributed to large losses at the company, and the Federal Reserve has found it necessary to restructure and extend our support. In addition, under its Troubled Asset Relief Program, the Treasury injected capital into AIG in both November and March. Throughout this difficult period, our goals have remained unchanged: to protect our economy and preserve financial stability; and to position AIG to repay the Federal Reserve and return the Treasury's investment as quickly as possible. In our role as creditor, we have made clear to AIG's management, beginning last fall, our deep concern surrounding compensation issues at AIG. We believe it is in the taxpayers' interest for AIG to retain qualified staff to maintain the value of the businesses that must be sold to repay the government's assistance. But, at the same time, the company must scrupulously avoid any excessive and unwarranted compensation. We have pressed AIG to ensure that all compensation decisions are covered by robust corporate governance, including internal review, review by the compensation committee at the board of directors, and consultations with outside experts. Operating under this framework, AIG has voluntarily limited the salary, bonuses, and other types of compensation for 2008 and 2009 of the CEO and other senior managers. Moreover, executive compensation must comply with the most stringent set of rules promulgated by the Treasury for TARP fund recipients. The New York attorney general has also imposed restrictions on compensation at AIG. Many of you have raised specific issues with regard to the payout of retention bonuses to employees at AIG FP. My reaction upon becoming aware of these specific payments was that, notwithstanding the business purposes that might be served by this action, it was highly inappropriate to pay substantial bonuses to employees of a division that had been the primary source of AIG's collapse. I asked that the AIG FP payments be stopped but was informed that they were mandated by contracts agreed to before the government's intervention. I then asked that suit be filed to prevent the payments. Legal staff counseled against this action on the grounds that Connecticut law provides for substantial punitive damages if the suit would fail. Legal action could thus have the perverse effect of doubling or tripling the financial benefits to the AIG FP employees. I was also informed that the company had been instructed to pursue all available alternatives and that the Reserve Bank had conveyed the strong displeasure of the Federal Reserve with the retention payment arrangement. I strongly supported President Dudley's conveying that concern and directing the company to redouble its efforts to renegotiate all plans that could result in excessive bonus payments. I have also directed staff to work with the Treasury and the Administration in their review of whether the FP bonus and retention payments can be reclaimed. Moreover, the Federal Reserve and the Treasury will work closely together to monitor and address similar situations in the future. To conclude, I would note that AIG offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform: First, AIG highlights the urgent need for new resolution procedures for systemically important, nonbank financial firms. If a Federal agency would have had such tools on September 16th, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second, the AIG situation highlights the need for strong, effective, consolidated supervision of all systemically important firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 70 of the appendix.] " CHRG-111hhrg56776--64 Mr. Volcker," Conceptually, there could be one supervisor. I think that is the way to go. Many countries have it that way. We have a particularly big and complex country and financial markets with their own traditions. That has led to a multiplicity of regulatory agencies, and I think it is fair to say, a certain amount of confusion. We have to do better in coordinating what they do. We have been left with extremely weak supervision outside the banking system as a matter of historic development. Let me say on the other side as I said in my statement, and this is basically a political decision, there are some advantages in having more than one regulator. In many instances, I think, countries find a single regulator gets pretty rigid in its bureaucracy and there are legitimate complaints by the financial institutions that there is too little room for innovation and flexibility and freedom. On the other hand, I do not want regulatory agencies competing with each other in liberalism. " CHRG-111hhrg52406--181 Mr. Yingling," I don't know about the word profitability, particularly with respect to banks. I think that there were severe, terrible problems in the subprime lending market. In the President's proposal, it points out that 94 percent of that took place outside the traditional regulated banking market. There were terrible problems with mortgage brokers who were giving loans to people that never should have been made. There were problems with the fact that those loans went over the banking system to Wall Street where they were given AAA. Mr. Miller of North Carolina. My time is about to expire, and I haven't really gotten much on that. But the second question, there have been several mentions of protecting consumer choice. And I am very perplexed at what consumers appeared to have chosen in financial products in the last few years. Can you get me the names of some consumers that I can talk to who would explain why they chose a double cycle billing for credit card transactions, or consumers who qualified for a prime mortgage but instead asked for a mortgage that had an initial rate that started at about prime; after 2 or 3 years, the rate adjusted, their monthly payment went up 30 to 50 percent, and they had a prepayment penalty? Could you give me the names of consumers who went into one of your member institutions and asked for those products, so I could somehow fathom how they made those choices? " CHRG-109shrg24852--89 Chairman Greenspan," No. We are not raising the question with respect to the portfolios as a risk to the GSE's; on the contrary. It is expanding their profitability and everything else that goes with it. Our concern is the systemic risk, not safety and soundness risk. The House bill specifically puts the capability of a regulator to adjust portfolios on the basis of safety and soundness, which I read refers to the safety and soundness of the GSE's, not the systemic questions that we raise. Senator Corzine. Is that consistent with bank regulation? " CHRG-111hhrg56241--126 Mr. Green," Thank you Mr. Chairman. Mr. Chairman, we are dealing today with the irony of ironies, because most who opposed raising the minimum wage to $7.25 an hour were supporters and are supporters of maintaining a bonus structure that creates systemic risk. Now, the public may not understand systemic risk and perverse incentives and proprietary trading, but the public does understand this: that it took us 10 years to raise the minimum wage to $7.25 an hour. And if a person--and there is such a person--who gets a bonus of $69.7 million, it will take a minimum wage worker 4,622 years to make $69.7 million. Some things bear repeating, 4,622 years. The public understands that when you explain that the CEO or the CEOs of the biggest companies make more in 1 day than a minimum wage worker makes in a year, and this CEO has reason to envy the hedge fund manager who makes more in 10 minutes than the average worker makes in a year, and only pays 28 percent--pardon me, 15 percent, capital gains, not ordinary income. I am one who supports allowing people to make bonuses as large as they can make, as long as they don't do it based upon perverse incentives that create systemic risk. And that is what this is all about--perverse incentives that create systemic risk. Let people make as much they can. But let's not allow them to create perverse incentives that will bring down this economy. Enough already with this notion that we should just let the economy collapse. If we had not bailed out AIG--and I did not want to do it, I had to hold my nose and close my eyes to cast a vote--but if we had not bailed out AIG, Bear Stearns, the auto industry, would the world be a better place today, Ms. Minow? Ms. Minow. I think we could have done a better job of bailing them out, but I think we should have bailed them out. " CHRG-111hhrg54867--177 Mr. Manzullo," Thank you, Mr. Chairman. Thank you, Mr. Secretary. Mr. Secretary, would you agree that the root cause of the financial collapse of this country was the fact that subprimes were not regulated too closely? " CHRG-111shrg57322--1133 Mr. Blankfein," Again, this is what the lawsuit is, over whether we satisfied it, and that is a factual and a legal dispute now. Senator Tester. OK. You know the instruments. Do you, on behalf of Goldman, accept any responsibility for the collapse of 2008? " FinancialCrisisReport--3 Wall Street and The Financial Crisis: Anatomy of a Financial Collapse April 13, 2011 In the fall of 2008, America suffered a devastating economic collapse. Once valuable securities lost most or all of their value, debt markets froze, stock markets plunged, and storied financial firms went under. Millions of Americans lost their jobs; millions of families lost their homes; and good businesses shut down. These events cast the United States into an economic recession so deep that the country has yet to fully recover. This Report is the product of a two-year bipartisan investigation by the U.S. Senate Permanent Subcommittee on Investigations into the origins of the 2008 financial crisis. The goals of this investigation were to construct a public record of the facts in order to deepen the understanding of what happened; identify some of the root causes of the crisis; and provide a factual foundation for the ongoing effort to fortify the country against the recurrence of a similar crisis in the future. Using internal documents, communications, and interviews, the Report attempts to provide the clearest picture yet of what took place inside the walls of some of the financial institutions and regulatory agencies that contributed to the crisis. The investigation found that the crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street. While this Report does not attempt to examine every key moment, or analyze every important cause of the crisis, it provides new, detailed, and compelling evidence of what happened. In so doing, we hope the Report leads to solutions that prevent it from happening again. I. EXECUTIVE SUMMARY A. Subcommittee Investigation In November 2008, the Permanent Subcommittee on Investigations initiated its investigation into some of the key causes of the financial crisis. Since then, the Subcommittee has engaged in a wide-ranging inquiry, issuing subpoenas, conducting over 150 interviews and depositions, and consulting with dozens of government, academic, and private sector experts. The Subcommittee has accumulated and reviewed tens of millions of pages of documents, including court pleadings, filings with the Securities and Exchange Commission, trustee reports, prospectuses for public and private offerings, corporate board and committee minutes, mortgage transactions and analyses, memoranda, marketing materials, correspondence, and emails. The Subcommittee has also reviewed documents prepared by or sent to or from banking and securities regulators, including bank examination reports, reviews of securities firms, enforcement actions, analyses, memoranda, correspondence, and emails. CHRG-111shrg52619--2 Chairman Dodd," The Committee will come to order. Senator Shelby is in his office. He will be along shortly but asked us to commence the hearing. So we will begin this morning. Let me welcome my colleagues, welcome our witnesses as well. We have another long table here this morning of witnesses, and we are trying to move through this series of hearings on the modernization of financial regulation. So I am very grateful to all of you for your testimony. The testimony is lengthy, I might add. Going through last evening the comments--there is Senator Shelby. Very, very helpful, though, and very informative testimony, so we thank you all for your contribution. I will open up with some comments. I will turn to Senator Shelby, and then we will get right to our witnesses. We have got votes this morning as well, I would notify my colleagues, coming up so we are going to have to stagger this a bit so we do not delay the hearing too long, and we will try to, each one of us, go out and vote and come back so we can continue the hearing uninterrupted, if that would work out. So I will ask my colleagues' indulgence in that regard as well. We are gathering here again this morning to discuss the modernization of bank supervision and regulation. This hearing marks yet another in a series of hearings to identify causes of the financial crisis and specific responses that will guide this Committee's formulation of a new architecture for the 21st century financial services regulation. Today, we are going to explore ways to modernize and improve bank regulation and supervision, to protect consumers and investors, and help grow our economy in the decades ahead. A year ago, this Committee heard from witnesses on two separate occasions that the banking system was sound and that the vast majority of banks would be well positioned to weather the storm. A year later, taxpayers are forced to pump billions of dollars into our major banking institutions to keep them afloat. Meanwhile, every day 20,000 people, we are told, are losing their jobs in our country, 10,000 families' homes are in jeopardy from foreclosure, and credit--the lifeblood of our economy--is frozen solid. People are furious right now, and they should be. But history will judge whether we make the right decisions. And as President Obama told the Congress last month, we cannot afford to govern out of anger or yield to the politics of the moment as we prepare to make choices that will shape the future of our country literally for decades and decades to come. We must learn from the mistakes and draw upon those lessons to shape the new framework for financial services regulation, an integrated, transparent, and comprehensive architecture that serves the American people well through the 21st century. Instead of the race to the bottom we saw in the run-up to the crisis, I want to see a race to the top, with clear lines of authority, strong checks and balances that build the confidence in our financial system that is so essential to our economic growth and stability. Certainly there is a case to be made for a so-called systemic risk regulator within that framework, and whether or not those vast powers will reside in the Fed remains an open question, although the news this morning would indicate that maybe a far more open question in light of the balance sheet responsibilities. And, Mr. Tarullo, we will be asking you about that question this morning to some degree as well. This news this morning adds yet additional labors and burdens on the Fed itself, and so the question of whether or not, in addition to that job, we can also take on a systemic risk supervisor capacity is an issue that I think a lot of us will want to explore. As Chairman Bernanke recently said, the role of the systemic risk regulator will entail a great deal of expertise, analytical sophistication, and the capacity to process large amounts of disparate information. I agree with Chairman Bernanke, which is why I wonder whether it would not make more sense to give authority to resolve failing and systemically important institutions to the agency with actual experience in the area--the FDIC. If the events of this week have taught us anything, it is that the unwinding of these institutions can sap both public dollars and public confidence essential to getting our economy back on track. This underscores the importance of establishing a mechanism to resolve these failing institutions. From its failure to protect consumers, to regulate mortgage lending, to effectively oversee bank holding companies, the instances in which the Fed has failed to execute its existing authority are numerous. In a crisis that has taught the American people many hard learned lessons, perhaps the most important is that no institution should ever be too big to fail. And going forward, we should consider how that lesson applies not only to our financial institutions, but also to the Government entities charged with regulating them. Replacing Citibank-size financial institutions with Citibank-size regulators would be a grave mistake. This crisis has illustrated all too well the dangers posed to the consumer and our economy when we consolidate too much power in too few hands with too little transparency and accountability. Further, as former Fed Chairman Volcker has suggested, there may well be an inherent conflict of interest between prudential supervision--that is, the day-to-day regulation of our banks--and monetary policy, the Fed's primary mission--and an essential one, I might add. One idea that has been suggested that could complement and support an entity that oversees systemic risk is a consolidated safety and soundness regulator. The regulatory arbitrage, duplication, and inefficiency that comes with having multiple Federal banking regulators was at least as much of a problem in creating this crisis as the Fed's inability to see the crisis coming and its failure to protect consumers and investors. And so systemic risk is important, but no more so than the risk to consumers and depositors, the engine behind our very banking system. Creating that race to the top starts with building from the bottom up. That is why I am equally interested in what we do to the prudential supervision level to empower regulators, the first line of defense for consumers and depositors, and increase the transparency that is absolutely essential to checks and balances and to a healthy financial system. Each of these issues leads us to a simple conclusion: The need for broad, comprehensive reform is clear. We cannot afford to address the future of our financial system piecemeal or ad hoc without considering the role that every actor at every level must play in creating a stable banking system that helps our economy grow for decades to come. That must be our collective goal. With that, let me turn to Senator Shelby. CHRG-110hhrg46593--16 DEPOSIT INSURANCE CORPORATION Ms. Bair. Thank you. Chairman Frank, Ranking Member Bachus, and members of the committee, I appreciate the opportunity to testify on recent efforts to stabilize the Nation's financial markets and to reduce foreclosures. Conditions in the financial markets have deeply shaken the confidence of people around the world and their financial systems. The events of the past few months are unprecedented to say the least. The government has taken a number of extraordinary steps to bolster public confidence in the U.S. banking system. The most recent were measures to recapitalize our banks and provide temporary liquidity support to unlock credit markets, especially interbank lending. These moves match similar actions taken in Europe. Working with the Treasury Department and the other bank regulators, the FDIC will do whatever it takes to preserve the public's trust in the financial system. Despite the current challenges, the bulk of the U.S. banking industry remains well capitalized. But what we do have is a liquidity problem. This liquidity squeeze was initially caused by uncertainty about the value of mortgage-related assets. Since then, credit concerns have broadened considerably, making banks reluctant to lend to each other and to lend to consumers and businesses. As you know, in concert with the Treasury and the Federal Reserve, we took a number of actions to bolster confidence in the banking system. These included temporarily increasing deposit insurance coverage and providing guarantees to new senior unsecured debt issued by banks, thrifts, and holding companies. The purpose of these programs is to increase bank lending and minimize the impact of deleveraging on the American economy. As a result of these efforts, the financial system is now more stable and interest rate spreads have narrowed substantially. However, credit remains tight and this is a serious threat to the economic outlook. Regulators will be watching to make sure these emergency resources are mainly used for their intended purpose--responsible lending to consumers and businesses. In the meantime, we must focus on the borrower side of the equation. Everyone agrees that more needs to be done for homeowners. We need to prevent unnecessary foreclosures, and we need to modify loans at a much faster pace. Foreclosure prevention is essential to helping find a bottom for home prices, to stabilizing mortgage credit markets, and to restoring economic growth. We all know there is no single solution or magic bullet. But as foreclosures escalate, we are clearly falling behind the curve. Much more aggressive intervention is needed if we are to curb the damage to our neighborhoods and to the broader economy. Last Friday, we released the details of our plan to help 1.5 million homeowners avoid foreclosure. Our program would require a total of about $24 billion in Federal financing. The plan is based on our practical experience in modifying thousands of mortgages at IndyMac Federal Bank. As we have done at IndyMac, we would convert unaffordable mortgages into loans that are sustainable over the long term. The plan would set loan modification standards. Eligible borrowers would get lower interest rates and, in some cases, longer loan terms and principal forbearance to make their monthly payments affordable. To encourage the lending industry to participate, the program would create a loan guarantee program that would absorb up to half the losses if the borrower defaults on the modified loan. While we applaud recent announcements by the GSEs and major servicers to adopt more streamlined approaches to loan modifications along the lines we have employed at IndyMac, the stakes are too high and time is too short to rely exclusively on voluntary efforts. Moreover, these recent announcements do not reach mortgages held in private label securitizations. We need a national solution for a national problem. We need a fast-track Federal program that has the potential to reach all homeowners regardless of who owns their mortgages. What we are proposing is a major investment program that can yield significant returns by attacking the self-reinforcing cycle of unnecessary foreclosures that is placing downward pressure on home prices. Average U.S. home prices have declined by more than 20 percent from their peak and are still spiraling down. If this program can keep home prices from falling by just 3 percentage points less than would otherwise be the case, over half a trillion dollars would remain in homeowners' pockets. Even a conservative estimate of the wealth effect this could have on consumer spending would exceed $40 billion. That would be a big stimulus for the economy and nearly double our investment. In conclusion, the FDIC is fully engaged in preserving trust and stability in the banking system. The FDIC stands committed to achieving what has been our core mission since we were created 75 years ago in the wake of the Great Depression--protecting depositors and maintaining public confidence in the financial system. Thank you. [The prepared statement of Chairwoman Bair can be found on page 100 of the appendix.] " CHRG-111hhrg48875--87 Mr. Klein," Well, I look forward to working with you on that notion to make sure we don't have another too-big-to-fail scenario, but we allow a free enterprise system that is healthy and allows banks and others to thrive. I thank you, Mr. Chairman. " CHRG-111hhrg48875--61 Mr. Ellison," Could you tell me why the Treasury would be given resolution authority over systemically significant financial institutions such as bank holding companies, hedge funds, and large insurance firms? Why would the Treasury be given such resolution authority? " CHRG-110hhrg46593--150 Mr. Bernanke," In order to extend credit to currency swaps to allow dollar liquidity to be provided around the world, to allow access to banks and primary dealers, to provide that security, that liquidity backstop, and to strengthen our financial system, yes, we have done that. " CHRG-111shrg54533--70 Secretary Geithner," Senator, I think I need to just say one thing which is important to point out. If you look at the mortgage market in the United States where practices were worse, they were worse the greater distance you had from a Fed-supervised institution. If you look at where the pockets of risk in the financial system were worse, where you had leverage go to the point where institutions were at the edge of the abyss, no longer could decide independently, like in the case of Countrywide, for example, and two of the world's largest investment bank, or if you look at AIG, those were institutions that the Fed had no ability to affect risk taking those institutions. So I do not think it is fair to say, looking at the record of performance of our system over this period of time--even though, as I said, everybody part of this system, there are areas where they could have done substantially better. But I do not believe either in the mortgage area or in the core things that threaten the stability of the system it is fair to say that where those things were most acute, they were institutions that were under the Fed's supervision. And I did not believe that the additional accountability and clarity of responsibility we are proposing to give the Fed, building on their existing responsibilities today, has any significant risk of undermining their capacity to keep growth stable, sustainable over time, and keep inflation low and stable in the future. Senator Merkley. Well, I appreciate your response. I am not fully persuaded, but I do not pretend to be an expert in this area. But I will try to dive into it a little more and follow up with your team, and thank you very much. " fcic_final_report_full--617 Chapter 18 1. Joseph Sommer, counsel, Federal Reserve Bank of New York, email to Patrick M. Parkinson, deputy research director, Board of Governors of the Federal Reserve System, et al., “Re: another option we should present re triparty?” July 13, 2008. 2. James Dimon, interview by FCIC, October 20, 2010. 3. Barry Zubrow, 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, ses- sion 2: Lehman Brothers, September 1, 2010, p. 212. 4. Richard S. Fuld Jr., 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 2: Lehman Brothers, September 1, 2010, p. 148. See also Fuld’s written testimony at same hearing, p. 6. 5. Ben Bernanke, 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 2, ses- sion 1: The Federal Reserve, September 2, 2010, transcript, pp. 26, 89. 6. Kenneth D. Lewis, interview by FCIC, October 22, 2010. 7. Bernanke, testimony before the FCIC, September 2, 2010, p. 22. 8. Bernanke told the examiner that the Federal Reserve, the SEC, and “markets in general” viewed Lehman as the next most vulnerable investment bank because of its funding model. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Debtors, Chapter 11 Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 2:631 (hereafter cited as Valukas); see also 1:5 and n. 16, 2:609 and nn. 2133–34, 4:1417 and n. 5441, 4:1482 and n. 5728, 4:1494, and 5:1663 and n. 6269. Paulson, 2:632. Geithner told the examiner that following Bear Stearns’s near collapse, he considered Lehman to be the “most exposed” investment bank, 2:631; see also 1:5 and n. 16, 2:609, 4:1417 and n. 5441, 4:1482 and n. 5728, 4:1491 and n. 5769, and 5:1663 and n. 6269. Cox reported that after Bear Stearns collapsed, Lehman was the SEC’s “number one focus”; 1:5 and n. 16, and p. 1491 and n. 5769; see also 2:609, 631. 9. Timothy Geithner, quoted in Valukas, 1:8 and n. 30, 4:1496. 10. Donald L. Kohn, email to Bernanke, “Re: Lehman,” June 13, 2008. Valukas, 2:615; 2:609 and n. 2134. 11. Harvey R. Miller, bankruptcy counsel for Lehman Brothers, interview by FCIC, August 5, 2010; Lehman board minutes, September 14, 2008, p. 34. 12. Erik R. Sirri, interview by FCIC, April 1, 2010. 13. Paolo R. Tonucci, interview by FCIC, August 6, 2010. 14. Specifically, Lehman drew $1.6 billion on March 18; $2.3 billion on March 19 and 20; $2.7 billion on March 24; $2.1 billion on March 25 and 26; and $2 billion on April 16. Lehman Brothers, “Presenta- tion to the Federal Reserve: Update on Capital, Leverage & Liquidity,” May 28, 2008, p. 15. See also Robert Azerad, vice president, Lehman Brothers, “2008 Q2—Liquidity Position (June 6, 2008),” p. 3. Af- ter its bankruptcy, Lehman drew $28 billion, $19.7 billion, and $20.4 billion, on September 15, 16, and 17, until Barclays replaced the Fed in providing financing. Valukas, 4:1399. See also David Weisbrod, senior vice president, Treasury and Securities Services–Risk Management, JPMorgan Chase & Co., email to James Dimon et al., “Re: TriParty Close,” September 15, 2008. 15. Thomas A. Russo, former vice chairman and chief legal officer, Lehman Brothers, email to Richard S. Fuld Jr., forwarding article by John Brinsley (originally sent to Russo by Robert Steel), “Paul- son Says Investment Banks Making Progress in Raising Funds,” Bloomberg, June 13, 2008 (quoting Robert Steel), June 13, 2008. 16. Richard S. Fuld Jr., interview by FCIC, April 28, 2010. 17. Valukas, 2:713 and nn. 2764–65, 2:715 and n. 2774. See also Russo, email to Fuld, “Fw: Rumors of hedge fund putting together a group to have another run at Lehman,” March 20, 2008 (forwarding dis- cussions with SEC regarding short sellers). 18. Dan Chaudoin, Bruce Karpati, and Stephanie Shuler, Division of Enforcement, SEC, interview by FCIC, April 6, 2010; Mary L. Schapiro, chairman, SEC, written responses to written questions—specifically, response to question 13—from FCIC, asked after the hearing on January 14, 2010. 19. Jesse Eisinger, “The Debt Shuffle: Wall Street Cheered Lehman’s Earnings, but There Are Ques- tions about Its Balance Sheet,” Portfolio.com, March 20, 2008. 20. David Einhorn, Greenlight Capital, “Private Profits and Socialized Risk,” speech at Grant’s Spring Investment Conference, April 8, 2008, p. 9. See also David Einhorn, “Accounting Ingenuity,” speech at Ira W. Sohn Investment Research Conference, May 21, 2008, pp. 3–4. 21. Nell Minow, interview by FCIC, September 13, 2010. 22. Nell Minow, testimony before the House Committee on Oversight and Government Reform, CHRG-110shrg50414--202 Secretary Paulson," I would say the reason we want flexibility to, if we need to, buy some other classes of assets would be that if the banks--if capital starts to--as capital flows more freely, it will help the housing, because the fact that the financial system is gummed up and there is illiquidity hurts it and it may be that to deal with---- Senator Bunning. Student loans and then credit card debt are messing up the housing? " CHRG-111shrg57709--123 Mr. Wolin," Senator, if I could just add, I think your question is obviously a critically important one. The Volcker rule, were it to have been in place, I think would not have solved all the problems and nor is it the only piece of what we think is a comprehensive package of proposals. But there were plenty of bank holding companies that did suffer losses in their hedge funds and in their proprietary trading activity, that had capital holes that were in part therefore filled by taxpayer funds. We think as we go forward the real goal here, at the end of the day, is to create a financial regulatory system in which firms do not pose undue risk and where the whole system in its entirety is well protected. Our view is that having banking firms that fundamentally subsidize their riskier activities in these areas because they have access to the safety net is something we can and should avoid as we construct a framework going forward. Senator Johanns. But here is the challenge that you have here today, I think, in trying to move this Committee in this direction. The challenge is this: When you say, well, I can find some places where they lost money, my response to you on that is and you know what, I can find some places where they lost money on mortgages, on commercial real estate, on residential real estate. So what are we getting to here? " CHRG-111hhrg56776--271 Mr. Nichols," Chairman Watt, Ranking Member Paul, thank you for the opportunity to participate in today's hearing, to share our views regarding the Federal Reserve, and specifically, the relationship of supervisory authority to the Central Bank's effective discharge of its duties as our Nation's monetary authority. By way of background, the Financial Services Forum is a non-partisan financial and economic policy organization comprised of the chief executives of 18 of the largest and most diversified financial institutions doing business in the United States. Our aim is to promote policies that enhance savings investment in a sound, open, competitive financial services marketplace. Reform and modernization of our Nation's framework of financial supervision is critically important. We thank you, Mr. Chairman, Ranking Member Paul, and all the members of this committee for all of your tireless work over the past 15 months. To reclaim our position of financial and economic leadership, the United States needs a 21st Century supervisory framework that is effective and efficient, ensures institutional safety and soundness, as well as systemic stability, promotes the competitive and innovative capacity of our capital markets, and protects the interests of depositors, consumers, investors, and policyholders. In our view, the essential elements of such a meaningful reform are enhanced consumer protections, including strong national standards, systemic supervision ending once and for all ``too-big-to-fail,'' by establishing the authority and procedural framework from winding down any financial institution in an orderly non-chaotic way in a strong, effective, and credible Central Bank, which in our view requires supervisory authority. On the 11th of December, your committee passed a reform bill that would preserve the Federal Reserve's role as a supervisor of financial institutions. On Monday of this week, Chairman Dodd of the Senate Banking Committee released a draft bill that would assign supervision of bank and thrift holding companies with assets of greater than $50 billion to the Fed. While we think that it is sensible that the Fed retains meaningful supervisory authority in that bill, we also believe the Fed and the U.S. financial system would benefit from the Fed also having a supervisory dialogue with small and medium-sized institutions, a point which is well articulated by Jeff Gerhart in his testimony. You will hear from him in a moment. As this 15-month debate regarding the modernization of our supervisory architecture has unfolded, some have held the view that the Fed should be stripped of all supervisory powers, duties which some view as a burden to the Fed and distract the Central Bank from its core responsibility as the monetary authority and lender of last resort. Mr. Chairman, we do not share that view. Far from a distraction, supervision is altogether consistent with and supportive of the Fed's critical role as the monetary authority and lender of last resort for the very simple and straightforward reason that financial institutions are the transmission belt of monetary policy. Firsthand knowledge and understanding of the activities, condition and risk profiles of the financial institutions through which it conducts open market operations, or to which it might extend discount window lending, is critical to the Fed's effectiveness as the monetary authority and lender of last resort. It must be kept in mind that the banking system is the mechanical gearing that connects the lever of monetary policy to the wheels of economic activity. If that critical gearing is broken or defective, monetary policy changes by the Fed will have little, or even none, of the intended impact on the broader economy. In addition, in order for the Federal Reserve to look across financial institutions and the interaction between them and the markets for emerging risks, as it currently does, it is vital that the Fed have an accurate picture of circumstances within banks. By playing a supervisory role during crises, the Fed has a firsthand view of banks, is a provider of short-term liquidity support, and oversees vital clearing and settlement systems. As former Fed Chairman Paul Volcker observed earlier this afternoon, monetary policy and concerns about the structure and condition of banks and the financial system, more generally, are inextricably intertwined. While we don't see eye-to-eye with former Chairman Volcker on everything, we sure do agree with him on that. As Anil Kashyap noted, U.S. policymakers should also be mindful of international trends in the wake of financial crisis. In the United Kingdom--I'll point to the same example as Anil--serious consideration is being given to shifting bank supervision back to the Bank of England, which had been stripped of such powers when the FSA was created in 2001. It has been acknowledged that the lack of supervisory authority and the detailed knowledge and information derived from such authority likely undermined the Bank of England's ability to swiftly and effectively respond to the recent crisis. Thank you for the opportunity to appear before you today. [The prepared statement of Mr. Nichols can be found on page 96 of the appendix.] " CHRG-111hhrg53245--209 Mr. Perlmutter," Thank you, Mr. Chairman. And I think I agree with the chairman on increasing capitalization for all institutions, and especially in good times increase the capital, in bad times, give them a little bit of a break. But I guess sort of as a philosophical economic question to the panel, whether we are better off or worse off having over the years slowly eroded and chipped away at Glass-Steagall and unit banking so that we have separated the investment side, the stock traders from the bankers and the insurance company, and we have made banks stand--every bank stand on its own capital? So that would be my first question to the panel. Are we better off by having a more efficient system or were we better off by having every bank stood on its own merits, and we kept the investment side separate from the banking side? Ms. Rivlin. In other words, should we never have passed Gramm-Leach-Bliley? " CHRG-111hhrg53021--284 Mr. Lynch," Thank you, Mr. Chairman. Thank you, Mr. Secretary. We had a chance to chat about this a little earlier in the week. But I want to go back to the system that the President's plan envisions, where you have standard derivatives traded over an exchange, standard ones being linear in many cases, well understood. And yet you have another system right beside that parallel system for custom derivatives trading privately with far less transparency. There are a number of moral hazards here, and I want to have you address them. Number one, as the Chairman pointed out earlier, there is a big payday for the banks and for the derivative designers on the custom side of the house, much more so than on the standards side. Second, experience has shown us whenever you have a regulated system operating beside an unregulated system, the markets favor that unregulated system and the money migrates over. Third, the absence of an exchange by--the exchange serves a purpose as a pricing mechanism, and a major problem with these derivatives has been the accurate pricing of risk. And so you are putting these custom derivatives off the exchange where there will be, again, a mispricing of risk that will continue. And, last, we are still allowing these gratuitous side bets where folks can come in and take a bet where they have no interest at all in the underlying asset. And those are all moral hazards that are going to lead us to continue to have a system that has gaping holes in it. And I just don't know how I can support such a system. " CHRG-111hhrg53021Oth--284 Mr. Lynch," Thank you, Mr. Chairman. Thank you, Mr. Secretary. We had a chance to chat about this a little earlier in the week. But I want to go back to the system that the President's plan envisions, where you have standard derivatives traded over an exchange, standard ones being linear in many cases, well understood. And yet you have another system right beside that parallel system for custom derivatives trading privately with far less transparency. There are a number of moral hazards here, and I want to have you address them. Number one, as the Chairman pointed out earlier, there is a big payday for the banks and for the derivative designers on the custom side of the house, much more so than on the standards side. Second, experience has shown us whenever you have a regulated system operating beside an unregulated system, the markets favor that unregulated system and the money migrates over. Third, the absence of an exchange by--the exchange serves a purpose as a pricing mechanism, and a major problem with these derivatives has been the accurate pricing of risk. And so you are putting these custom derivatives off the exchange where there will be, again, a mispricing of risk that will continue. And, last, we are still allowing these gratuitous side bets where folks can come in and take a bet where they have no interest at all in the underlying asset. And those are all moral hazards that are going to lead us to continue to have a system that has gaping holes in it. And I just don't know how I can support such a system. " FinancialCrisisInquiry--389 BASS: OK. Thank you. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Kyle Bass. I’m the managing partner of Hayman Advisors in Dallas. And I would like to thank you and the members of the committee for the opportunity to share my views with you today as you consider the causes of the recent crisis as well as certain changes that must take place to avoid or minimize future crises. I believe that I have somewhat of a unique perspective with regard to this crisis, as my firm and I were fortunate enough to have seen parts of it coming. Hayman is a global asset management firm that managed several billion dollars of subprime and Alt-A mortgage positions during the crisis. And we remain an active participant in the marketplace today. While I realize the primary objective of the hearing today is to provide baseline information on the current state of the financial crisis and to discuss the roles that four specific banks or investment banks—Goldman, Morgan Stanley, Bank of America and JPMorgan—have played in the crisis, in my opinion, no single bank or group of large institutions single-handedly caused the crisis. While I will address each participant’s structure and problems independently later in my testimony, the problems with the participants and regulatory structure needs to be considered more holistically in order to prevent future systemic breakdowns and taxpayer harm. January 13, 2010 While there are many factors that led to the crisis, I will address what I believe to be the key factors that contributed to the enormity of the crisis. The first of which is the OTC derivatives marketplace. It was brought up in the prior hearing. But with nearly infinite leverage that it—that it afforded and continues to afford the dealer community, it must be changed. AIG, Bear Stearns and Lehman would not have been able to take on as much leverage as they did had they been required to post initial collateral on day one for the risk positions they were assuming. Asset management firms, including Hayman, have always been required to post initial collateral and maintenance collateral for virtually every derivatives trade we engage in. However, in AIG’s case, not only did they have to post initial collateral—or didn’t have to post initial collateral for these positions, when the positions moved against them, the dealer community forgave the so-called variance margin. The dealer community as well as other supposed AAA rated counterparties were, and some still are, able to transact with one another without sending collateral for the risk they are taking. This so-called initial margin was and still is only charged to counterparties that are deemed to be of lesser credit quality. Imagine if you were a 28-year-old mathematics superstar at AIG Financial Products Group, and you were compensated at the end of each year based upon the profitability of your trading book, which was ultimately based upon the risks you were able to take without posting any money initially. How much risk would you take? Well, the unfortunate answer turned out to be many multiples of the underlying equity of many of the firms in question. In AIG’s case, the risks taken in the company’s derivatives book were more than 20 times the firm’s shareholder equity. For a comprehensive look at those leverage ratios we can move to tables in my presentation later. The U.S. taxpayer is still paying huge bonuses to the members of AIG’s Financial Products Group because they’ve convinced the overseers that they possess some unique skill necessary to unwind these complex positions. In reality there are hundreds of out-of-work derivatives traders that would happily take that job for $100,000 a year instead of the many millions being paid to these supposed experts. January 13, 2010 To solve this OTC derivatives problem—I heard a few of the—of the potential solutions this morning. But I’ll go over the three that I think are absolutely mandatory to fix this problem. One is—is the key issue—is homogeneous minimum collateral requirements. All participants in the derivatives marketplace—do not bar the dealers from this— should be required to post initial capital based upon some formulaic determination of the risk by the appropriate regulatory body. Two, centralized clearing and mandatory price reporting of all standardized CDS, FX and interest rate derivatives—we believe close to 90 percent of these derivatives are standardized. Centralized data repository for all cleared and non-cleared derivatives trades—essentially there must be some place where every single transaction is recorded and monitored. As of today, that still doesn’t exist. It’s hard for me to believe that where we are today that that doesn’t exist. The second thing I’d like to talk about is bank leverage. And this is just the fundamental tenants of the U.S. banking system. Under current regulatory guidelines, banks are deemed to be well- capitalized with 6 percent tier one capital and adequately capitalized with 4 percent tier one capital based upon risk weighted assets. As an aside, the concept of risk weighting in assets should also be reviewed. This in turn means that a well-capitalized bank is leveraged 16 times to its capital, much more to its tangible common equity. And an adequately capitalized bank is—or a minimum capitalized bank—sorry—is 25 times levered to its tier one capital. I don’t know how many prudent individuals or institutions can possibly manage a portfolio of assets that is 25 times levered when we hit a crisis. But—but I surely can’t. Unfortunately, the answer so far has been not many of the other banks have been able to manage these risks either. Of the 170 banks that have failed during the crisis to date, the average loss to the FDIC and the taxpayer is well over 25 percent of their assets. When you think about that, that means they’ve lost more than six times their equity, of the banks that have gone down so far. January 13, 2010 Depository institutions like Citibank were able to parlay their deposits into large levered bets in the derivatives marketplace. In fact, at fiscal year-end 2007, Citigroup was 68- times levered to its tangible common equity, including off balance sheet exposures. Clearly, the composition of these assets is important as well, but I am simply trying to illustrate how levered these companies were at the start of the financial crisis. While AIG’s derivatives book was only 20-times levered to their book equity, $64 billion of these derivatives were related to subprime and subprime credit securities, the majority of which were ultimately worth zero. In some cases, excessive leverage cost the underlying company many years of lost earnings, and in other cases it cost them everything. I’ve put a table labeled “exhibit two” in my presentation. What we’ve done is looked back at the cumulative net income that was lost in financial institutions since the third quarter of 2007. Fannie Mae lost 20 ½ years of its profits in the last 18 months. AIG lost 17 ½ years of its profits in the last 18 months. Freddie Mac lost 11 ½ years of profits in a little bit more than a year. The point I’m trying to make is the ridiculousness of what’s gone on in the leverage that was in the system. The key problem with the system is the leverage and we must regulate that leverage. I’m going to—my third point that I’ll talk about briefly here is Fannie and Freddie. With $5.5 trillion of outstanding debt in mortgaged-backed securities, the quasi-public are now in conservatorship, Fannie and Freddie, have obligations that approach the total amount of government-issued bonds the U.S. currently has outstanding. There are so many things that went wrong or are wrong at these so-called “GSEs” that I don’t even know where to start. First, why are there two for-profit companies with boards, shareholders, charitable foundations, and lobbying arms ever given the implicit backing of the U.S. government? The Chinese won’t buy them anymore because our government won’t give them the explicit backing. The U.S. government cannot give them the explicit backing because the resulting federal debt burden will crash through the congressionally January 13, 2010 mandated debt ceiling, which was already recently raised to accommodate more deficit spending. These organizations have been the single largest political contributors in the world over the past decade, with over $200 million being given to 354 lawmakers in the last 10 years or so. Yes, the United States needs low-cost mortgages, but why should organizations created by Congress have to lobby Congress? Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage-backed bonds in the crisis. At one point in 2007, Fannie was over 95-times levered to its statutory minimum capital, with just 18 basis points set aside for loss. That’s right -- 18/100ths of 1 percent set aside for potential loss, with 95 times leverage. They must not be able to put Humpty Dumpty back together again. If they are going to exist going forward, Fannie and Freddie should be 100 percent government-owned and the government should simply issue mortgages to the population of the United States directly since this is essentially what is already happening today, with the added burden of supporting a privately funded, arguably insolvent capital structure. I will conclude my testimony there, and—and leave it to questions. CHRG-111shrg52619--204 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM SCOTT M. POLAKOFFQ.1. Two approaches to systemic risk seem to be identified: (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse? If you support approach one how you would limit institution size and how would you identify new areas creating systemic importance? If you support approach two how would you identify systemically important institutions and what new regulations and market discipline would you recommend?A.1. OTS endorses the establishment of a systemic risk regulator with broad authority, including regular monitoring, over companies that if, due to the size or interconnected nature of their activities, their actions or their failure would pose a risk to the financial stability of the country. Such a regulator should be able to access funds, which would present options to resolve problems at these institutions. 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. Any systemic regulator should have all of the authority necessary to supervise institutions and companies especially in a crisis situation, but this regulator would be in addition to the functional regulator. The systemic risk regulator would not have supervisory authority over nonsystemically important banks. However, the systemic risk regulator would need access to data regarding the health and activities of these institutions for purposes of monitoring trends and other matters influencing monetary policy. In addition, the systemic risk regulator would be charged with coordination of supervision of conglomerates that have international operations. The safety and soundness standards including capital adequacy and other measurable factors should be as comparable as possible for entities that have multinational businesses. The ability of banks and other entities in the United States to compete in today's global financial services market place is critical. The identification of systemically important entities would be accomplished by looking at those entities whose business is so interconnected with the financial services market that its failure would have a severe impact on the market generally. Any systemic risk regulator would have broad authority to monitor the market and products and services offered by a systemically important entity or that dominate the market. Important additional regulations would include additional requirements for transparency regarding the entity and the products. Further, such a regulator would have the authority to require additional capital commensurate with the risks of the activities of the entity and would monitor liquidity with the risks of the activities of the entity. Finally, such a regulator would have authority to impose a prompt corrective action regime on the entities it regulates.Q.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. The most significant barrier to disclosure is that if a regulator discloses confidential supervisory information to another regulator, the disclosure could lead to further, unintended disclosure to other persons. Disclosure to another regulator raises two significant risks: the risk that information shared with the other regulator will not be maintained confidential by that regulator, or that legal privileges that apply to the information will be waived by sharing. The regulator in receipt of the information may not maintain confidentiality of the information because the regulator is required by law to disclose the information in certain circumstances or because the regulator determines that it is appropriate to do so. For example, most regulators in the United States or abroad may be required to disclose confidential information that they received from another supervisor in response to a subpoena related to litigation in which the regulator may or may not be a party. While the regulator may seek to protect the confidentiality of the information that it received, the court overseeing the litigation may require disclosure. In addition, the U.S. Congress and other legislative bodies may require a regulator to disclose confidential information received by that regulator from another regulator. Moreover, if a regulator receives information from another regulator that indicates that a crime may have been committed, the regulator in receipt of the information may provide the information to a prosecutor. Other laws may require or permit a regulator in receipt of confidential information to disclose the information, for example, to an authority responsible for enforcement of anti-trust laws. These laws mean that the regulator that provides the information can no longer control disclosure of it because the regulator in receipt of the information cannot guarantee that it will not disclose the information further. With respect to waiver of privileges through disclosure to another regulator, legislation provides only partial protection against the risk that legal privileges that apply to the information will be waived by sharing. When privileged information is shared among covered U.S. federal agencies, privileges are not waived. 12 U.S.C. 1821(t). This statutory protection does not, however, extend to state regulators (i.e., insurance regulators) or foreign regulators. To reduce these risks, OTS has information-sharing arrangements with all but one state insurance regulator, 16 foreign bank regulators, and one foreign insurance regulator. (Some of these foreign bank regulators may also regulate investment banking or insurance.) OTS is in the process of negotiating information-sharing arrangements with approximately 20 additional foreign regulators. OTS also shares information with regulators with which it does not have an information-sharing arrangement on a case-by-case basis, subject to an agreement to maintain confidentiality and compliance with other legal requirements. See 12 U.S.C. 1817(a)(2)(C), 1818(v), 3109(b); 12 C.F.R. 510.5. In terms of practical steps to ensure a robust flow of communication, OTS, as part of its supervisory planning, identifies foreign and functional regulators responsible for major affiliates of its thrifts and maintains regular contact with them. This interaction includes phone and e-mail communication relating to current supervisory matters, as well as exchanging reports of examination and other supervisory documentation as appropriate. With its largest holding companies, OTS sponsors an annual supervisory conference to which U.S. and foreign regulators are invited to discuss group-wide supervisory issues. ------ CHRG-111hhrg53248--72 Secretary Geithner," We have not made a judgment on whether guidance in that particular area is necessary or appropriate or possible, but that is something we would be happy to talk to you and your staff about in more detail. Stepping back a second, you are right to say this is still a significant challenge for the U.S. financial system. We do have in place today, though, relatively creative, carefully designed programs to help mitigate the effects. The first is the program that allows us to give capital to community banks, a program we expanded and extended 2 or 3 months ago. And that is a very important thing to do. The second is a program we designed with the Fed to provide financing to the markets that are central and important to commercial real estate financing. Now those are important programs. We think they can be helpful in this. But I think you are right to say this is still going to be a challenge for our economy and our financial system to work through. " CHRG-111shrg61513--16 Mr. Bernanke," Thank you, Senator. As you know, I think that stripping the Federal Reserve of its supervisory authorities in the light of the recent crisis would be a grave mistake for several reasons. First, we have learned from the crisis that large, complex financial firms that pose a threat to the stability of the financial system need strong consolidated supervision. That means they need to be seen and overseen as a complete company, reflecting the developments not only in their banks, but also in their securities dealers and all the various aspects of their operations. A bank supervisor which focuses on looking at credit files is not prepared to look at the wide range of activities of a complex international financial firm. The Federal Reserve, in contrast, by virtue of its efforts in monetary policy, has substantial knowledge of financial markets, payment systems, economics, and a wide range of areas other than just bank supervision, and in our stress test, we demonstrated that we can use that whole range of multidisciplinary skills to do a better job of consolidated oversight. By the same token, we need to look at systemic risks. Systemic risks themselves also involve risks that can span across companies and into various markets. There again, you need an institution that has a breadth of skills. It is hard for me to understand why in the face of a crisis that was so complex and covers so many markets and institutions you would want to take out of the regulatory system the one institution that has the full breadth and range of those skills to address those issues. Let me mention your second point, and I think your point is very well taken. As I discussed in my testimony, we have taken very, very seriously both changes in our performance, changes in the way we go about doing supervision, but also changes in the structure of supervision, and we have made very substantial changes in order to increase the quality of our supervision, to increase our ability to look for systemic risks, and to use a multidisciplinary cross-expertise platform to look at these different issues. So we are very committed, and I would be happy to discuss with you through a letter or individually more details. I guess I would also like, if I might just have one more second, the Federal Reserve, of course, made errors and made mistakes in the supervisory function, but we were hardly alone in that respect and there were---- Senator Shelby. But what have you learned? I guess that is the question. " FinancialCrisisReport--337 The CDO Trading Desk conducted trades for both clients and other Deutsche Bank entities. It was further divided into three trading desks, designated the CDO, ABS, and ABS Correlation Desks. Each traded certain structured finance products, tracked relevant market news and developed expertise in its assigned products, and served as a source of asset and market information for other branches of Deutsche Bank. The CDO Desk focused on buying and selling CDO securities; the ABS Desk concentrated on trading RMBS and other asset backed securities as well as short trading strategies involving credit default swap (CDS) contracts in single name RMBS; and the ABS Correlation Desk acted primarily in a market making capacity for Deutsche Bank clients, trading both long and short RMBS and CDO securities and CDS contracts with the objective of taking offsetting positions that minimized the bank’s risk. 1272 Mr. Lippmann was well known in the CDO marketplace as a trader. He had joined Deutsche Bank in 2000, after a stint at Credit Suisse trading bonds. One publication noted that Mr. Lippmann “made his name with big bets on a housing bust,” continuing: “Mr. Lippmann emerged as a Cassandra of the financial crisis, spotting cracks in the mortgage market as early as 2006. His warnings helped Deutsche brace for the crisis. He also helped investors – and himself – land huge profits as big bets that the housing market would collapse materialized.” 1273 (3) Deutsche Bank’s $5 Billion Short In 2006 and 2007, Deutsche Bank’s top CDO trader, Greg Lippmann, repeatedly warned his Deutsche Bank colleagues and some clients outside of the bank about the poor quality of the assets underlying many RMBS and CDO securities. Although senior management within the bank did not agree with his views, they allowed Mr. Lippmann, in 2005, to establish a large short position on behalf of the bank, essentially betting that mortgage related securities would fall in value. From 2005 to 2007, Mr. Lippmann built that position into a $5 billion short. (a) Lippmann’s Negative Views of Mortgage Related Assets Emails produced to the Subcommittee provide repeated examples of Mr. Lippmann’s negative views of mortgage related assets, particularly those involving subprime mortgages. At times, he expressed his views to colleagues within the bank; at other times he expressed them in connection with advising a client to bet against an RMBS security by taking a short position. At times, Mr. Lippmann recommended that his clients short poor quality RMBS assets, even while his trading desk was participating in a selection process that included those same assets in Gemstone 7. The following emails by Mr. Lippmann, written during 2006 and 2007, provide examples of his negative views. 1272 Subcommittee interview of Greg Lippmann (10/18/2010). 1273 “Lippmann, Deutsche Trader, Steps Down,” New York Times (4/21/2010), http://dealbook.nytimes.com/2010/04/21/lippmann-deutsche-trader-steps-down/. See also Michael Lewis, The Big Short (2010), at 64. • Emails regarding LBMLT 2004-3 M8, a subprime RMBS security issued by Long CHRG-110hhrg44903--77 Mr. Cox," I think that the Gramm-Leach-Bliley essence of eliminating the Glass-Steagall in a wall of separation was a good thing and can be distinguished from what I am trying to point out here, which are the essential differences even in today's world that characterize investment banks on the one hand and commercial banks on the other. Some of those differences are regulatory, some of them are accounting, some of them are the nature of the business. The approach to leverage and risk is very different in investment banks than it is for commercial banks. For accounting reasons, investment banks have to daily mark to market everything they have. Commercial banks don't often have to do that. If we don't appreciate these distinctions and appreciate the different roles that these institutions play, then I think we will find that applying the commercial bank model of regulation to investment banks will so restrain the role that they play in the economy that somebody else then in the marketplace is going to rush in to do that, likely an unregulated entity, hedge funds and others private pools of capital. Then we will have the same set of questions to ask all over again but now with a new set of entities, and we haven't really solved that problem. " CHRG-111shrg56415--81 PREPARED STATEMENT OF JOHN C. DUGAN * Comptroller of the Currency Office of the Comptroller of the Currency October 14, 2009--------------------------------------------------------------------------- * Statement Required by 12 U.S.C. Sec. 250: The views expressed herein are those of the Office of the Comptroller of the Currency and do not necessarily represent the views of the President.---------------------------------------------------------------------------I. Introduction Chairman Johnson, Senator Crapo, and members of the Subcommittee, I am pleased to testify on the current condition of the national banking system, including trends in bank ending, asset quality, and problem banks. The OCC supervises over 1,600 national banks and Federal branches, which constitute approximately 18 percent of all federally insured banks and thrifts, holding just over 61 percent of all bank and thrift assets. These nationally chartered institutions include 15 of the very largest U.S. banks, with assets generally exceeding $100 billion; 23 mid-sized banks, with assets generally ranging between $10 billion and $100 billion; and over 1,500 community banks and trust banks, with assets between $1.5 million and $10 billion. The OCC has dedicated supervisory programs for these three groups of institutions that are tailored to the unique challenges faced by each. My testimony today makes three key points. First, credit quality is continuing to deteriorate across almost all classes of banking assets in nearly all sizes of banks. As the economy has weakened, the strains on borrowers that first appeared in the housing sector have spread to other retail and commercial borrowers. For some credit portfolio segments, the rate of nonperforming loans is at or near historical highs. In many cases, this declining asset quality reflects risks that built up over time, and while we may be seeing some initial signs of improvement in some asset classes as the economy begins to recover, it will generally take time for problem credits to work their way through the banking system. Second, the vast majority of national banks are strong and have the financial capacity to withstand the declining asset quality. As I noted in my testimony last year before the full Committee, we anticipated that credit quality would worsen and that banks would need to further strengthen their capital and loan loss reserves.\1\ Net capital levels in national banks have increased by over $186 billion over the last 2 years, and net increases to loan loss reserves have exceeded $92 billion. While these increases have considerably strengthened national banks, we anticipate additional capital and reserves will be needed to absorb the additional potential losses in banks' portfolios. In some cases that may not be feasible, however, and as a result, there will continue to be a number of smaller institutions that are not likely to survive their mounting credit problems. In these cases we are working closely with the FDIC to ensure timely resolutions in a manner that is least disruptive to local communities.--------------------------------------------------------------------------- \1\ Testimony of John C. Dugan before the Committee on Banking, Housing, and Urban Affairs, United States Senate, June 5, 2008, page 2.--------------------------------------------------------------------------- Third, during this stressful period we are extremely mindful of the need to take a balanced approach in our supervision of national banks, and we strive continually to ensure that our examiners are doing just that. We are encouraging banks to work constructively with borrowers who may be facing difficulties and to make new loans to creditworthy borrowers. And we have repeatedly and strongly emphasized that examiners should not dictate loan terms or require banks to charge off loans simply due to declines in collateral values. Balanced supervision, however, does not mean turning a blind eye to credit and market conditions, or simply allowing banks to forestall recognizing problems on the hope that markets or borrowers may turn around. As we have learned in our dealings with problem banks, a key factor in restoring a bank to health is ensuring that bank management realistically recognizes and addresses problems as they emerge, even as they work with struggling borrowers.II. Condition of the National Banking System: Credit Quality Has Replaced Liquidity as Major Concern Beginning in the fall of 2007 and extending through the first quarter of this year, bank regulators and the industry were confronted with unprecedented disruptions in the global financial markets. In the wake of severe problems with subprime mortgages, the value of various securitized assets and structured investment products declined precipitously. Key funding and short term credit markets froze, sparking a severe contraction in the liquidity that sustains much of our economy and banking system, including uninsured deposit funding. The combination of these events led to failures, government assistance, and government takeover of several major financial institutions. Through the collective efforts and programs resulting from actions taken by Congress, the Treasury Department, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and governments around the world, there has been significant stabilization in credit and funding markets for all financial institutions, including banks of all sizes. As reflected in both the TED and Libor-OIS spreads,\2\ each of which has fallen to less than 20 basis points after peaking at well over 300 basis points during the crisis, the interbank funding market has vastly improved, with banks once again willing to extend credit to counterparties. There has also been a slight rebound in certain securitization markets. For example, non-mortgage asset-backed securities issuance for 2Q:2009 totaled $49 billion, up 121 percent from 1Q:2009. Similarly, syndicated market loan issuances increased to $156 billion in 2Q:2009, up 37 percent from 1Q:2009.--------------------------------------------------------------------------- \2\ The TED spread reflects the difference between the interest rates on interbank loans in the Eurodollar market and short-term U.S. Government Treasury bills. The OIS is the overnight indexed swap rate. Both spreads are a measure of how markets are viewing the risks of financial counterparties.--------------------------------------------------------------------------- The drag on national banks' balance sheets and earnings from the overhang of various structured securities products has been very significantly reduced due to the substantial write-downs that banks took on these assets in 4Q:2008 and 1Q:2009 and the overall recovery in credit markets. Losses sustained at our 10 largest banking companies for these securities reached $44 billion in 2008, but dropped to $8 billion in 1Q:2009 and $1 billion in 2Q:2009. There are some banks that still face strains in their investment portfolios, largely due to their holding of certain private label mortgage-backed and trust preferred securities. While most banks will be able to absorb the losses that may arise from these holdings, there is a small population of banks that have significant concentrations in these products that we are closely monitoring. We expect these banks will continue to take incremental credit impairments through earnings until mortgage metrics improve. In my financial condition testimony before the full Committee last year, I observed that, as market conditions began to stabilize, the focus of supervisors and bankers would increasingly turn to the more traditional challenges of identifying and managing problem credits.\3\ That has indeed proven to be the case, as declining asset quality has become the central challenge facing banks and supervisors today. While there recently have been some signs of economic recovery, data through the second quarter of this year demonstrate that asset quality across the national bank population significantly deteriorated over the preceding twelve months, as both retail and commercial borrowers remained under stress from job losses and the overall contraction in the economy. The percentage of noncurrent loans (loans that are 90 days or more past due or on nonaccrual) increased dramatically and reached the highest level in at least twenty 5 years (see Chart 1).--------------------------------------------------------------------------- \3\ Testimony of John C. Dugan before the Committee on Banking, Housing, and Urban Affairs, United States Senate, June 5, 2008, page 9. In addition, the rate at which banks are charging off loans has also accelerated and, for some portfolio segments, now exceeds previous peaks experienced during the last credit cycle. Continued concerns about the economy are also affecting loan growth and demand as businesses, consumers, and bankers themselves retrench on the amount of leverage and borrowing they want to assume. As a result, loan growth through 2Q:2009 has slowed across the national bank population and in various portfolio segments. (See charts 2 and 3) A number of factors are evident for this decline in credit, including the following: Reduction in loan demand, as reductions in consumer spending have caused businesses to cut back on inventory and other investments; Reduction in the demand for credit from borrowers who may have been able to afford or repay a loan when the economy was expanding, but now face constrained income or cash-flow and debt service capacity; Reductions in loan demand as households work to rebuild their net worth, as reflected in the increased U.S. savings rate; Actions taken by bankers to scale back their risk exposures due to weaknesses in various market and economic sectors, and to strengthen underwriting standards and loan terms that had become, in retrospect, too relaxed. In addition, many banks have increasingly shifted their focus and resources to loan collections, workouts, and resolutions, and some troubled banks have curtailed lending due to funding and capital constraints; and Continued uncertainty on the part of borrowers and lenders about the strength and speed of the economic recovery in many regions of the country. As demonstrated in chart 4 below, businesses have significantly reduced their investments and inventories and, in an effort to strengthen their own balance sheets, many larger businesses have replaced short-term borrowing with longer-term corporate bond issues. Similarly, chart 5 shows that consumers are repairing their personal balance sheets with significant increases in their personal savings rates. This interplay of factors and their effects on lending are consistent with our recent annual underwriting survey and the Federal Reserve Board's most recent Senior Loan Officer Survey. OCC examiners report that the financial market disruption continues to affect bankers' appetite for risk and has resulted in a renewed focus on fundamental credit principles by bank lenders. Our survey indicates that primary factors contributing to stronger underwriting standards are bankers' concerns about unfavorable external conditions and product performance.\4\ In its July Senior Loan Officer Survey, the Federal Reserve reported that ``demand for loans continued to weaken across all major categories except for prime residential mortgages.''\5\--------------------------------------------------------------------------- \4\ OCC Survey of Underwriting Practices 2009, page 3. \5\ Board of Governors of the Federal Reserve System, ``The July 2009 Senior Loan Officer Survey on Bank Lending Practices,'' page 1.--------------------------------------------------------------------------- Some have also suggested that unnecessary supervisory actions may have significantly contributed to the decline in credit availability. While I do not believe the evidence supports this suggestion, I do believe, as addressed in more detail at the end of this testimony, that it is critical for supervisors to stay focused on the type of balanced supervision that is required in the stressful credit conditions prevalent today. Finally, the combination of deteriorating credit quality, lower yields on earning assets, and slower loan growth is the primary factor currently affecting national banks' earnings. As shown in Chart 6, there has been a marked deterioration in the return on equity across the national banking population as modest increases in banks' net interest margins due to more favorable costs of funds have failed to offset credit quality problems and the continued need for banks to build loan loss reserves.III. Trends in Key Credit Portfolios and Capital and Reserve Positions Against this backdrop, let me now describe trends in major credit segments and in capital and loan loss reserve levels.A. Retail Credit Although retail loans--mortgages, home equity, credit cards, and other consumer loans--account for just over half of total loans in the national banking system, they currently account for two-thirds of total losses, delinquencies, and nonperforming credits. To a large extent, however, these problems are confined to the largest 15 national banks, which hold almost 91 percent of retail loans in the national banking system.1. First and Second Mortgages The residential mortgage sector was the epicenter of the financial turmoil and continues to figure prominently in the current condition of the banking industry. As the economy has worsened, problems that started in the subprime market have spread to the so-called ``Alt A'' market, and increasingly, to the prime market. While over-leverage and falling housing prices were the initial drivers of delinquencies and loan losses, borrower strains resulting from rising unemployment and underemployment are an increasingly important factor. In the first mortgage market, the June 30, 2009 Mortgage Bankers Association's National Delinquency Survey shows continued growth in foreclosure inventory, but a relatively flat rate of new foreclosure starts overall between the first and second quarter of this year. The rate of prime foreclosures, however, continues to increase, with starts at about 1 percent of the surveyed population as of the end of the second quarter. Although this percentage is still relatively small, the impact is significant given the much larger size of the prime market segment compared to the markets for subprime and Alt-A loans. While it is true that many first mortgages were sold to third party investors via the securitization market, and the loan quality of such mortgages retained by banks is generally higher than those sold to third parties, it nevertheless remains the case that a number of larger banks have significant on-balance sheet exposure to first mortgage losses from portfolios that continue to deteriorate. The same is true of second mortgages--home equity loans and lines of credit--except that the overwhelming majority of these loans reside on bank balance sheets. There were some positive signs in the second quarter showing home equity loan delinquency rates falling, and the pace of increase in second lien charge-off rates slowing. But the hard fact is that losses on these loans through the first half of this year nearly equaled total losses for all of 2008, and loss rates are expected to continue to climb--though at a slower rate--through at least the middle of 2010. In short, deterioration in the first and second residential mortgage markets continue to dominate the credit quality performance in national banks' retail portfolios, as it has since the second half of 2008. Total delinquent and nonperforming residential real estate loans (mortgage and home equity) in national banks now hover around 9.4 percent, with a loss rate of just over 2.5 percent--the highest level since we have been collecting this data. There have been some positive indicators in the housing market in recent months that could slow the pace of losses in residential mortgages, including increased home sales in June and July, and slight increases in the Case-Shiller composite index for certain metropolitan areas. While these signs are encouraging, it is too early to determine whether they signal a true turning point in this sector. For example, the increase in home sales this summer is consistent with seasonal trends and may not be sustainable. In addition, sales may be enjoying a temporary boost from the First-Time Homebuyer Tax Credit program which, unless extended, will end in November. Much will depend, of course, on the extent to which economic recovery takes hold and truly stabilizes the housing market. In terms of mortgage modifications, all of the major national bank mortgage servicers are actively participating in the Administration's Making Home Affordable Program. Servicers have been significantly expanding their staff levels in the loss mitigation/collection areas--doubling and tripling customer contact personnel, and requiring night and weekend overtime work. Servicers have also been ramping up their training efforts, customer service scripts, and automated qualification and underwriting systems to improve the processing of loan modification requests. The OCC is closely monitoring these and other home modification efforts through onsite examinations and other ongoing supervisory initiatives, as well as through our Mortgage Metrics quarterly reporting program. And examiners continue to monitor modification programs for compliance with all applicable fair lending and consumer compliance laws. Our latest Mortgage Metrics report shows that actions to keep Americans in their homes grew by almost 22 percent during 2Q:2009.\6\ Notably, the percentage of modifications that reduced borrowers' monthly principal and interest payments continued to increase to more than 78 percent of all new modifications, up from about 54 percent in the previous quarter. We view this as a positive development, as modifications that reduce borrowers' monthly payments generally produce lower levels of re-defaults and longer term sustainability than modifications that either increase payments or leave them unchanged.--------------------------------------------------------------------------- \6\ See OCC News Release 2009-118, September 30, 2009.---------------------------------------------------------------------------2. Credit Cards Credit card performance began to deteriorate sharply in the latter part of 2008 and has continued to weaken further this year, with record levels of losses and delinquencies. As with second lien mortgages, there have been some encouraging signs recently in the form of declining early stage delinquency rates, but loss rates continue to climb. As of June 30, the overall loss rate was 10.3 percent for national banks, and more recent data shows continued deterioration-with industry analysts predicting even higher loss rates into 2010. In response to these trends and the overall deterioration in the economy, many credit card issuers are adjusting their account management policies to reflect and respond to the increased risk in these accounts. In some cases these actions have resulted in credit lines being reduced or curtailed. In other cases, they have led to increased interest rates, effectively increasing the minimum payment to cover the higher finance charges. In still other cases they have resulted in an increase in minimum payments to extinguish the outstanding debt more quickly. Many credit card issuers are also re-evaluating certain credit card product features, such as ``no annual fees'' or various reward programs, and are offering cards with simpler terms and conditions, in part due to the recently enacted Credit CARD Act. We are monitoring these changes in credit card account terms to ensure that they comply with all applicable limit and notice requirements, including those mandated by the Credit CARD Act. For example, in July we notified national banks that, effective August 22, 2010, they must conduct periodic reviews of accounts whose interest rates have been increased since January 1, 2009, based on factors including market conditions and borrower credit risk. More recently, we issued a bulletin advising national banks abut the interim final rules issued by the Federal Reserve under the Credit CARD Act that became effective on August 20, 2009. The Federal Reserve's rules require lenders to notify customers 45 days in advance of any rate increase or significant changes in credit card account terms and to disclose that consumers can have the right to reject these changes. Under the rules, the new rates or terms can be applied to any transaction that occurs more than 14 days after the notice is provided--even if the customer ultimately rejects those terms. To address the risk of consumer confusion, the OCC directed national banks to include an additional disclosure not required by the rules to alert consumers, if applicable, to the imposition of the new terms on transactions that occur more than 14 days after thenotice is provided, regardless of whether the consumer rejects the change and cancels the account. As with residential mortgages, we are encouraging national banks to work with consumers who may be facing temporary difficulties and hardships, and more banks are reaching out to assist customers before they become delinquent. Banks have a number of viable default management options to assist in this endeavor, although it is important that, as they do so, they continue to appropriately account for losses as they occur. Card issuers are also reevaluating the size of unused credit lines in response to current credit conditions, recent regulatory changes, and recent adoption by the Financial Accounting Standards Board (FASB) of two new accounting standards, Statement No. 166, Accounting for Transfers of Financial Assets--an amendment of FASB Statement No. 140 (FAS 166) and Statement No. 167, Amendments to FASB Interpretation No. 46(R) (FAS 167). These standards become effective for an entity's first fiscal year beginning after November 15, 2009, and will have a significant impact on many banking institutions. In particular, many securitization transactions, including credit card securitizations, will likely lose sales accounting treatment, prompting the return of the securitized assets to banks' balance sheets. Although we are still evaluating the impact of these changes, we anticipate that they will have a material effect on how banks structure transactions, manage risk, and determine the levels of loan loss reserves and regulatory capital they hold for certain assets, including credit cards. The net effect of these changes is that banks will most likely face increased funding and capital costs for these products. The combination of all these factors has resulted in a decline in overall credit card debt outstanding and--especially--overall unfunded credit card commitments, reflecting pullbacks by both consumers and lenders. For national banks, managed card outstandings (i.e., funded loans both on and off banks' balance sheets) declined by 4 percent thus far this year, or roughly $27 billion. Unfunded credit card commitments (lines available to customers) have declined more precipitously, by 14.8 percent or $448 billion. These trends are consistent with overall industry data. In summary, retail credit quality issues continue to be an area of concern, especially for the larger national banks. Although there are some early signs of delinquency rates declining, with some bankers telling us they are beginning to see adverse trends leveling off, sustained improvements in this sector will largely depend on the length and depth of the recession and levels of unemployment.B. Commercial and Industrial Loans The fallout from the housing and consumer sectors to other segments of the economy is evident in the performance of national banks' commercial and industrial (C&I) loan portfolios. Adverse trends in key performance measures, including 30-day or morepast due delinquencies, non-performing rates, and net loss rates, sharply accelerated in the latter part of last year and have continued to trend upward in 2009. For example, the percentage of C&I loans that are delinquent or nonperforming has risen from a recent historical low of 1.02 percent in 2Q:2007 to 3.90 percent in 2Q:2009. Although this is the highest rate since the ratio peaked at 4.15 percent in 2Q:2002 during the last recession, it is still well below the 1991 recession peak of 6.5 percent. In contrast to retail loans, which primarily affect the larger national banks, the effect of adverse trends in C&I loans is fairly uniform across the national bank population. This segment of loans represents approximately 20 percent of total loans in the national banking system, with levels somewhat more concentrated at larger institutions than at community banks, where C&I loans account for approximately 16 percent of total loans. While credit quality indicators are marginally worse at the larger national banks, the trend rate and direction are fairly consistent across all sizes of national banks. One measure of C&I loan quality comes from the Federal banking agencies' Shared National Credit (SNC) program, which provides an annual review of large credit commitments that cut across the financial system. These large loans to large borrowers are originated by large banks, then syndicated to other banks and many types of nonbank financial institutions such as securitization pools, hedge funds, insurance companies, and pension funds.\7\ This year's review, which was just recently completed, also found sharp declines in credit quality. The review, which covered 8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers, found a record level of $642 billion in criticized assets--meaning loans or commitments that had credit weaknesses--representing approximately 22 percent of the total SNC portfolio. Total loss of $53 billion identified in the 2009 review exceeded the combined loss of the previous eight SNC reviews and nearly tripled the previous high in 2002. Examiners attributed the declining credit quality to weak economic conditions and the weak underwriting standards leading up to 2008.\8\--------------------------------------------------------------------------- \7\ In fact, nonbanks hold a disproportionate share of classified assets compared with their total share of the SNC portfolio, owning 47 percent of classified assets and 52 percent of nonaccrual loans, whereas FDICinsured institutions hold only 24.2 percent of classified assets and 22.7 percent of nonaccrual loans. \8\ See OCC News Release 2009-11, September 24, 2009.---------------------------------------------------------------------------C. Commercial Real Estate Loans The greatest challenge facing many banks and their supervisors is the continued deterioration in commercial real estate loans (CRE). There are really two stories here, with one related to the other. The first involves residential construction and development (C&D) lending, especially with respect to single family homes. Not surprisingly, given the terrible strains in the housing sector over the last 2 years, delinquency rates have already climbed tohigh levels, with significant losses already realized and more losses continuing to work their way through the banking system. For national banks as of June 30, total delinquent and nonperforming rates were at just over 34 percent in the largest national banks; 23.4 percent in mid-size banks; and 17.5 percent in community banks. The relative size of these loss rates is somewhat misleading, however, because many community banks and some mid-size banks have much greater concentrations in residential C&D loans than the largest banks. As a result, the concentrated losses in these smaller institutions has had a much more pronounced effect on viability, with concentrated residential C&D lending constituting by far the single largest factor in commercial bank failures in the last two years. At this point in the credit cycle, we believe the bulk of residential C&D problems have been identified and are being addressed, although a number will continue to produce losses that result in more bank failures. The second story involves all other types of commercial real estate loans, including loans secured by income producing properties. Credit deterioration has spread to these assets as well, and trend lines are definitely worsening, but thus far the banking system has not experienced anywhere near the level of delinquency and loss as it has in C&D lending. Still, the signs are troubling. Declining real estate values caused by rising vacancy rates, increasing investor return requirements, falling rental rates, and weak sales are affecting all CRE segments. For example, Property and Portfolio Research reports that apartment vacancy rates have hit a 25-plus year high at 8.4 percent nationally, and there are similar patterns for retail, office, and warehouse space as demand falls across all segments. But unlike the CRE markets in 1991, much of the current fallout is driven more by a decrease in demand than from an oversupply of properties. The outlook for these markets over the near term, especially for the income producing property sector, is not favorable. In general, deterioration in performance for these CRE loans lags the economy as borrowers' cash-flows may be sufficient during the early stages of a downturn, but become increasingly strained over time. There are alsogrowing concerns about the refinancing risk within the commercial mortgage-backed securities market (CMBS) where there is a currently moderate-but-growing pipeline of loans scheduled to mature. Permanent or rollover refinancing of these loans may be difficult due to the declines in commercial property values coupled with the return to more prudent underwriting standards by both lenders and investors. While this is an area that we are monitoring, the largest proportion and more problematic of these mortgages will not mature until 2011 and 2012. As with C&I loans, trends in total delinquent and nonperforming CRE rates (including C&D loans) have been fairly consistent across all segments of the national bank population, climbing to roughly 8.3 percent in 2Q:2009. While C&D losses will continue to be most problematic for the banks that have the largest concentrations in these assets, theextent to which other types of CRE loan losses will continue to climb will depend very much on the overall performance of the economy.D. Capital and Reserve Levels Perhaps the most critical tools for dealing with and absorbing credit losses are substantial levels of capital and reserves. As a result, in anticipation of rising credit losses over the last 2 years, the OCC has directed banks to build loan loss reserves and strengthen capital. In aggregate, the net amount of capital in national banks (i.e., the net increase after items such as losses and dividends and including capital as a result of acquisitions and net TARP inflows) has risen by over $186 billion over the last 2 years, and the net build to loan loss reserves (i.e., loan loss provisions less net credit losses) has been over $92 billion. These increases in loss-absorbing resources are critical contributors to the overall health of the national banking system. As illustrated by the dotted line in the chart below, the level of reserves to total loans in the national banking system has increased dramatically to a ratio of 3.3 percent, the highest in over 25 years. While such high reserves are imperative for dealing with the high level of noncurrent loans, the solid line in the chart below shows that more provisions may be needed, because the ratio of reserves to noncurrent loans has continued to decline, to under 100 percent--reflecting the fact that the substantial growth in reserves is not keeping pace with the even greater growth in noncurrents. Substantially building reserves at the same time as credit conditions weaken is often described as unduly ``pro-cyclical,'' because bank earnings decline sharply from provisioning well before charge-offs actually occur. That is certainly an accurate characterization under the current accounting system for loan loss reserving, although there will always be a need to build reserves to some extent as credit losses rise. The issue is really about how much; that is, if reserve levels are high going into a credit downturn, then the need to build reserves is far lower than it is when the going-in levels are low. Unfortunately, our current accounting standards tend to produce very low levels of reserves just before the credit cycle turns downward, especially after prolonged periods of benign credit conditions as we had in the first part of this decade. In such periods, the backward-looking focus of the current accounting model creates undue pressure to decrease reserve levels even where lenders believe the cycle is turning and credit losses will clearly increase. I strongly believe that a more forward looking accounting model based on expected losses would both more accurately account for credit costs and be less pro-cyclical. This is an issue that I have been working on as co-chair of the Financial Stability Board's (FSB) Working Group on Provisioning, and I continue to be hopeful that accounting standard setters will embrace this type of change as they consider adjustments to loan loss provisioning standards.IV. Most National Banks Have Capacity to Weather This Storm The credit conditions I have just described are stark and will require considerable skills by bankers and regulators to work through. Despite these challenges, I believe the vast majority of national banks are and will continue to be sound, and that they have the wherewithal to manage through this credit cycle. Notwithstanding the negative trends and earnings pressures that banks are facing, we should not lose sight that, as of June 30, 2009,97 percent of all national banks satisfied the required minimum capital standards to be considered well capitalized, and 76 percent reported positive earnings. As previously described, the OCC has separate supervisory programs for Large Banks (assets generally exceeding $100 billion); Mid-Sized Banks (assets from $10 billion to $100 billion); and Community Banks (assets below $10 billion). Let me summarize our general assessment of the condition of each group.A. Large Banks In some respects, large banks faced the earliest challenges, with the disruptions in wholesale funding markets, the significant losses they sustained on various structured securities. and the pronounced losses that emerged earlier in their retail credit portfolios. As I mentioned, there are some preliminary indicators that the rate of increased problems in the retail sector may have begun to slow, but as with credit conditions in general, much of this will depend on the timing and strength of the economy, and in particular, on unemployment rates. C&I and CRE loan exposures remain a concern for these banks, but they have more diversified portfolios and exposures than many smaller banks and thus may be in a better position to absorb these problems. Collectively, the fifteen banks in our Large Bank program raised $132 billion in capital (excluding TARP funding) in 2008 and, over the past twenty 4 months, their net build to loan loss reserves totaled approximately $85 billion. Earlier this year we and the other Federal regulators conducted a detailed stress test of the largest U.S. banks as part of the Supervisory Capital Assessment Program (SCAP) to examine their ability to withstand even further deterioration in market and credit conditions. I believe that was an extremely valuable exercise for four reasons. First, the one-time public assessment of individual institution supervisory results--which was only made possible by the U.S. Government backstop made available by TARP funding--alleviated a great deal of uncertainty about the depth of credit problems on bank balance sheets, which a number of analysts had assumed to be in far worse condition. Second, the reduction of uncertainty allowed institutions to access private capital markets to increase their capital buffer for possibly severe future losses, instead of requiring more government capital. Third, the additional capital required to be raised or otherwise generated now--over $45 billion in common stock alone has already been issued by the nine SCAPinstitutions with national bank subsidiaries--provides these banks with a strong buffer to absorb the severe losses and sharply reduced revenue associated with the adverse stress scenario imposed under SCAP for the 2-year period of 2009 and 2010, should that scenario come to pass. Fourth, as we track banks' actual credit performance against the SCAP adverse stress scenario to ensure that capital levels remain adequate, we have found that, through the first half of 2009--which constitutes 25 percent of the overall 2-year SCAP stress period--actual aggregate loan losses were well below 25 percent of the aggregate losses projected for the full SCAP period, and actual aggregate revenues were well above 25 percent of the aggregate projected SCAP revenues. While those trends could change as the stress period continues, the early results are promising.B. Mid-Size Banks Although mid-size national banks engage in retail lending, the scope and size of their exposures are not as significant as those of the largest national banks. Mid-size banks also did not have the significant losses that larger banks did from various structured investment products. Nevertheless, loan growth at these banks turned negative in 2Q:2009, and although they experienced modest improvements in net interest margins in the second quarter, they still face downward earnings pressures, primarily due to increasing loan loss provisions. Given their exposures to the C&I and CRE markets, we expect these pressures will persist, notwithstanding the $3.5 billion in net reserve builds over the last twenty four months. These banks have also had success in attracting new capital, raising close to $5 billion thus far this year.C. Community Banks Nearly all national community banks entered this environment with strong capital bases that exceeded regulatory minimums. As a group, they have been less exposed to problems in the retail credit sector that have confronted large and mid-size banks, and the vast majority of these banks remain in sound financial condition. As noted earlier, there is a small number of community banks that have concentrations in trust preferred and private label mortgage-backed securities that we are closely monitoring. Of more significance are the exposures that many community banks have to commercial real estate loans. As I noted in my June 2008 testimony, we have been concerned for some time about the sizable concentrations of CRE loans found at many smaller national banks. While national banks of all sizes have significant CRE exposures, as shown in Chart 8, CRE concentrations are most pronounced at community and mid-size banks. Because of this, the OCC began conducting horizontal reviews of banks with significant concentrations about 5 years ago. As credit conditions worsened, our efforts intensified in banks that we believed were at high risk from downturns in real estate markets. Our goal has been to work with bankers to get potential CRE problems identified at an early stage so that bank management can take effective remedial action. In most but not all cases, bank management teams are successfully working through their problems and have adequate capital and stable funding bases to weather additional loan losses and earnings pressures.V. Resolution of Problem Banks Given the strains in the economy and banking system, it is not surprising that the number of problem banks has increased from the recent historical lows. In the early 1990s, the number of problem national banks--those with a CAMELS composite rating of 3, 4 or 5--reached a high of 28 percent of all national banks. Thereafter, the number of problem national banks relative to all national banks dropped dramatically and then fluctuated in a range of three to 6 percent until 2007. Since then, however, the number of problem banks has risen steadily, and it is now approximately 17 percent of national banks. As would be expected, this upward trend in problem banks also has resulted in an increased number of bank failures. In January, 2008, we had the first national bank failure in almost 4 years, the longest period without a failure in the 146-year history of theOCC. That began the current period of significantly increased failures. In total, since January 1 of 2008, there have been 123 failures of insured banks and thrifts. Of these, 19 have been national banks, accounting for 11 percent of the total projected loss to thedeposit insurance fund from all banks that failed during this period. All of the 19 failed national banks have been community banks, although the total obviously does not include the two large bank holding companies with lead national banks that were the subject of systemic risk determinations and received extraordinary TARP assistance on an open-institution basis. While the vast majority of national banks have the financial capacity and management skills to weather the current environment, some will not. Given the real estate concentrations in community banks, the number of problem banks, the severe problems in housing markets, and increasing concern with CRE, we expect more bank failures in the months ahead. Some troubled banks will be able to find strong buyers--in some instances with our assistance--that will enable them to avoid failure and resolution by the FDIC. But that will not always be possible. When it is not, our goal, consistent with the provisions of the Federal Deposit Insurance Corporation Improvement Act, is to effect early and least cost resolution of the bank with a minimum of disruption to the community.VI. OCC Will Continue to Take a Balanced Approach in Our Supervision of National Banks Finally, I want to underscore the OCC's commitment to provide a balanced and fair approach in our supervision of national banks as bankers work through the challenges that are facing them and their borrowers. We recognize the important roles that credit availability and prudent lending play in our nation's economy, and we are particularly aware of the vital role that many smaller banks play in meeting the credit needs of small businesses in their local communities. Our goal is to ensure that national banks can continue to meet these needs in a safe and sound manner. I have heard some reports that bankers are receiving mixed messages from regulators: on one hand being urged to make loans to creditworthy customers, while at the same time being subjected to what some have characterized as ``overzealous'' regulatory examinations. In this context, let me emphasize that our messages to bankers have and continue to be straight-forward: Bankers should continue to make loans to creditworthy borrowers; But they should not make loans that they believe are unlikely to be repaid in full; and They should continue to work constructively with troubled borrowers--but recognize repayment problems in loans when they see them, because delay and denial only makes things worse. Let me also underscore what OCC examiners will and will not do. Examiners will not tell bankers to call or renegotiate a loan; dictate loan structures or pricing; or prescribe limits (beyond regulatory limits) on types or amounts of loans that a bank may make if the bank has adequate capital and systems to support and manage its risks. Examiners will look to see that bankers have made loans on prudent terms, based on sound analysis of financial and collateral information; that banks have sufficient risk management systems inplace to identify and control risks; that they set aside sufficient reserves and capital to buffer and absorb actual and potential losses; and that they accurately reflect the condition of their loan portfolios in their financial statements. Nevertheless, balanced supervision does not mean that examiners will allow bankers to ignore or mask credit problems. Early recognition and action by management are critical factors in successfully rehabilitating a problem bank. Conversely, the merepassage of time and hope for improved market conditions are not successful resolution strategies. We have taken a number of steps to ensure that our examiners are applying these principles in a balanced and consistent manner. For example, we hold both regular meetings and periodic national teleconferences with our field examiners to convey key supervisory messages and objectives. In our April 2008 nationwide call, we reviewed and discussed key supervisory principles for evaluating commercial real estate lending. In April of this year we issued guidance to our examiners on elements of an effective workout/restructure program for problem real estate loans. We noted that effective workouts can take a number of forms, including simple renewal or extension of the loan terms, extension of additional credit; formal restructuring of the loan terms; and, in some cases, foreclosure on underlying collateral. We further reiterated these key principles in a nationwide call with our mid-size and community bank examiners earlier this month. Through the FFIEC, we are also working with the other Federal and state banking agencies to update and reinforce our existing guidance on working with CRE borrowers and to help ensure consistent application of these principles across all banks. This guidance will reaffirm that prudent workouts are often in the best interests of both the bank and borrower and that examiners should take a balanced approach in evaluating workouts. In particular, examiners should not criticize banks that implement effective workouts afterperforming a comprehensive review of the borrower's condition, even if the restructured loans have weaknesses that result in adverse credit classification. Nor should they criticize renewed or restructured loans to borrowers with a demonstrated ability to repay, merelybecause of a decline in collateral values. Consistent with current policies, loans that are adequately protected by the current sound worth and debt service capacity of the borrower, guarantor, or the underlying collateral generally will not be classified. However, deferring issues for another day does not help the CRE sector or banking industry recover. It is important that bankers acknowledge changing risk and repayment sources that may no longer be adequate.VII. Conclusion I firmly believe that the collective measures that government officials, bank regulators, and many bankers have taken in recent months have put our financial system on a much more sound footing. These steps are also crucial to ensuring that banks will be ableto continue their role as lenders and financial intermediaries. Nonetheless, it is equally clear that there are still many challenges ahead, especially with regard to the significant deterioration in credit that both supervisors and bankers must work through. There are no quick fixes to this problem, and there is the real potential that, for a large number of banks, credit quality will get worse in the months ahead. Notwithstanding the significant loan loss provisions that banks have taken over the past 2 years, more may be needed as provisions and resulting loan loss reserves have not kept pace with the rapid increase in nonperforming assets. The OCC is firmly committed to taking a balanced approach as bankers work through these issues. We will continue to encourage bankers to lend and to work with borrowers. However, we will also ensure that they do so in a safe and sound manner and that they recognize and address their problems on a timely basis. ______ CHRG-110hhrg46593--38 Mr. Kanjorski," Thank you, Mr. Chairman. Mr. Secretary, I heard you use the comment in a response to a question just a little while ago, ``turning the corner.'' It is a quotable phrase, I think. It reminds me of another famous phrase, ``return to normalcy.'' And it sort of scares me if you look at the context of when ``return to normalcy'' was used. I think there is a crisis of confidence that is in the general public and within this body of the Congress. We are trying to figure out, those of us who extended ourselves on the vote for the bailout and the 180-degree change that you made in policy from buying bad assets to injecting investments of equity in banking institutions. I do not fault you for it. It just was an extreme change and rather shocking. And it wasn't your idea. It was the idea of the drafters of the legislation that you set up in the form of a 3\1/2\ page draft and we converted after several weeks to 400 pages. And part of those 400 pages gave you the authority to make that 180-degree change. Now, my problem is, that has happened once. And now suddenly I see other things occurring where you make 180-degree changes in policy. One example is this thing we are struggling with this week, the potential bankruptcy or collapse of our auto industry in the country. And it seems that there is a dual idea, either at Treasury or at the White House, that if you take the $25 billion out of certain qualified funds, then it is necessary and should be used and obviously would avoid systemic risk. The underlying principle: We shouldn't do it unless there is systemic risk. But if you were to use money from the TARP fund, that is unacceptable to the White House and Treasury and should not be done. Now it seems to me, when you are treating the disease, you don't decide where the disease came from. You decide, what is the prognosis, the likely prognosis, and then you take action. So there is a lack of confidence it seems to me, both in this body and in the general population. They want to get some idea, do we have a plan? Where are we going? To say ``turning the corner'' really is not terribly significant. It is no different than what Herbert Hoover said, ``return to normalcy.'' And it is causing fright to the people. Why can this Treasury and this White House not lay out a plan that takes into consideration all the contingencies that will happen or may happen and what our potential response will be, knowing full well mistakes will be made, money will be unreasonably or foolishly expended, but we all tend to agree that if, in fact, we are on the precipice of a disaster or a meltdown, we are willing to take those opportunities. But we do not want to walk into a room of darkness. We really want you to shed as much light in that room before we take the leap over the threshold. So I am sort of calling upon you, can you now give us some indication, do you consider the loss of the American auto industry a significant and systemic risk? Or do you not? If we lose 3 million jobs, what would it cost to make it up? What would be the loss of revenue? And would it be worth spending $25 billion initially to stop that from occurring? And if we do not do that, what is our backup plan, and what do we tend to do? It seems to me that if we are going to build confidence among our constituents, the American people, and confidence within this institution to respond to your requests and the White House's requests just over the next 60 days and then the next Administration, it seems to me we have to be a little more forthcoming. " fcic_final_report_full--423 CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS CONTENTS Introduction ......................................................................................................  How Our Approach Differs from Others’ .........................................................  Stages of the Crisis .............................................................................................  The Ten Essential Causes of the Financial and Economic Crisis .......................  The Credit Bubble: Global Capital Flows, Underpriced Risk, and Federal Reserve Policy ................................................................................  The Housing Bubble .........................................................................................  Turning Bad Mortgages into Toxic Financial Assets .........................................  Big Bank Bets and Why Banks Failed ...............................................................  Two Types of Systemic Failure ...........................................................................  The Shock and the Panic ...................................................................................  The System Freezing .........................................................................................  INTRODUCTION We have identified ten causes that are essential to explaining the crisis. In this dis- senting view: • We explain how our approach differs from others’; • We briefly describe the stages of the crisis; • We list the ten essential causes of the crisis; and • We walk through each cause in a bit more detail. We find areas of agreement with the majority’s conclusions, but unfortunately the areas of disagreement are significant enough that we dissent and present our views in this report. We wish to compliment the Commission staff for their investigative work. In many ways it helped shape our thinking and conclusions. Due to a length limitation recently imposed upon us by six members of the Com- mission,  this report focuses only on the causes essential to explaining the crisis. We regret that the limitation means that several important topics that deserve a much fuller discussion get only a brief mention here.  CHRG-111hhrg56776--251 Mr. Meltzer," Thank you, Mr. Chairman. Happy St. Patrick's Day. It's a pleasure to be here again. Both Houses of Congress have worked hard to develop means of reducing greatly the risk of future financial crises. I believe they have neglected to remove completely the two most important causes of the recent crisis. First, in my opinion, the disastrous mortgage and housing problem, especially the rules as followed by Fannie Mae and Freddie Mac and all recent Administrations. If they had not existed, the crisis would not have happened. Second, without advance warning, the Treasury and the Federal Reserve ended a 30-year policy of ``too-big-to-fail'' in the midst of a recession by letting Lehman fail. The first reform, the one that is ignored most is, I believe you need to put Fannie Mae and Freddie Mac on the budget the way--with a subsidy on the budget. It's not a question of whether there should be a housing and mortgage policy; it's where it should be located. It should not be located as a subsidy through the financial markets, subsidies in a well-run democratic country are on the budget. After the failure, after the mistake of allowing Lehman to fail, the Fed acted forcefully, directly, aggressively, and intelligently to prevent the failure from spreading. What we want to consider is what might be done to avoid a repeat of government policy failure. ``Too-big-to-fail'' encouraged some large bankers, to use the word of the then-chairman of Citigroup, ``to get up to dance when the music was playing.'' That was a mistake. That mistake, I believe, would not have happened if there were not--if he didn't believe that he could take the risks and allow the taxpayers to pay the losses. The taxpayers, indeed, paid for the losses. So did he. We need a system that protects the public. The current system leans toward protecting the banks. It's important, most important, to end ``too-big-to-fail'' in a way that will work in crises. Regulation often fails. We have the examples of Madoff, Stanford, the structured--the SIVs that circumvented the Basel Accord Basel regulated risks. The markets circumvented it. Ask yourselves what happened to FDICIA. This committee, in 1991, passed a rule that said we're going to try to do early intervention before companies fail, before banks fail. It didn't happen. FDICIA has been missing. Is that unusual? No. It's the common effect of regulation. The first law of regulation, my first law of regulation is that bureaucrats, lawyers make regulations. Markets learn to circumvent the costly ones. The second law of regulation is regulation is static; markets are dynamic. If they don't figure out how to circumvent them at first, they will after a while. That's what has happened very often in the case of regulation. So you need to do something. You must regulate, but you have to regulate in ways that rely on incentives that affect the way the bankers behave. And my proposal is, you want to tie the capital standards to the size of the bank. Let the banks choose their size. Beyond some minimum size, say $10 billion, for every 1 percent they increase their assets, they have to increase their capital by 1.2 percent. That way, the capital ratio will go up and up and up with the size of the bank and that will limit the size of the bank and it will put the stockholders and the management at risk. That's the way to prevent failures. One other step: If failures occur, markets require something to be done about the counterparties. In the 96 years of its history, the Fed has never announced or followed a consistent lender of last resort policy. Never. They have never announced it. They have discussed it internally many times. They have never had a consistent policy. Congress should insist on a lender of last resort policy and it has to be one that the Congress will honor in a crisis. So it should negotiate with the management of the Fed to choose a lender of last resort strategy that the Congress is willing to honor. Let me say a few other things in my remaining 10 seconds. First, the regulators talk about systemic risk, and there's a systemic risk council. No one can define systemic risk in an operational way. You and your colleagues will properly say there is a large failure in your district. It's a responsibility to do something about it. That's a systemic risk as far as you're concerned. Who will decide on systemic risk? The Secretary of the Treasury. Who has been the person most active in bailouts? The Secretary of the Treasury. Therefore, moving to a systemic risk council with the Secretary of the Treasury as its chairman is an invitation to continue to do the things we have been doing: bailing them out. " CHRG-111shrg57709--13 Mr. Wolin," Chairman Dodd, Ranking Member Shelby, members of this Committee, thank you for the opportunity to testify before this Committee today about financial reform--and, in particular, about the Administration's recent proposals to prohibit certain risky financial activities at banking firms and to prevent excessive concentration in the financial sector. The recent proposals complement the much broader set of reforms proposed by the Administration in June, passed by the House in December, and currently under active consideration by this Committee. We have worked closely with you and with your staffs over the past year, and we look forward to working with you to incorporate these additional proposals into comprehensive legislation. The goals of financial reform are simple: to make the markets for consumers and investors fair and efficient; to lay the foundation for a safer, more stable financial system, less prone to panic and crisis; to safeguard American taxpayers from bearing risks that ought to be borne by shareholders and creditors; and to end, once and for all, the dangerous perception any financial institution is too big to fail. From the start of the financial reform process, we have sought to constrain the growth of large complex financial firms, through tougher supervision, higher capital and liquidity requirements, the requirement that larger firms develop and maintain rapid resolution plans, and the financial recovery fee which the President proposed at the beginning of January. In addition, both the Administration's proposal and the bill passed by the House would give regulators explicit authority to require banking firms to cease activities or divest businesses that might threaten the safety of the firm or the broader financial system. The two additional reforms proposed by the President a few weeks ago complement those reforms and go further. Rather than merely authorize regulators to take action, we propose to prohibit certain activities at banking firms: proprietary trading and the ownership or sponsorship of hedge funds and private equity funds, as well as to place limits on the size of the largest firms. Commercial banks enjoy a Federal Government safety net in the form of access to Federal deposit insurance, the Federal Reserve discount window, and Federal Reserve payment systems. These protections, in place for generations, are justified by the critical role that the banking system plays in serving the credit, payment, and investment needs of consumers and businesses. To prevent the expansion of that safety net and to protect taxpayers from the risk of loss, commercial banking firms have long been subject to statutory activity restrictions. Our scope proposals represent a natural evolution in this framework. The activities targeted by our proposal tend to be volatile and high risk. The conduct of such activities also makes it more difficult for the market, investments, and regulators to understand risks in major financial firms and for their managers to mitigate such risks. Exposing the taxpayer to potential risks from these activities is ill-advised. In addition, proprietary trading, by definition, is not done for the benefit of customers or clients. Rather, it is conducted solely for the benefit of the bank itself. Accordingly, we have concluded that proprietary trading and the ownership or sponsorship or hedge funds and private equity funds should be separated from the business of banking and from the safety net that benefits the business of banking. This proposal forces firms to choose between owning an insured depository institution and engaging in proprietary trading, hedge fund, or private equity activities. But--and this is very important to emphasize--it does not allow any major firm to escape strict Government oversight. Under our regulatory reform proposals, all major financial firms, whether or not they own a depository institution, must be subject to robust consolidated supervision and regulation--including strong capital and liquidity requirements--by a fully accountable and fully empowered Federal regulator. The second of the President's recent proposals is to place a cap on the relative size of the largest financial firms. Since 1994, the United States has had a 10-percent concentration limit on bank deposits. This deposit cap has helped constrain the concentration of the U.S. banking sector, and it has served the country well. But its narrow focus on deposit liabilities has limited its usefulness. With the increasing reliance on non-bank financial intermediaries and non-deposit funding sources, it is important to supplement the deposit cap with a broader restriction. Before closing, I would like to emphasize the importance of putting these new proposals in the broader context of financial reform. The proposals I have outlined do not represent an ``alternative'' approach to reform. Rather, they complement the set of comprehensive reforms put forward by the Administration last summer. Added to the core elements of effective financial reform previously proposed, the activity restrictions and concentration cap that are the focus of today's hearing will play an important role in making the system safer and more stable. But like each of the other core elements of financial reform, the scale and scope proposals are not designed to stand alone. We look forward to working with you to bring comprehensive financial reform across the finish line. Thank you, Mr. Chairman and Senator Shelby. " CHRG-110hhrg45625--205 Mr. Royce," Thank you, Chairman Bernanke. Going over to the issue of private equity, Secretary Paulson, as you know, the current 25 percent limit on private equity stake in banking institutions has arguably, I guess, minimized the involvement of these private equity firms in the current turmoil, and I was going to ask you, you know, should this cap on private equity investment be lifted considering the amount of capital that it could provide to our banking system? " CHRG-111shrg52619--199 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM DANIEL K. TARULLOQ.1. Two approaches to systemic risk seem to be identified: (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse? If you support approach one how you would limit institution size and how would you identify new areas creating systemic importance? If you support approach two how would you identify systemically important institutions and what new regulations and market discipline would you recommend?A.1. As we have seen in the current financial crisis, large, complex, interconnected financial firms pose significant challenges to supervisors. In the current environment, market participants recognize that policymakers have strong incentives to prevent the failure of such firms because of the risks such a failure would pose to the financial system and the broader economy. A number of undesirable consequences can ensue: a reduction in market discipline, the encouragement of excessive risk-taking by the firm, an artificial incentive for firms to grow in size and complexity in order to be perceived as too big to fail, and an unlevel playing field with smaller firms that are not regarded as having implicit government support. Moreover, of course, government rescues of such firms can be very costly to taxpayers. The nature and scope of this problem suggests that multiple policy instruments may be necessary to contain it. Firms whose failure would pose a systemic risk should be subject to especially close supervisory oversight of their risk-taking, risk management, and financial condition, and should be held to high capital and liquidity standards. As I emphasized in my testimony, the government must ensure a robust framework--both in law and practice--for consolidated supervision of all systemically important financial firms. In addition, it is important to provide a mechanism for resolving systemically important nonbank financial firm in an orderly manner. A systemic risk authority that would be charged with assessing and, if necessary, curtailing systemic risks across the entire U.S. financial system could complement firm-specific consolidated supervision. Such an authority would focus particularly on the systemic connections and potential risks of systemically important financial institutions. Whatever the nature of reforms that are eventually adopted, it may well be necessary at some point to identify those firms and other market participants whose failure would be likely to impose systemic effects. Identifying such firms is a very complex task that would inevitably depend on the specific circumstances of a given situation and requires substantial judgment by policymakers. That being said, several key principles should guide policymaking in this area. No firm should be considered too big to fail in the sense that existing stockholders cannot lose their entire investment, existing senior management and boards of directors cannot be replaced, and over time the organization cannot be wound down or sold in an orderly way either in whole or in part, which is why we have recommended that Congress create an orderly resolution procedure for systemically important financial firms. The core concern of policymakers should be whether the failure of the firm would be likely to have contagion, or knock-on, effects on other key financial institutions and markets and ultimately on the real economy. Of course, contagion effects are typically more likely in the case of a very large institution than with a smaller institution. However, size is not the only criterion for determining whether a firm is potentially systemic. A firm may have systemic importance if it is critical to the functioning of key markets or critical payment and settlement systems.Q.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. In general, there are few formal regulatory or legal barriers to sharing bank supervisory information among regulators, and such sharing is done routinely. Like other federal banking regulators, the Board's regulations generally prohibit the disclosure of confidential supervisory information (such as examination reports and ratings, and other supervisory correspondence) and other confidential information relating to supervised financial institutions without the Board's consent. See 12 C.F.R. 261, Subpart C. These regulations, however, expressly permit designated Board and Reserve Bank staff to make this information available to other Federal banking supervisors on request. 12 C.F.R. 261.20(c).. As a practical matter, federal banking regulators have access to a database that contains examination reports for regulated institutions, including commercial banks, bank holding companies, branches of foreign banks, and other entities, and can view examination material relevant to their supervisory responsibility. State banking supervisors also have access to this database for entities they regulate. State banking supervisors may also obtain other information on request if they have direct supervisory authority over the institution or if they have entered into an information sharing agreement with their regional Federal Reserve Bank and the information concerns an institution that has acquired or applied to acquire a financial institution subject to the state regulator's jurisdiction. Id. at 261.20(d). The Board has entered into specific sharing agreements with a number of state and federal regulators, including most state insurance regulators, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of Foreign Asset Control (OFAC), and the Financial Crimes Enforcement Network (FinCEN), authorizing sharing of information of common regulatory and supervisory interest. We frequently review these agreements to see whether it would be appropriate to broaden the scope of these agreements to permit the release of additional information without compromising the examination process. Other supervisory or regulatory bodies may request access to the Board's confidential information about a financial institution by directing a request to the Board's general counsel. Financial supervisors also may use this process to request access to information that is not covered by one of the regulatory provisions or agreements discussed above. Normally such requests are granted subject to agreement on the part of the regulatory body to maintain the confidentiality of the information, so long as the requester bas identified a legitimate basis for its interest in the information. Because the Federal Reserve is responsible for the supervision of all bank holding companies and financial holding companies on a consolidated basis, it is critical that the Federal Reserve also have timely access to the confidential supervisory information of other bank supervisors or functional regulators relating to the bank, securities, or insurance subsidiaries of such holding companies. Indeed, the Gramm-Leach-Bliley Act (GLBA) provides that the Federal Reserve must rely to the fullest extent possible on the reports of examinations prepared by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the SEC, and the state insurance authorities for the national bank, state nonmember bank, broker-dealer, and insurance company subsidiaries of a bank holding company. The GLBA also places certain limits on the Federal Reserve's ability to examine or obtain reports from functionally regulated subsidiaries of a bank holding company. Consistent with these provisions, the Federal Reserve has worked with other regulators to ensure the proper flow of information to the Federal Reserve through information sharing arrangements and other mechanisms similar to those described above. However, the restrictions in current law still can present challenges to timely and effective consolidated supervision in light of, among other things, differences in supervisory models--for example, between those favored by bank supervisors and those used by regulators of insurance and securities subsidiaries--and differences in supervisory timetables, resources, and priorities. In its review of the U.S. financial architecture, we hope that the Congress will consider revising the provisions of Gramm-Leach-Bliley Act to help ensure that consolidated supervisors have the necessary tools and authorities to monitor and address safety and soundness concerns in all parts of an organization.Q.3. What delayed the issuance of regulations under the Home Ownership Equity Protection Act for more than 10 years? Was the Federal Reserve receiving outside pressure not to write these rules? Is it necessary for Congress to implement target timelines for agencies to draft and implement rules and regulations as they pertain to consumer protections?A.3. In responding, I will briefly report the history of the Federal Reserve's rulemakings under the Home Ownership and Equity Protection Act (HOEPA). Although I did not join the Board until January 2009, I support the action taken by Chairman Bernanke and the Board in 2007 to propose stronger HOEPA rules to address practices in the subprime mortgage market. I should note, however, that in my private academic capacity I believed that the Board should have acted well before it did. HOEPA, which defines a class of high-cost mortgage loans that are subject to restrictions and special disclosures, was enacted in 1994 as an amendment to the Truth in Lending Act. In March 1995, the Federal Reserve published rules to implement HOEPA, which are contained in the Board's Regulation Z. HOEPA also gives the Board responsibility for prohibiting acts or practices in connection with mortgage loans that the Board finds to be unfair or deceptive. The statute further requires the Board to conduct public hearings periodically, to examine the home equity lending market and the adequacy of existing laws and regulations in protecting consumers, and low-income consumers in particular. Under this mandate, during the summer of 1997 the Board held a series of public hearings. In connection with the hearings, consumer representatives testified about abusive lending practices, while others testified that it was too soon after the statute's October 1995 implementation date to determine the effectiveness of the new law. The Board made no changes to the HOEPA rules resulting from the 1997 hearings. Over the next several years, the volume of home-equity lending increased significantly in the subprime mortgage market. With the increase in the number of subprime loans, there was increasing concern about a corresponding increase in the number of predatory loans. In response, during the summer of 2000 the Board held a series of public hearings focused on abusive lending practices and the need for additional rules. Those hearings were the basis for rulemaking under HOEPA that the Board initiated in December 2000 to expand HOEPA's protections. The Board issued final revisions to the HOEPA rules in December 2001. These amendments lowered HOEPA's rate trigger for first-lien mortgage loans to extend HOEPA's protections to a larger number of high-cost loans. The 2001 final rules also strengthened HOEPA's prohibition on unaffordable lending by requiring that creditors generally document and verify consumers' ability to repay a high-cost HOEPA loan. In addition, the amendments addressed concerns that high-cost HOEPA loans were ``packed'' with credit life insurance or other similar products that increased the loan's cost without commensurate benefit to consumers. The Board also used the rulemaking authority in HOEPA that authorizes the Board to prohibit practices that are unfair, deceptive, or associated with abusive lending. Specifically, to address concerns about ``loan flipping'' the Board prohibited a HOEPA lender from refinancing one of its own loans with another HOEPA loan within the first year unless the new loan is in the borrower's interest. The December 2001 final rule addressed other issues as well. As the subprime market continued to grow, concerns about ``predatory lending'' grew. During the summer of 2006, the Board conducted four public hearings throughout the country to gather information about the effectiveness of its HOEPA rules and the impact of the state predatory lending laws. By the end of 2006, it was apparent that the nation was experiencing an increase in delinquencies and defaults, particularly for subprime mortgages, in part as a result of lenders' relaxed underwriting practices, including qualifying borrowers based on discounted initial rates and the expanded use of ``stated income'' or ``no doc'' loans. In response, in March 2007, the Board and other federal financial regulatory agencies published proposed interagency guidance addressing certain risks and emerging issues relating to subprime mortgage lending practices, particularly adjustable-rate mortgages. The agencies finalized this guidance in June 2007. Also in June 2007, the Board held a fifth hearing to consider ways in which the Board might use its HOEPA rulemaking authority to further curb abuses in the home mortgage market, including the subprime sector. This became the basis for the new HOEPA rules that the Board proposed in December 2007 and finalized in July 2008. Among other things, the Board's 2008 final rules adopt the same standard for subprime mortgage loans that the statute previously required for high cost HOEPA loans--a prohibition on making loans without regard to borrowers' ability to repay the loan from income and assets other than the home's value. The July 2008 final rule also requires creditors to verify the income and assets they rely upon to determine borrowers' repayment ability for subprime loans. In addition, the final rules restrict creditors' use of prepayment penalties and require creditors to establish escrow accounts for property taxes and insurance. The rules also address deceptive mortgage advertisements, and unfair practices related to real estate appraisals and mortgage servicing. We can certainly understand the desire of Congress to provide timelines for regulation development and implementation. This could be especially important to address a crisis situation. However, in the case of statutory provisions that require consumer disclosure for implementation, we hope that any statutory timelines would account for robust consumer testing in order to make the disclosures useful and effective. Consumer testing is an iterative process, so it can take some additional time, but we have found that it results in much clearer disclosures. Additionally, interagency rulemakings are also more time consuming. While they have the potential benefit of bringing different perspectives to bear on an issue, arriving at consensus is always more time consuming than when regulations are assigned to a single rule writer. Moreover, assigning rulewriting responsibility, to multiple agencies can result in diffused accountability, with no one agency clearly responsible for outcomes. ------ CHRG-111shrg51395--263 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JOHN C. COFFEE, JR.Q.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. Would a merger or rationalization of the roles of the SEC and CFTC be a valuable reform, and how should that be accomplished? 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? How should we update our rules and guidelines to address the potential failure of a systematically critical firm?A.1. Bernanke's Comments: I would strongly agree with Chairman Bernanke's above quoted remarks, and I believe that his final question about the desirability of a systemic risk regulator must be answered in the affirmative (although the identity of that regulators can be reasonably debated). The term ``too big to fail'' is a misnomer. In reality, a systemic risk regulator must have the authority to identify financial institutions that are ``too interconnected to fail'' and to regulate their capital structure and leverage so that they do not fail and thereby set off a chain reaction. SEC/CFTC Merger: Although a merger of the SEC and the CFTC would be desirable, it is not an essential reform that must be accomplished to respond effectively to the current financial crisis (and it would be a divisive issue that might stall broader reform legislation). At most, I would suggest that jurisdiction over financial futures be transferred from the CFTC to the SEC. An even narrower transfer would be to give the SEC jurisdiction over single stock futures and narrow-based stock indexes. Over the counter derivatives might be divided between the two in terms of whether the derivative related to a security or a stock index (in which case the SEC would receive jurisdiction) or to something else (in which case the CFTC should have jurisdiction). The AIG Failure: AIG's failure perfectly illustrates the systemic risk problem (because its failure could have caused a parade of falling financial dominoes). It also illustrates the multiple causes of such a failure. AIG Financial Products, Inc., the key subsidiary, was principally based in London and was the subsidiary of the parent of the insurance company. As a non-insurance subsidiary of an insurance holding company, it was beyond the effective oversight of the New York State Insurance Commissioner, and there is no Federal insurance regulator. Although AIG also owned a small thrift, the Office of Thrift Supervision (OTS) could not really supervise an unrelated subsidiary operating in London. Thus, this was a case of a financial institution that fell between the regulatory cracks. But it was also a case of a private governance failure caused by excessive and short-term executive compensation. The CEO of AIG Financial Products (Mr. Cassano) received well over a $100 million in compensation during a several year period between 2002 and 2006. This gave him a strong bias toward short-term profit maximization and incentivized him to continue to write credit default swaps for their short term income, while ignoring the long term risk to AIG of a default (for which no reserves were established). Thus, there were both private and public failures underlying the AIG collapse. Procedures for Failure of a ``Systematically Critical Firm'': The Lehman bankruptcy will remain in the courts for a decade or more, with considerable uncertainty overhanging the various outcomes. In contrast, the FDIC can resolve a bank failure over a weekend. This suggests the superiority of a resolution-like procedure following the FDIC model, given the uncertainty and resulting potential for panic in the case of a failure of any major financial institution. Both the Bush and Obama Administrations have endorsed such a FDIC-like model to reduce the prospect of a financial panic. I note, however, that one need not bail out all counterparties at the level of 100 percent, as a lesser level of protection would avert any panic, while also leaving the counterparties with a strong incentive to monitor the solvency of their counterparty. ------ fcic_final_report_full--360 On Sunday morning, September , Adam Ashcraft of the New York Fed circu- lated a memo, “Comment on Possible - Lending to AIG,” discussing the effect of a fire sale by AIG on asset markets.  In an accompanying email, Ashcraft wrote that the “threat” by AIG to sell assets was “a clear attempt to scare policymakers into giv- ing [AIG] access to the discount window, and avoid making otherwise hard but vi- able options: sell or hedge the CDO risk (little to no impact on capital), sell subsidiaries, or raise capital.”  Before a : P . M . meeting, LaTorre sent an analysis, “Pros and cons of lending to AIG,” to colleagues. The pros included avoiding a messy collapse and dislocations in markets such as commercial paper. If AIG collapsed, it could have a “spillover effect on other firms involved in similar activities (e.g. GE Finance)” and would “lead to B increase in European bank capital requirements.” In other words, European banks that had lowered credit risk—and, as a result, lowered capital requirements— by buying credit default swaps from AIG would lose that protection if AIG failed. AIG’s bankruptcy would also affect other companies because of its “non-trivial exotic derivatives book,” a . trillion over-the-counter derivatives portfolio of which  trillion was concentrated in  large counterparties. The memo also noted that an AIG failure “could cause dislocations in CDS market [that] . . . could leave dealer books significantly unbalanced.”  The cons of a bailout included a “chilling effect” on private-sector solutions thought to be under way; the possibility that a Fed loan would be insufficient to keep AIG afloat, “undermining efficacy of - lending as a policy tool”; an increase in moral hazard; the perception that it would be “incoherent” to lend to AIG and not Lehman; the possibility of assets being insufficient to cover the potential liquidity hole. LaTorre concluded, “Without punitive terms, lending [to AIG] could reward poor risk management,” which included AIG’s unwillingness to sell or hedge some of its CDO risk.  The private-sector solutions LaTorre referred to had hit a wall, however. By Sunday afternoon, Flowers had been “summarily dismissed” by AIG’s board. Flowers told the FCIC that under his proposal, his firm and Allianz, the giant insurance company, would have each invested  billion in exchange for the stock of AIG subsidiaries. With approval from the NYSID, the subsidiaries would “upstream”  billion to the parent company, and the parent company would get access to bridge financing from the Fed. Then, Allianz would take control of AIG almost immediately. Flowers said that he was surprised by AIG’s unwillingness to negotiate. “I’m not saying it would have worked or that it was perfect as written, but it was astounding to me that given what happened, nobody bothered to check this [deal] out,” he said.  Willumstad referred to the Flowers deal as a “so-called offer”—he did not consider it to be a “serious effort,” and so it was “dismissed immediately.” With respect to the other potential investors AIG spoke with over the weekend, Willumstad said that negotiations were unsuccessful because every potential deal would have required government assistance—something Willumstad had been assured by the “highest levels” would not be forthcoming.  CHRG-111shrg57322--1238 Mr. Blankfein," I am sorry. Senator Levin. I said ``I.'' Let me just close with a very brief statement. We have a debate going on here at this moment on how Congress should respond to the abuses that we have looked at in four hearings now. Those abuses include the conveyor belt of toxic mortgages that got into the financial system, huge demand for them that came from a whole lot of places. We focused on WaMu. We always focus on a case history and they were a very logical case history. So WaMu dumps, and others like them, dump billions of dollars of toxic mortgages into the system. Goldman and other banks like them provided these lenders with more money to issue bad loans. There is evidence, by the way, from the documents we came in with today that Goldman was very much aware that they were buying loans from companies that were selling bad loans, including New Century. Then the financial engineering comes along to turn those high-risk mortgages into allegedly safe investments, taking BBBs and other things that are not good, solid B's, turning them into ``safe investments'' through the magic of CDOs. Selling them then to pension funds, universities, municipalities, insurance companies, and banks. So now the poison spreads further. Then we have these synthetic securities, which magnifies all of that. The mortgage system begins to buckle under the weight of these loans and the synthetic stuff that floods the system. And then we have this situation where Goldman bets against the mortgage market as a whole, profits from its collapse. I know it was only a half-a-billion dollars in 2007, but amazingly enough there was a profit at all. The rare instance where despite all the losses that you took in your inventory and on the longs, you nonetheless were able to make a profit because of your huge investment on the short side. I happen to be one that believes in a free market. But if it is going to be truly free, it cannot be designed for just a few people to reap enormous benefits while passing the risks on to the rest of us. It must be free of deception. It has got to be free of conflicts of interest. It needs a cop on the beat and it has got to get back on Wall Street. Senator Dodd's bill is an important beginning, and we hope to strengthen it with provisions that address conflicts of interest, that address proprietary trading that puts a firm's self-interest ahead of its clients' interests. That is what we saw evidence of today. That addresses these synthetic instruments that magnify risk while gambling on the demise of companies instead of on their successes; that ends these reckless lending practices, such as stated income, which means liar loans, and negatively amortizing loans; that gives stronger enforcement tools for regulators to protect consumers. That is what we have got to do to rebuild the defenses to protect Main Street from the excesses of Wall Street and those other excesses that we have studied during these four hearings. I hope these hearings provide added strength to the reform effort. A lot of us will be working on legislation to stop the abuses that were exposed in these four hearings. We thank our staffs. They have worked extremely hard and extremely long hours. Elise Bean and our staff, and I know that this is true also of Senator Coburn's staff, have spent untold hours digging through these documents. I love the way some of your folks tell the press that the documents were cherry-picked. That book in front of you is a whole bowl of cherries. These are not cherry-picked. Those documents reflect the history of what happened here. From millions of documents, you obviously have to select some that you think represent a reality, and we did that. It is a reality which has some unseemly aspects to it, particularly in terms of conflicts. But we are just hoping that whether or not we can get the support of Wall Street firms, and you indicated some willingness to support reforms here today, but whether we get that support for a strong reform bill, we have to have the willpower and the backbone to do just that. We thank our witnesses. Mr. Blankfein, we thank you. It has been a long day. We thank all of the witnesses. And again, particularly, we thank our staffs. We stand adjourned. [Whereupon, at 8:42 p.m., the Subcommittee was adjourned.] CHRG-111shrg50815--114 Mr. Ausubel," I would generally agree with what has been said. I mean, that securitization in the credit card market is fundamentally different than the mortgage market because the credit card issuer remains the residual claimant in the whole business operation. The place where you can find some similarity is that when consumers get distressed, there are some parallels between it giving bad dynamics in one market than the other. I mean, so you have been hearing on the mortgage market you have this problem that the whole system may be better off because--the whole system may be better off if there were some forgiveness, like you modify the terms. When we securitize it, you have one group of people who own the mortgage, another set of people who service the mortgage. The people who service the mortgage may not want to relax the terms because it is not in their benefit. You have the same thing in the credit card market with universal default and that sort of thing, that if a consumer gets into trouble, all the banks, the entire system may be better off if there were some forgiveness, but instead what each bank does is they try to load up what is owed to them and they try to collect as rapidly as possible from the consumer before the consumer goes bankrupt. So you have the same sort of divergence of interests which leads to a sub-optimal level of forgiveness. " CHRG-111shrg55278--20 Mr. Tarullo," Absolutely. All I am saying is we couldn't figure out in some cases exactly what one of their proposals meant, which is why the testimony is phrased in such a way as to agree with the concept of needing to have every systemically important institution supervised and needing to have a resolution mechanism. As you probably saw, the Fed is certainly not endorsing the proposal of the Administration to create the new consumer agency. It is not opposing it, either. Senator Shelby. Let me get into that a little bit. Safety and soundness regulation, very important here. In your testimony, you state there are synergies between the monetary policy and systemic risk regulation. In order to capture these synergies, you argue that the Fed should become a systemic risk regulator, as I understand it. Yesterday, Chairman Bernanke testified that he believed there are synergies between prudential bank regulation and consumer protection. This argues in favor of establishing one consolidated bank regulator. Do you agree with Chairman Bernanke that there are synergies between prudential supervision and consumer protection, and if so, do you believe that the Obama administration's call for a separate consumer protection agency would undermine the safety and soundness regulation that we have? " fcic_final_report_full--428 II. Housing bubble. Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for home- owners and investors. III. Nontraditional mortgages. Tightening credit spreads, overly optimistic as- sumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to in- crease the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mort- gages and to make prudent financial decisions. These factors further ampli- fied the housing bubble. IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies er- roneously rated mortgage-backed securities and their derivatives as safe in- vestments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages. V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enor- mous concentrations of highly correlated housing risk. Some did this know- ingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions. VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liq- uidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were in- sufficiently transparent about their housing risk, creating uncertainty in mar- kets that made it difficult for some to access additional capital and liquidity when needed. CHRG-111hhrg54869--34 Mr. Volcker," The subprime phenomena is interesting because, you know, I am not in the middle of the markets these days, and I wasn't conscious of the speed in which they were increasing. They were a phenomena of practically a standing start to a trillion, trillion and a half dollar business in the space of 3 or 4 years that arose very rapidly, and apparently there was no clear sense in the regulatory community of the potential threat that this posed; and it probably, because they were obscured by the same thing that obscured bank managements and others, that we had some fancy financial engineering here that somehow presto magic, the risks go away if we put it in a big package and get a good credit rating, which is what they were getting. But I think that was a failure in risk management, a failure of the credit rating agencies, but it also was a failure of the regulators that weren't on top of this. And this arose not in the traditional banks. They may have participated, and they did participate in the end, but it arose in kind of fringe operations, but nobody sat there and said look, this is a potential threat if it increases at this rate of speed to the financial system. Nobody that I know of. Somebody should have been raising that question. And in my view, you know, as the Federal Reserve was already given clearance to do it, they are in the best position to do it. " CHRG-111shrg55278--60 Mr. Tarullo," Well, I think it depends, Senator, again, on where the concentration is to be found and what the impact of the failure of an institution holding any form of exposure would be. Let me just say with respect to commercial real estate, I agree with your assessment that it is a looming problem. It is a looming problem for communities and for economic performance generally. It is a looming problem for many financial institutions in this country. I do not know that one can classify it in and of itself as being a systemic risk or not being a systemic risk. It is surely an issue and a problem, which is why I think all the bank supervisors have been paying attention to the exposures. And now speaking only for the Fed, we extended the TALF program to commercial mortgages precisely because of the absence of credit flows and the absence of secondary markets there. Ms. Schapiro. Senator, I would just add briefly that I think there are--your question really points out something very important. We are very focused on systemically important institutions, but there are absolutely systemically risky practices that, if engaged in by a broad range of institutions, no one of which might be a systemically important institution, but those practices taken together across the marketplace as a whole absolutely have the potential to create broad systemic risk for the financial system at large. Senator Menendez. My time is up, but I will submit a question to you, Chairman Bair, about your FDIC-OCC dispute on big banks versus community banks, because I just do not quite understand that community banks that were not the cause of the challenges we face get hit at the same rate as entities that did create some of those risks and that have greater risk overall. So I do not quite get it, but I would love to hear the answer. Senator Warner. Thank you, Senator Menendez, and I would like to thank the panel. You have hung in for a long time and we will, I know, have additional questions which we will submit to you. Thank you all. If we could go ahead and move to the second panel, and my thanks to the second panel's forbearance. If the second panel could move quickly to their seats so that we could move forward, I think we do have a vote, as I understand, coming up in the next 45 minutes, so we want to make sure folks get a chance to testify. I am going to go ahead and introduce our panel, even though they are in the midst of still being seated. Vincent Reinhart has spent more than two decades working on domestic and international aspects of U.S. monetary policy. He served for the last 6 years of his Federal Reserve career as Secretary and Economist to the Federal Open Market Committee and has served in a variety of senior positions at the Federal Reserve. Mr. Reinhart, thank you for being here. Paul Schott Stevens has served as President and Chief Executive Officer of the Investment Company Institute since June 2004. Outside ICI, Mr. Stevens' career has included varied roles in private law practices, corporate counsel, and in Government service. Mr. Stevens, thank you for being here, as well. Alice Rivlin, as we all know, is the Senior Fellow in Economic Studies Programs at Brookings. She was the Founding Director of the CBO and has served as Director of the White House Office of Management and Budget. Alice, thank you for appearing here, as well. Allan Meltzer is a Professor of Political Economy and Public Policy at the Carnegie Mellon University and is also a visiting scholar at AEI. I don't normally get a chance to sit here in the chair. I don't want to mess it up too much, but recognizing that Senator Bunning said we actually may have a series of votes starting even earlier than 45 minutes from now, I would ask each of the panel, recognizing there are only three of us here still on this side of the dais, if they could make their statements relatively short so that we could make sure we could get a chance to ask questions. " Mr. Reinhart," STATEMENT OF VINCENT R. REINHART, RESIDENT SCHOLAR, AMERICAN CHRG-111shrg55278--48 Mr. Tarullo," And Senator, with respect to bank holding companies, you don't have to reach that question because there is no need to distinguish between the systemically important and nonsystemically important. It is only when you get to the entities that are not currently supervised that you have that issue. Senator Crapo. Right. " CHRG-110hhrg34673--159 Mr. Bernanke," Well, we see a lot of State data, for example, unemployment rate data by State, but the other important thing about the Federal Reserve is that it is a Federal--that is, a regionalized--system, and as I am sure you know, we have 12 Reserve Banks around the country-- " FinancialCrisisReport--331 To understand how Deutsche Bank continued to issue and market CDO securities even as the market for mortgage related securities began collapsing, the Subcommittee examined a specific CDO in detail, called Gemstone CDO VII Ltd. (Gemstone 7). In October 2006, Deutsche Bank began assisting in the gathering of assets for Gemstone 7, which issued its securities in March 2007. It was the last in a series of CDOs sponsored by HBK Capital Management (HBK), a large hedge fund which acted as the collateral manager for the CDO. Deutsche Bank made $4.7 million in fees from the deal, while HBK was slated to receive $3.3 million. It was not the last CDO issued by Deutsche Bank. Even after Gemstone 7 was issued in March of 2007, Deutsche Bank issued 9 additional CDOs. Gemstone 7 was a hybrid CDO containing or referencing a variety of high risk, subprime RMBS securities initially valued at $1.1 billion when issued. Deutsche Bank’s head global trader, Mr. Lippmann, recognized that these RMBS securities were high risk and likely to lose value, but did not object to their inclusion in Gemstone 7. Deutsche Bank, the sole placement agent, marketed the initial offering of Gemstone 7 in the first quarter of 2007. Its top tranches received AAA ratings from Standard & Poor’s and Moody’s, despite signs that the CDO market was failing and the CDO itself contained many poor quality assets. Nearly a third of Gemstone’s assets consisted of high risk subprime loans originated by Fremont, Long Beach, and New Century, three lenders known at the time within the financial industry for issuing poor quality loans and RMBS securities. Although HBK directed the selection of assets for Gemstone 7, Mr. Lippmann’s CDO Trading Desk was involved in the process and did not object to including certain RMBS securities in Gemstone 7, even though Mr. Lippmann was simultaneously referring to them as “crap” or “pigs.” Mr. Lippmann was also at the same time advising some of his clients to short some of those same RMBS securities. In addition, Deutsche Bank sold five RMBS securities directly from its inventory to Gemstone 7, several of which were also contemporaneously disparaged by Mr. Lippmann. The Deutsche Bank sales force aggressively sought purchasers for the CDO securities, while certain executives expressed concerns about the financial risk of retaining Gemstone 7 assets as the market was deteriorating in early 2007. In its struggle to sell Gemstone 7, Deutsche Bank motivated its sales force with special financial incentives, and sought out buyers in Europe and Asia because the U.S. market had dried up. Deutsche Bank also talked of providing HBK’s marks, instead of its own, to clients asking about the value of Gemstone 7’s assets, since HBK’s 1258 Subcommittee interview of Greg Lippmann (10/18/2010); Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003. marks showed the CDO’s assets performing better. Deutsche Bank was ultimately unable to sell $400 million, or 36%, of the Gemstone 7 securities, and agreed with HBK to split the unsold securities, each taking $200 million onto its own books. Deutsche Bank did not disclose to the eight investors whom it had solicited and convinced to buy Gemstone 7, that its global head trader of CDOs had an extremely negative view of a third of the assets in the CDO or that the bank’s internal valuations showed that the assets had lost over $19 million in value since purchased. 1259 CHRG-111hhrg48875--180 Secretary Geithner," If an entity that is not now a bank were to rise to the point in the future where, because of its structure, because of how connected it is to the system, because of its relationships and role in these markets it could pose systemic risk, then in our judgment they should be brought within a framework similar to what we are going to impose on large, complex, regulated financial institutions. And that means a fully elaborated set of capital requirements, requirements on liquidity, on risk management, that are applied and enforced on a consolidated basis by a competent authority. " CHRG-111shrg53085--98 Mr. Whalen," I think there are two aspects to that. It is a very good question. One is size and the other is complexity. If you look at Citi, for example, a quarter of their liabilities actually contribute to the deposit insurance fund now, the domestic deposits. The foreign deposits do not contribute and all of the bonds, which fund the other half of the company, do not contribute. So if you look at Citi, really they are actually contributing on a dollar of assets basis less than the community bankers are, because most of their deposits are domestic. The little guys are pulling the train. So I think that Congress has to look at market share and has to look at complexity, and based on those two, if it were up to me, I would break up the top four banks and have them end up maybe a third of their current size. If I had 10 or 20 or 30 banks the size of U.S. Bankcorp, instead of four, which now predominate over the entire industry, I think we would have a more stable system. Let me give you a number that will probably scare you a little bit. My maximum probable loss for the banks in the country above $10 billion in assets is $1.7 trillion. That is what we call ``economic capital.'' It is a worst-case loss number. But $1.4 trillion of that is top four institutions. There are a lot of banks in that list that actually subtract from that number because they are so much less risky than the big guys. We need a market share limit that looks at liabilities instead of deposits, in my opinion, and then as I said before, I would love to see the FDIC, as part of the systemic risk solution, rate banks based on their risk. Their premium, the contribution, the tax that they pay toward bank resolution costs should reflect their riskiness. And many of the institutions at this table would obviously be at the low end of that scale, as they should be. Senator Johanns. Your thoughts on this tend to lend some support, in my judgment, to this concept of maybe it is almost a group sort of approach, because you are looking at a number of different factors, and I wanted to throw that out. The second thing that I wanted to ask you--and this is maybe a little bit at the edges, but maybe not. When I think about systemic risk and I think about what has happened in the last 6 months, I think about the money that has been put into AIG and others, and I recognize it is all borrowed money. And I ask Chairman Bernanke about this, and he thoughtfully answered that, you know, this is a very difficult time for the economy, we probably need to solve the deficit issue at a later date. Next week, we will start debating a budget with massive deficits, as far as the eye can see, new programs, Government expansion, on and on and on. How big of a risk is that to our economy? I see China's comments. I see economists starting to opine about the threat that this is creating. How big of a risk is our inability to manage our deficits to our Nation's economy. " CHRG-111shrg54533--46 Secretary Geithner," Senator, again, this is a critical issue. Again, I think the acid test or the critical test of credibility of any system is: Is it strong enough to withstand the pressures that could come with a failure of a large institution? Because if you do not build the system strong enough to withstand those pressures, then the Government will be forced over time in future crises to intervene to prevent their failure, and that will create the risk of greater crises in the future. So that is critical to the objective of what we are trying to achieve. I believe the best way to do that and the really only effective way to do that is, again, to make sure there are tougher constraints on leverage and risk taking in the future, applied not just to every institution that is a bank does those--takes those kind of risks, but to the largest in particular; that the core markets where institutions come together to transact also have thicker safeguards, thicker cushions to prevent the contagion that can be caused by default of a major institution, and to have better tools for managing an orderly failure of a large institution through resolution authority. I think that mix of proposals I think represents the best hope of limiting the moral hazard risk that comes from any modern financial system where you can have some institutions whose role in markets by definition is so important that, if they get in trouble, it is going to risk undermining the broader health of the economy as a whole. So I think that is the best mix. A lot of people, a lot of thoughtful people have ideas in this area. We will be open to ideas, and we will look at whatever we think the best balance of proposals are to deal with that challenge. Senator Menendez. You know, one of the things you propose and some of my colleagues have already raised is the oversight council, and I think that has a valuable function in watching for developments that pose risk to the banking system and better coordinating the regulators. My concern, again, is that it is basically advisory and it has no power to carry out corrective actions that will be needed in response to the council's own findings. So give me a sense of how do you envision--so the council comes up with a series of findings that say, hey, this poses risk. What happens if an individual regulatory agency disagrees? What happens when, in fact, the council's conclusion that a particular product or activity poses a risk to the financial system, how is the corrective action going to be both considered and acted upon if it is only advisory at the end of the day? " CHRG-111hhrg48867--9 Mr. Sherman," Thank you. I think the ranking member points out something interesting, and that is if the Fed is the systemic risk regulator, or any kind of regulator, they could see their regulation called into question, ``Oops, you made a mistake.'' And they could cover themselves by using their powers under section 13(3) to make unlimited loans from the Fed. I think we need to divorce the rescue authority from the regulatory authority or a regulator may do a rescue in order to cover up the fact that their regulatory authority was not used all that prudently. Secondly, if the Fed is going to be a systemic risk regulator we ought to make sure that all of its officers and decisionmakers are appointees of the President or appointees of appointees of the President, that none are appointed by committees of private bankers. The Fed needs to be clearly just a government agency and not also an association of banks. As to systemic risk, it can be prevented perhaps by higher capital requirements, but when we do confront systemic risk that has to be acted, this systemic risk regulator needs to be respond with receiverships, not with bailouts. Never again should the taxpayer be called upon to bear risks or to bear costs. And no activity which is too big to be covered by a receivership should be allowed because nobody should be allowed to bet if the taxpayer is going to be called upon under the theory of systemic risk or any other theory to bail them out. No casino should be too so big that we can't let those who break the bank deal with it in the private sector. Finally, and this is off point, I look forward to working with other colleagues on a tax law that would impose a substantial surtax on excessive compensation paid to executives at bailed-out firms, especially AIG. It is clear that we have until April 15, 2010, to act on the 2009 Tax Code, and I think we could act on 2008 as well. " CHRG-111hhrg48674--343 Mr. Royce," Chairman, I served on the agency subcommittee, and there is a history in terms of what happened in Japan that was interesting to me. Between 1992 and 1999, you had a series over 8 years of stimulus bills that were passed by the Japanese Legislature in an effort to get them out of recession, and during that period of time, it ended up being about $1.3 trillion U.S. that they spent on this, but they ended up doubling their debt to GDP. It went from something like 60 percent to 128 percent during that period of time. And we had a meeting with Junichiro Koizumi, who was the prime minister. He finally pushed through some reforms that did two things. He basically privatized a lot of the parastatals. But the other thing he did was he leaned on the banks and got them to write off their toxic loans, their bad assets, and that, he always felt, was what finally in 1999 brought them out, rather than the spending stimuluses. And in light of that, and also in light of what happened in Scandinavia, with the Swedish experiments in the 1990's, when they had the subprime problem, and they developed a system where they had the aggregator bank take those assets out of the system so that their banking management were spending their time on generating new loans instead of worrying about these assets that were segregated; and then the assets, of course, were held, and it was 5 or 6 years or whatever, and eventually the price came back up and sort of netted out--I guess it cost a couple of GDP points to their economy, but they got through it without the type of crash that they had feared. And so I was going to ask basically wasn't it the act of addressing the toxic assets that really worked for Japan and worked for the Swedish government at the time? Getting those financial institutions to move those off of their books on to a different write-down concept, isn't that what eventually probably had most to do with those countries' economic recovery? " fcic_final_report_full--32 Maker told the board that she feared an “enormous economic impact” could re- sult from a confluence of financial events: flat or declining incomes, a housing bub- ble, and fraudulent loans with overstated values.  In an interview with the FCIC, Maker said that Fed officials seemed impervious to what the consumer advocates were saying. The Fed governors politely listened and said little, she recalled. “They had their economic models, and their economic mod- els did not see this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”  Soon nontraditional mortgages were crowding other kinds of products out of the market in many parts of the country. More mortgage borrowers nationwide took out interest-only loans, and the trend was far more pronounced on the West and East Coasts.  Because of their easy credit terms, nontraditional loans enabled borrowers to buy more expensive homes and ratchet up the prices in bidding wars. The loans were also riskier, however, and a pattern of higher foreclosure rates frequently ap- peared soon after. As home prices shot up in much of the country, many observers began to wonder if the country was witnessing a housing bubble. On June , , the Economist magazine’s cover story posited that the day of reckoning was at hand, with the head- line “House Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,” the article declared. “How the current housing boom ends could decide the course of the entire world economy over the next few years.”  That same month, Fed Chairman Greenspan acknowledged the issue, telling the Joint Economic Committee of the U.S. Congress that “the apparent froth in housing markets may have spilled over into the mortgage markets.”  For years, he had warned that Fannie Mae and Freddie Mac, bolstered by investors’ belief that these in- stitutions had the backing of the U.S. government, were growing so large, with so lit- tle oversight, that they were creating systemic risks for the financial system. Still, he reassured legislators that the U.S. economy was on a “reasonably firm footing” and that the financial system would be resilient if the housing market turned sour. “The dramatic increase in the prevalence of interest-only loans, as well as the in- troduction of other relatively exotic forms of adjustable rate mortgages, are develop- ments of particular concern,” he testified in June. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is be- ginning to add to the pressures in the marketplace. . . . Although we certainly cannot rule out home price declines, espe- cially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages makes it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.  CHRG-109shrg26643--76 Chairman Shelby," Thank you, Senator Sarbanes. I want to shift to Basel II capital requirements, Mr. Chairman. The Federal Reserve is presently in the process of implementing the Basel II Capital Accord, which will establish new capital requirements for our largest banks. Capital requirements play a vital role in protecting the safety and soundness of the U.S. banking system. I think it is very important that there be no surprises to this Committee and others in the implementation of Basel II, especially unanticipated reductions in capital requirements. Last year, Chairman Bernanke, this Committee held a hearing at which several witnesses here expressed concerns that the adoption of Basel II would result in the lowering of capital requirements. In addition, last year, the Fourth Quantitative Impact Study, unexpectedly, Mr. Chairman, showed that Basel II would result in substantially lower capital requirements which gives then this Committee concern. What steps, Mr. Chairman, need to be taken to make sure that Federal banking regulators, and you are one of these regulators, Congress and the public at large are confident that the implementation of Basel II will not, will not adversely impact the safety and the soundness of the banking system that we know today? " CHRG-109shrg26643--81 Chairman Bernanke," Senator, first, we cannot really evaluate the formulas unless we see the results from the banks' own models and their own analyses. There needs to be a dialogue process going on so that we can continue to learn, and second, it is, after all, a very flexible framework that allows for capital under Pillar II. It allows for multipliers and other changes. I hear you very clearly and I assure you once again that it is not in the Federal Reserve's interest to allow inadequate capital in the banking system because financial stability is one of our primary objectives. Senator Sarbanes. Let me just add. Is it a conflict for the banks, to look to the banks to develop the model since the banks stand to benefit in significant ways if they can lower the capital requirement? It will enhance their competitive position vis-a-vis other banks in the U.S. and it will keep them, or they would argue presumably, in a competitive position vis-a-vis banks in other countries that are moving to Basel II. So you keep telling me, well, we are looking for the banks to give us the models, but don't the banks have a particular vested interest in what they want the models to produce? " FinancialCrisisReport--350 Mr. Lippmann had an unrelentingly negative view of the RMBS and CDO securities he traded. He believed the securities would ultimately lose value, but he also believed investment banks would do all they could to sustain the CDO market for as long as possible due to the CDO fees, prestige, market share, and jobs at stake. (5) Gemstone To understand how one investment bank, Deutsche Bank, continued to develop and aggressively solicit its clients to purchase CDO securities even as mortgage related securities lost value and the CDO market began collapsing, the Subcommittee examined in detail Gemstone 7, a $1.1 billion CDO. Gemstone 7 was assembled and marketed by Deutsche Bank, as sole placement agent, from October 2006 to March 2007. 1343 Gemstone 7 was the last in a series of CDOs sponsored by HBK Capital Management (HBK), a large hedge fund. 1344 Deutsche Bank issued the Gemstone 7 securities in March 2007. Six out of Gemstone’s seven tranches received investment grade ratings, including AAA ratings for the top three tranches. Two months later, in July 2007, the major credit rating agencies issued mass rating downgrades of RMBS and CDO securities, including 19 of the 115 RMBS securities included or referenced in Gemstone 7. In November 2007, the credit rating agencies began to downgrade the Gemstone 7 securities. Today, all seven tranches have been downgraded to junk status, and the Gemstone 7 securities are nearly worthless. (a) Background on Gemstone Gemstone 7 was a $1.1 billion hybrid CDO whose assets consisted predominantly of high risk subprime RMBS securities. Nearly 90% of its assets were mid and subprime RMBS securities with 33% carrying non-investment grade ratings. 1345 Of the remaining assets, 4.5% were CDO securities; 3.3% were commercial mortgage backed securities; and 3.5% were securities backed by pools of student loans. 1346 When the deal closed in March 2007, Gemstone 7 had about $476 million in cash RMBS asset s as well as $625 million in synthetic assets. 1347 Gemstone 7 was constructed as a “partially static” CDO, meaning that while some of its assets were set and could not change, others could be replaced by the collateral manager, HBK. 1343 In the Gemstone 7 offering circular, Deutsche Bank is described as the placement agent: “The Notes purchased by the Initial Purchaser, if any, will be privately placed with eligible investors by the Initial Purchaser” where the Initial Purchaser was Deutsche Bank. Gemstone 7 Offering Circular, GEM7-00000427-816 at GEM7-00000640. In contrast, other documents produced by Deutsche Bank indicate that the bank was acting as an underwriter in the Gemstone 7 transaction. See, e.g., 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and undated Gemstone 7 Securitization Credit Report, MTSS000011-13. For ease of reference but without making a judgment on the matter, this Report uses the term “placement agent” when describing Deutsche Bank’s role in Gemstone 7. 1344 Subcommittee interview of HBK Managing Director Jamiel Akhtar (9/15/2010). 1345 The intended portfolio composition of Gemstone 7 was disclosed to investors in a Debt Investor Presentation. See 2/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747 at 1695. 1346 Id. at 1691. 1347 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03. FOMC20060328meeting--16 14,MR. KOHN.," My second question has to do with New Zealand and Iceland. I guess I thought you ascribed this entirely to an unwinding of the carry trade. But I thought there were other things going on. I thought that there were some very weak data for New Zealand, so that despite the decline in the New Zealand dollar, interest rates actually fell there, and that there was a report from some Scandinavian bank about problems in the Icelandic banking systems. I hesitate to ascribe this situation entirely to the carry trade." CHRG-111hhrg54868--89 Mr. Dugan," I am not sure that we have seen that as a rampant problem in the system. There are some rights related to set off when you have some issues, but I don't believe that banks can routinely use one account to pay the debts of another bank. But I will get back to you on that, on where we are on that, if I could, for the record. Let me just also say that earlier this week, I did spend some time with Georgia community national bankers in Atlanta, and would just echo all of the comments that my colleague just said about the situation in Georgia and some of the issues that they have. " CHRG-110hhrg46593--208 Mr. Campbell," Thank you, Mr. Chairman. A question for Mr. Bartlett, Mr. Yingling, or Ms. Blankenship, whichever one of you. Most of the TARP money thus far has been spent, as Mr. Bartlett just pointed out, for capital infusions into banks and financial institutions, or will be by the time they finish the first tranche of money. In all of your views, is the banking system now adequately capitalized such that it can get further capital privately, or do you think that more capital injections are necessary? " CHRG-111hhrg54867--255 Secretary Geithner," Well, again, banks operate with that mismatch. What they do is they take deposits and they lend them to people who need to buy a home or a business who wants to finance investment. That is inherent in any well-functioning financial system. But what you need do is to make sure that, again, you constrain leverage so that there is enough capital against risk and that there is as stable a funding base as you can achieve. And what we did not do well as a country is that there were large institutions, very important, very complicated, very risky, that didn't have effective constraints on leverage and, as you said quite correctly, were allowed to fund themselves overnight with very, very high vulnerability to a run in a panic. And so, you need to make sure that both the capital requirements and the liquidity requirements, margin, etc., are applied to that set of institutions who present those kind of risks. If you don't do that, we will be in this mess again. " FOMC20070918meeting--73 71,MS. JOHNSON.," The situation in the United Kingdom is an unfolding drama that is just a soap opera in many respects. At the root there seem to be some severe differences of opinion of what the right response is to situations in the markets. In the beginning, there was virtually no explicit action by the Bank of England to counter heightened demand for liquidity on the part of banks in U.K. markets. So the spreads of overnight pound LIBOR, relative to target, opened up widely, and they were not addressed. They were allowed to just sort of sit there. The term pound market had a problem, too. Of course, many of the dollar issues that we have spoken of— and that Bill talked about—are really being captured as a London phenomenon. But you might say that, from the point of view of the Bank of England or the U.K. economy, these dollar issues are somewhat separate from the domestic economy. There is some truth to that, but also the institutions are involved, the institutions have obligations, and the shocks to the institutions reverberate back into the domestic economy, it seems to me. That process went on for a while, and it is to some degree a function of the way the Bank of England manages its reserves and the system of reserve market interaction that exists. It has, among other features, a monthly timetable, not a two-week timetable; so even though the Bank of England operates daily in the sense that we do, it ties its own hands a bit each month. Toward the end of the month in which August 9 occurred, it announced that the subsequent month it was going to ease things just a bit in response to a lot of pressure both perhaps from disagreements inside the bank and criticisms of the bank. It has taken some steps to provide for greater flexibility within its existing system than it had for the three weeks before the month turnover in August. Indeed, the Bank of England did a two-day operation last night, or this morning U.K. time, which is the first temporary extra injection of reserves it had done on this basis. So it is moving in the direction of introducing flexibility into the market that was not there on August 9 and wasn’t there for some time after August 9. I think there is a great concern in the Bank of England, or certainly in the person of Mervyn King, with the moral hazard aspects of enabling the markets to solve their problems and deal with the consequences of their own decisions by the Bank of England’s providing them more liquidity. That lies behind some of his reluctance. On the other hand, we now have the Northern Rock issue. That is somewhat distinct from the problems of overnight lending or even term lending, in that Northern Rock has been questionable for a while, has been looked at for a while, has been kind of talked about a bit, but has not really been on anybody’s radar screen for a while. It is an institution that funded itself to an exceptional extent in wholesale markets as opposed to from a deposit base, and yet it had grown to be a very, very large mortgage lender in the United Kingdom. One might say that it is a bad coincidence that somehow Northern Rock hit a turning point this month, but that is perhaps going too far. I think the fact that the wholesale markets were disrupted had to interact with its business plan, had to be part of the reason that concerns that have been festering for a while became acute, and so forth. The actions that the Bank of England took with respect to Northern Rock were really from its lender-of-last-resort institution-based mechanisms as opposed to market concerns. But they came out basically on the same day. They announced that they were going to introduce flexibility into their reserves management system, and a different announcement was all about Northern Rock. They got it wrong on Northern Rock, quite understandably. That, too, was a function of their deposit insurance system, which is now under review because it is prone to this sort of thing. It was just, if you will, one thing after another, all of which are interacting. We have revised down somewhat our U.K. GDP forecast. In general, the industrial countries are where we see the weakness. That economy was, in terms of domestic demand, pretty strong. We think it can absorb some of this. But the set of factors is very complex—some of them are deep and structural, like the way they do deposit insurance; some of them have been ongoing for a while; and some of them are related to this crisis. I think the differences of opinion among the Financial Services Authority, the Treasury, and the Bank of England aren’t helping, the differences of opinion within the Bank of England aren’t helping, and the situation remains to be totally sorted out." CHRG-111shrg54789--160 Mr. Plunkett," Well, Senator, I hope that when we heard discussion today about choices, we were not hearing about choices like the large number of minority consumers who were steered into high-cost mortgage loans when they could have afforded and would have qualified for a lower-cost loan. I hope we are not talking about choices like what Congress has just eliminated in the credit card bill, not just double-cycle billing but interest rate increases on existing balances for no apparent reason. I mean, that is called ``negative financial engineering.'' That is not legitimate innovation. And that is the kind of, unfortunately, choice in many credit areas that has driven out positive credit, credit offered by some of the small banks you mentioned or credit unions. Senator Menendez. Well, Mr. Chairman, I hope that we will--you know, I do have concerns about how we structure this in a way that affects community banks that clearly have not been at the forefront of our economic challenges. We need to look at that. I do get concerned about how we harmonize the State regulator process with these efforts. And, third, I do want to see--I think Mr. Yingling does make a very valid comment that we have to apply--if we are going to have this consumer protection agency, which I generally support, it has to be applied across the spectrum of financial service entities; otherwise, we would do a disservice to the consumer, to the Nation, and certainly to the industry as well. So I look forward to working toward those goals. Senator Reed. Thank you, Senator Menendez. Senator Shelby, you have a comment? Senator Shelby. I have got a couple of scenarios here that I think we ought to consider. In case one, a borrower obtains a subprime loan, the only loan he could qualify for, and uses it to buy property and then realizes a 75-percent gain on the property 3 years later. This goes on. In case two, a borrower obtains a subprime loan in another market. This borrower has all the same credit and income characteristics at the time he received the loan as the borrower in the first scenario, but later loses his job, sees the real estate market collapse, and then defaults. I believe we need a system where we can accommodate both. How do we do that? In other words, the first guy--and this goes on--took a subprime loan and he made money out of it. Good for him, good probably for the market. The second one, he had the same qualifications, but things turned sour on him. He lost his job, and then he could not make the payments and so forth. How do we do this? Mr. Wallison, do you have any--how do we balance this, I guess? " FinancialCrisisInquiry--34 When you think of that extraordinary week after Lehman Brothers, which was the most hard, tense week there was, that weekend when we became a bank holding company, the next day we capitalized ourselves in part privately with Warren Buffett, and the day after that we did a capital raise for $5.75 billion, which you could have made a lot higher. We had access to the capital markets, and we could have made it more, and we weren’t relying on that government help. That government TARP legislation came about three weeks later. That being said, do I—I don’t know. I can’t say here and tell you what would’ve happened, and I know for sure no one else knows either. I felt good about it, but we were going to bed every night with more risk than any responsible manager should want to have, either for our business or for the system as a whole—risk, not certainty. Even after the TARP was done, roles were implemented. Did that exempt us from risk? No. And as you point out, there’s still risk today. But the question doesn’t have to turn on would you have gone under but for, would you have made? The fact is the world was unsafe. The government, regulators, taxpayers took extraordinary measures to reduce intolerable level of risk to a much more tolerable level of risk, and that we should all be appreciative of. CHAIRMAN ANGELIDES: And the reason I—look, the reason I press this is not to make you say “uncle,” but, you know, in—in kind of lay terms, what was done at investment banks, different risk profile, the more regulated commercial banks is extraordinary leverage—I mean the akin to a small businessperson who has $50,000 in net worth or a family borrowing $2 billion in some instances, $1.5 billion -- $1.5 million with much of that money due overnight. CHRG-111shrg50814--207 RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM BEN S. BERNANKEQ.1. I am very concerned that the Fed's tools could become limited and less flexible, and that the Fed's ability to stimulate the economy given an effective zero interest rate is hindered. What role will the Fed play going forward in our economic recovery?A.1. The Federal Reserve does not lose its ability to provide macroeconomic stimulus when short-term interest rates are at zero. However, when rates are this low, monetary stimulus takes nontraditional forms. The Federal Reserve has announced many new programs over the past year-and-a-half to support the availability of credit and thus help buoy economic activity. These programs are helping to restore the flow of credit to banks, businesses, and consumers. They are also helping to keep long-term interest rates and mortgage rates at very low levels. The Federal Reserve will continue to use these tools as needed to help the economy recover and prevent inflation from falling to undesirably low levels.Q.2. As part of the White House's new housing plan, the administration suggests changes to the bankruptcy law to allow judicial modification of home mortgages. Do you believe ``cramdown'' could affect the value of mortgage backed securities and how they are rated? Will bank capital be impacted if ratings on securities change? Is it better for consumers to get a modification from their servicer or through bankruptcy?A.2. The Federal Reserve Board and other banking agencies have encouraged federally regulated institutions to work constructively with residential borrowers at risk of default and to consider loan modifications and other prudent workout arrangements that avoid unnecessary foreclosures. Loss mitigation techniques, including loan modifications, that preserve homeownership are generally less costly than foreclosure, particularly when applied before default. Such arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower. (See Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages, released by banking agencies on September 5, 2007.) Modifications in these contexts would be voluntary on the part of the servicer or holder of the loan. Although various proposals have circulated regarding so-called ``cramdown,'' the common theme of the proposals would permit judicial modification of the mortgage contract in circumstances where the borrower has filed for bankruptcy. These proposals present a number of challenging and potentially competing issues that should be carefully weighed. These issues include whether borrower negotiation with the servicer or loan holder is a precondition to judicial modification, the impact on risk assessment of the underlying obligation by holders of mortgage loans, and the appropriateness of permitting modification decisions by parties other than the holders of the loan or their servicers. Whether a borrower would be better off with a modification from a servicer or through bankruptcy would depend on many factors including the circumstances of the individual borrower, the terms of the modification, and the conditions governing any judicial modification in a bankruptcy proceeding. In general, when a depository institution is a holder of a security, the capital of the institution would likely be affected if the security is downgraded. How bankruptcy would impact the servicer would depend in part on the securitization documents treatment of the mortgage loans affected by bankruptcies under the relevant pooling and servicing agreements and the obligations of the servicer with respect to those loans. In addition, because the terms that might govern judicial modification in a bankruptcy proceeding have not been established, it is not clear how the value of mortgage-backed securities in general would be affected by changes to the bankruptcy laws that would permit judicial modification of mortgages.Q.3. There is pressure to move quickly and reform our financial regulatory structure. What areas should we address in the near future and which areas should we set aside until we realize the full cost of the economic fallout we are currently experiencing?A.3. The experience over the past 2 years highlights the dangers that systemic risks may pose not only to financial institutions and markets, but also for workers, households, and non-financial Businesses. Accordingly, addressing systemic risk and the related problem of financial institutions that are too big to fail should receive priority attention from policymakers. In doing so, policymakers must pursue a multifaceted strategy that involves oversight of the financial system as a whole, and not just its individual components, in order to improve the resiliency of the system to potential systemic shocks. This strategy should, among other things, ensure a robust framework for consolidated supervision of all systemically important financial firms organized as holding companies. The current financial crisis has highlighted that risks to the financial system can arise not only in the banking sector, but also from the activities of financial firms, such as insurance firms and investment banks, that traditionally have not been subject to the type of consolidated supervision applied to bank holding companies. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors. In addition, a critical component of an agenda to address systemic risk and the too-big-to-fail problem is the development of a framework that allows the orderly resolution of a systemically important nonbank financial firm and includes a mechanism to cover the costs of such a resolution. In most cases, the Federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy laws do not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure would pose substantial systemic risks. Besides reducing the potential for systemic spillover effects in case of a failure, improved resolution procedures for systemically important firms would help reduce the too-big-to-fail problem by narrowing the range of circumstances that might be expected to prompt government intervention to keep a firm operating. Policymakers and experts also should carefully review whether improvements can be made to the existing bankruptcy framework that would allow for a faster and more orderly resolution of financial firms generally. Such improvements could reduce the likelihood that the new alternative regime would need to be invoked or government assistance provided in a particular instance to protect financial stability and, thereby, could promote market discipline. Another component of an agenda to address systemic risks involves improvements in the financial infrastructure that supports key financial markets. The Federal Reserve, working in conjunction with the President's Working Group on Financial Markets, has been pursuing several initiatives designed to improve the functioning of the infrastructure supporting credit default swaps, other OTC derivatives, and tri-party repurchase agreements. Even with these initiatives, the Board believes additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems. 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 critical payment and settlement systems have the necessary procedures and controls in place to manage their risks. By contrast, many major central banks around the world have an explicit statutory basis for their oversight of these systems. Given how important robust payment and settlement systems are to financial stability, and the functional similarities between many such systems, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems. The Federal Reserve has significant expertise regarding the risks and appropriate risk-management practices at payment and settlement systems, substantial direct experience with the measures necessary for the safe and sound operation of such systems, and established working relationships with other central banks and regulators that we have used to promote the development of strong and internationally accepted risk management standards for the full range of these systems. Providing such authority would help ensure that these critical systems are held to consistent and high prudential standards aimed at mitigating systemic risk. Financial stability could be further enhanced by a more explicitly macroprudential approach to financial regulation and supervision in the United States. Macroprudential policies focus on risks to the financial system as a whole. Such risks may be crosscutting, affecting a number of firms and markets, or they may be concentrated in a few key areas. A macroprudential approach would complement and build on the current regulatory and supervisory structure, in which the primary focus is the safety and soundness of individual institutions and markets. One way to integrate a more macroprudential element into the U.S. supervisory and regulatory structure would be for the Congress to direct and empower a governmental authority to monitor, assess, and, if necessary, address potential systemic risks within the financial system. Such a systemic risk authority could, for example, be charged with (1) monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets; (2) assessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (3) analyzing possible spillovers between financial firms or between firms and markets, for example through the mutual exposures of highly interconnected firms; (4) identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole; and (5) issuing periodic reports on the stability of the U.S. financial system, in order both to disseminate its own views and to elicit the considered views of others. A systemic risk authority likely would also need an appropriately calibrated ability to take measures to address identified systemic risks--in coordination with other supervisors, when possible, or independently, if necessary. The role of a systemic risk authority in the setting of standards for capital, liquidity, and risk-management practices for the financial sector also would need to be explored, given that these standards have both microprudential and macroprudential implications.Q.4. How should the government and regulators look to mitigate the systemic risks posed by large interconnected financial companies? Do we risk distorting the market by identifying certain institutions as systemically important? Should the Federal Reserve step into the role as a systemic regulator or should this task be given to a different entity.A.4. As discussed in response to Question 3, I believe there are several important steps that should be part of any agenda to mitigate systemic risks and address the problem caused by institutions that are viewed as being too big to fail. Some of these actions--such as an improved resolution framework--would be focused on systemically important financial institutions, that is, institutions the failure of which would pose substantial risks to financial stability and economic conditions. A primary--though not the sole focus--of a systemic risk authority also likely would include such financial institutions. Publicly identifying a small set of financial institutions as ``systemically important'' would pose certain risks and challenges. Explicitly and publicly identifying certain institutions as systemically important likely would weaken market discipline for these firms and could encourage them to take excessive risks--tendencies that would have to be counter-acted by strong supervisory and regulatory policies. Similarly, absent countervailing policies, public designation of a small set of firms as systemically important could give the designated firms a competitive advantage relative to other firms because some potential customers might prefer to deal with firms that seem more likely to benefit from government support in times of stress. Of course, there also would be technical and policy issues associated with establishing the relevant criteria for identifying systemically important financial institutions especially given the broad range of activities, business models and structures of banking organizations, securities firms, insurance companies, and other financial institutions. Some commentators have proposed that the Federal Reserve take on the role of systemic risk authority; others have expressed concern that adding this responsibility might overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, as well as on how the necessary resources and expertise complement those employed by the Federal Reserve in the pursuit of its long-established core missions. As a practical matter, effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role. The Federal Reserve traditionally has played a key role in the government's response to financial crises because it serves as liquidity provider of last resort and has the broad expertise derived from its wide range of activities, including its role as umbrella supervisor for bank and financial holding companies and its active monitoring of capital markets in support of its monetary policy and financial stability objectives.Q.5. The largest individual corporate bailout to date has not been a commercial bank, but an insurance company. What steps has the Federal Reserve taken to make sure AIG is not perceived as being guaranteed by the Federal government?A.5. In light of the importance of the American International Group, Inc (AIG) to the stability of financial markets in the recent deterioration of financial markets and continued market turbulence generally, the Treasury and the Federal Reserve have stated their commitment to the orderly restructuring of the company and to work with AIG to maintain its ability to meet its obligations as they come due. In periodic reports to Congress submitted under section 129 of the Emergency Economic Stabilization Act of 2008, in public reports providing details on the Federal Reserve financial statements, and in testimony before Congress and other public statements, we have described in detail our relationship to AIG, which is that of a secured lender to the company and to certain special purpose vehicles related to the company. These disclosures include the essential terms of the credit extension, the amount of AIG's repayment obligation, and the fact that the Federal Reserve's exposure to AIG will be repaid through the proceeds of the company's disposition of many of its subsidiaries. Neither the Federal Reserve, nor the Treasury, which has purchased and committed to purchase preferred stock issued by AIG, has guaranteed AIG's obligations to its customers and counterparties. Moreover, the Government Accountability Office has inquired into whether Federal financial assistance has allowed AIG to charge prices for property and casualty insurance products that are inadequate to cover the risk assumed. Although the GAO has not drawn any final conclusions about how financial assistance to AIG has impacted the overall competitiveness of the property and casualty insurance market, the GAO reported that the state insurance regulators the GAO spoke with said they had seen no indications of inadequate pricing by AIG's commercial property and casualty insurers. The Pennsylvania Insurance Department separately reported that it had not seen any clear evidence of under-pricing of insurance products by AIG to date.Q.6. Given the critical role of insurers in enabling credit transactions and insuring against every kind of potential loss, and the size and complexity of many insurance companies, do you believe that we can undertake serious market reform without establishing federal regulation of the insurance industry?A.6. As noted above, ensuring that all systemically important financial institutions are subject to a robust framework--both in law and practice--for consolidated supervision is an important component of an agenda to address systemic risks and the too-big-to-fail problem. While the issue of a Federal charter for insurance is a complex one, it could be useful to create a Federal option for insurance companies, particularly for large, systemically important insurance companies.Q.7. What effect do you believe the new Fed rules for credit cards will have on the consumer and on the credit card industry?A.7. The final credit card rules are intended to allow consumers to access credit on terms that are fair and more easily understood. The rules seek to promote responsible use of credit cards through greater transparency in credit card pricing, including the elimination of pricing practices that are deceptive or unfair. Greater transparency will enhance competition in the marketplace and improve consumers' ability to find products that meet their needs From the perspective of credit card issuers, reduced reliance on penalty rate increases should spur efforts to improve upfront underwriting. While the Board cannot predict how issuers will respond, it is possible that some consumers will receive less credit than they do today. However, these rules will benefit consumers overall because they will be able to rely on the rates stated by the issuer and can therefore make informed decisions regarding the use of credit.Q.8. The Fed's new credit card rules are not effective until July 2010. We have heard from some that this is too long and that legislation needs to be passed now to shorten this to a few months. Why did the Fed give the industry 18 months put the rules in place?A.8. The final rules represent the most comprehensive and sweeping reforms ever adopted by the Board for credit card accounts and will apply to more than 1 billion accounts. Given the breadth of the changes, which affect most aspects of credit card lending, card issuers must be afforded ample time for implementation to allow for an orderly transition that avoids unintended consequences, compliance difficulties, and potential liabilities. To comply with the final rules, card issuers must adopt different business models and pricing strategies and then develop new credit products. Depending on how business models evolve, card issuers may need to restructure their funding mechanisms. In addition to these operational changes, issuers must revise their marketing materials, application and solicitation disclosures, credit agreements, and periodic statements so that the documents reflect the new products and conform to the rules. Changes to the issuers' business practices and disclosures will involve extensive reprogramming of automated systems which subsequently must be tested for compliance, and personnel must receive appropriate training. Although the Board has encouraged card issuers to make the necessary changes as soon as practicable, an 18-month compliance period is consistent with the nature and scope of the required changes. ------ CHRG-110shrg46629--123 Chairman Bernanke," Senator, first let me say that I agree wholeheartedly with your views on financial literacy. As I discussed earlier, the Federal Reserve works very hard on all these disclosures for these sometimes complex financial products. But if people do not have the basic literacy to understand them and evaluate them, it is really of no use. Without financial literacy they are not going to be able to participate fully in our economy. In terms of bringing more people into the banking system, I think it would be a positive development. The main way the Federal Reserve can help that process is what we do, which is to encourage the banks and bank holding companies that we supervise to reach out into underserved communities, partly through the Community Reinvestment Act but more generally to provide services and to try to attract unbanked people into the banking system. I have given not only testimony before the Senate on financial literacy, but I have also given some testimony in the past on remittances which is one mechanism. Many of the remittances that immigrants send back home, they lose a significant portion of the money they are sending because of the high cost of the types of services they use and other problems. One of the ways in which credit unions and banks have made inroads into the minority communities, in particular, has been by offering better and cheaper remittance services. I think that is one particular way to get in. But we are seeing banks more and more employing Spanish speaking, for example, tellers and understanding that there really is a good market in these low and moderate income neighborhoods. And we encourage banks to provide services in those neighborhoods. Senator Akaka. Mr. Chairman, FDIC has found that their Money Smart financial literacy program has resulted in positive behavioral change among consumers. I know that measuring the effectiveness of financial literacy programs is an issue that the Federal Reserve has been interested in for several years. What has the Federal Reserve learned thus far about the effectiveness of financial education? " CHRG-111hhrg55814--329 Mr. Dugan," They will get systemically significant and big. That is what happened last year. We had companies that weren't banks that did that, and we ended up having to do something about it. So I guess the approach of this bill is you cannot ignore the fact that they can become systemically significant. And that being the case, you ought to have ways to go regulate them. Mr. Miller of North Carolina. And I support that approach. Mr. Moore of Kansas. The gentleman's time has expired. The Chair will next recognize the distinguished ranking member, Mr. Bachus. " CHRG-111shrg57322--269 Mr. Birnbaum," I think it is important to distinguish our role in terms of the products that we were trading versus making broader judgments about Goldman Sachs. So I just want to be clear. Are you asking about our specific role with the products that we traded? Or are you asking us to sort of editorialize about the financial system and how investment banks played a role? Senator Pryor. Well, I was actually asking about Goldman Sachs, but if you want to editorialize on the financial system, you can. But I was asking about Goldman. " CHRG-109hhrg28024--138 Mr. Bernanke," I think I agree with what you are saying, the point being that we want to have cooperation between the private and public sectors, with an increasing role for the private sector over time. Ms. Kelly. Chairman Bernanke, this committee has taken an active role in fighting terrorist use of our financial system. Working with Federal regulators, we have exposed Riggs Bank, the Arab Bank, violations of the law, and we have worked with other agencies to improve the effectiveness of examinations. Unfortunately, we have seen several cases of banks subject to Federal Reserve supervision who have been violating the law for years without being discovered, particularly, in the more recent case of ABM. I'd like you to explain to the committee, if you will, how you would strengthen the Federal Reserve's ability to defend our financial system against terrorists who want to use it for their advantage. I want to know if you think the Federal Reserve has enough staff resources and puts them into the enforcement of the BSA versus its other activities. I'm concerned especially about ABM deliberately violating U.S. laws by trading with Iran for 7 years. I wonder if you would be willing to address that. " CHRG-111shrg50814--131 Mr. Bernanke," Well, there were two things that he did within months of taking office that were extremely important. One was the bank holiday and subsequent measures like the deposit insurance program that stabilized the banking system. This is a point I have been making all morning, that we need to stabilize the banks. The second thing he did was to take the U.S. off the gold standard, which allowed the Federal Reserve to ease monetary policy, allowed for a rise in prices, which, after 3 years of horrible deflation, allowed for recovery. So those were the two perhaps most important measures that he took. He did some counterproductive things, like the National Recovery Act, which put the floors under prices and wages and prevented necessary adjustment. The most controversial issue recently, of course, has been fiscal policy, and I think there are two sides to that. The classic work on this by an old teacher of mine from MIT, E. Cary Brown, said that fiscal policy under Roosevelt was not successful but only because it was not tried, and he argued that it was not big enough relative to the size of the problem. Other writers have argued that this was not the right medicine. So that one is more controversial, but if you asked me what I think the most important things were, I think they had to do with stabilizing monetary policy and stabilizing the financial system. " CHRG-111hhrg52261--23 Mr. Robinson," Chairwoman Velazquez, Ranking Member Graves, and members of the committee, thank you for the opportunity to testify. I am J. Douglas Robinson, Chairman and Chief Executive Officer of the Utica National Insurance Group, a group led by two mutual insurers headquartered near Utica, New York. Utica National provides coverages primarily for individual and commercial risks with an emphasis on specialized markets, including public and private schools, religious institutions, small contractors, and printers. My company markets its products through approximately 1,200 independent agents and brokers. Our 2008 direct written premiums were more than $632 million. I am testifying today on behalf of the Property Casualty Insurers Association of America, which represents more than 1,000 U.S. insurers. We commend President Obama and Congress for working to ensure that the financial crisis we experienced last fall is never repeated. Achieving this goal requires a focus on fixing what went wrong with Wall Street without imposing substantial new one-size-fits-all regulatory burdens on Main Street, small businesses, and activities that are not highly leveraged nor systemically risky. My company insures small businesses like bakeries, child care centers, auto service centers, and funeral homes. These Main Street businesses should not bear the burden of an economic crisis they did not create. Home, auto, and commercial insurers did not cause the financial crisis, are not systemically risky and have strong and effective solvency and consumer protection regulation at the State level. We are predominantly a Main Street, not a Wall Street, industry with less concentration and more small business competition than other sectors. Property casualty insurers have not asked for government handouts. Our industry is stable and continues to provide critical services to local economies and communities. However, small insurers are concerned about being subject to administration proposals intended to address risky Wall Street banks and securities firms, but that apply broadly to the entire financial industry. Specifically, we are concerned about the following: The proposed Consumer Financial Protection Agency does not adequately exclude insurance from its scope. An exclusion should be added for credit, title, and mortgage insurance, which are generally provided by and to relatively small businesses. Protection should be added for insurance payment plans which are already well regulated by State insurance departments. The proposed new Office of National Insurance is given too much subpoena and preemption power without adequate due process or limits on its scope and its ability to enter into international insurance agreements. It also needs a definition of ""small insurer"" to prevent excessive reporting requirements. Systemic risk regulation needs to be modified to reduce government backing of large firms at the competitive expense of small financial providers. Leveraged Wall Street behemoths must not be made bigger through government bailouts and consolidation. Government shouldn't forget or harm Main Street in addressing systemic risk regulation. Resolution costs of systemically risky firms should be paid for by firms with the greatest systemic risk. Bank regulators should not be allowed to resolve systemic risk failures by reaching into the assets of small insurance affiliates whose losses would then be charged to other innocent small competitors through State guaranty funds. Finally, congressionally proposed repeal of the McCarran-Ferguson Act would significantly reduce insurance competition, primarily harming smaller insurers that would not otherwise have access to loss data and uniform policy forms necessary to compete effectively, and that would ultimately harm consumers. The cost of new regulations almost always disproportionately affects small business who can least afford the necessary legal and compliance requirements. The property casualty industry is healthy and competitive and the current system of regulating the industry at the State level is working well. Should the Congress fail to address the issues we have identified, the consequences on consumers and the economy could be quite harsh, imposing an especially large burden on small insurers and small businesses. Thank you. " CHRG-111hhrg54867--226 Secretary Geithner," I just don't think it goes far enough. Again, just due to practical reality, I think that would leave the current system basically intact, and we would be at too much risk of repeating this down the road. And I think that, again, a basic failure in our system was we left a bunch of institutions doing the same thing. Mortgages, credit cards, a bunch of credit-type products competing alongside banks where there was no effective deterrence enforcement. And I don't think you can fix the system without fixing that problem. And I don't think you can--I will say this more starkly than we need. But I don't think you are going to fix it by creating a committee. " CHRG-111shrg49488--53 Mr. Clark," The system, I think, would be very similar, as I understand from Dr. Carmichael, to the Australian system. There is a group that meets regularly that is chaired by the Deputy Minister of Finance and would have our regulator, OSFI, on it and would have the Bank of Canada on it and the Canada Deposit Insurance Corporation (CDIC), the equivalent to the FDIC, on it. And, in fact, they have now created two committees--one which is called the Financial Institutions Supervisory Committee (FISC), which is designed more to deal with low-level coordination issues, and then a second one that deals with more explicitly strategic issues. And I think it is probably fair to say that as a result of this crisis, the role of that committee in making sure that they are debating what the systemic risk is and who is doing what about it has been elevated as a result of this. Senator Collins. Mr. Green, what about in Great Britain? How is systemic risk handled? " fcic_final_report_full--368 On Monday, September , the Dow Jones Industrial Average fell more than  points, or , the largest single-day point drop since the / terrorist attacks. These drops would be exceeded on September —the day that the House of Repre- sentatives initially voted against the  billion Troubled Asset Relief Program (TARP) proposal to provide extraordinary support to financial markets and firms— when the Dow Jones fell  and financial stocks fell . For the month, the S&P  would lose  billion of its value, a decline of —the worst month since September . And specific institutions would take direct hits. MONEY MARKET FUNDS: “DEALERS WEREN ’ T EVEN PICKING UP THEIR PHONES ” When Lehman declared bankruptcy, the Reserve Primary Fund had  million in- vested in Lehman’s commercial paper. The Primary Fund was the world’s first money market mutual fund, established in  by Reserve Management Company. The fund had traditionally invested in conservative assets such as government securities and bank certificates of deposit and had for years enjoyed Moody’s and S&P’s highest ratings for safety and liquidity. In March , the fund had advised investors that it had “slightly underper- formed” its rivals, owing to a “more conservative and risk averse manner” of invest- ing—“for example, the Reserve Funds do not invest in commercial paper.”  But immediately after publishing this statement, it quietly but dramatically changed that strategy. Within  months, commercial paper grew from zero to one-half of Reserve Primary’s assets. The higher yields attracted new investors and the Reserve Primary Fund was the fastest-growing money market fund complex in the United States in , , and —doubling in the first eight months of  alone.  Earlier in , Primary Fund’s managers had loaned Bear Stearns money in the repo market up to two days before Bear’s near-collapse, pulling its money only after Bear CEO Alan Schwartz appeared on CNBC in the company’s final days, Primary Fund Portfolio Manager Michael Luciano told the FCIC. But after the government- assisted rescue of Bear, Luciano, like many other professional investors, said he as- sumed that the federal government would similarly save the day if Lehman or one of the other investment banks, which were much larger and posed greater apparent sys- temic risks, ran into trouble. These firms, Luciano said, were too big to fail.  On September , when Lehman declared bankruptcy, the Primary Fund’s Lehman holdings amounted to . of the fund’s total assets of . billion. That morning, the fund was flooded with redemption requests totaling . billion. State Street, the fund’s custodian bank, initially helped the fund meet those requests, largely through an existing overdraft facility, but stopped doing so at : A . M . With no means to borrow, Primary Fund representatives reportedly described State Street’s action as “the kiss of death” for the Primary Fund.  Despite public assurances from the fund’s investment advisors, Bruce Bent Sr. and Bruce Bent II, that the fund was committed to maintaining a . net asset value, investors requested an additional  billion later on Monday and Tuesday, September .  CHRG-111hhrg53245--21 Mr. Zandi," Thank you, Mr. Chairman, and members of the committee for the opportunity to be here today. I am an employee of the Moody's Corporation, but my remarks today reflect only my own personal views. I will make five points in my remarks. Point number one: I think the Administration's proposed financial regulatory reforms are much needed and reasonably well designed. The panic that was washing over the financial system earlier this year has subsided, but the system remains in significant disrepair. Our credit remains severely impaired. By my own estimate, credit, household, and non-financial corporate debt outstanding fell in the second quarter. That would be the first time in the data that we have all the way back to World War II, and highlights the severity of the situation. I think regulatory reform is vital to reestablishing confidence in the financial system, and thus reviving it, and thus by extension reviving the economy. The Administration's regulatory reform fills in most of the holes in the current system, and while it would not have forestalled the current crisis, it certainly would have made it much less severe. And most importantly, I think it will reduce the risks and severity of future financial crises. Point number two: A key aspect of the reform is establishing the Federal Reserve as a systemic risk regulator. I think that's a good idea. I think they're well suited for the task. They're in the most central position in the financial system. They have a lot of financial and importantly intellectual resources, and they have what's very key--a history of political independence. They can also address the age-old problem of the procyclicality of regulation; that is, regulators allow very aggressive lending in the good times, allowing the good times to get even better, and tighten up in the bad times, when credit conditions are tough. I also think as a systemic risk regulator, the Fed will have an opportunity to address asset bubbles. I think that's very important for them to do. There's a good reason for them to be reluctant to do so, but better ones for them to weigh against bubbles. They, as a systemic risk regulator, will have the ability to influence the amount of leverage and risk-taking in the financial system, and those are key ingredients into the making of any bubble. Point number three: I think establishing a consumer financial protection agency is a very good idea. It's clear from the current crisis that households really had very little idea of what their financial obligations were when they took on many of these products, a number of very good studies done by the Federal Reserve showing a complete lack of understanding. And even I, looking through some of these products, option ARMs, couldn't get through the spreadsheet. These are very, very difficult products. And I think it's very important that consumers be protected from this. There is certainly going to be a lot of opposition to this. The financial services industry will claim that this will stifle innovation and lead to higher costs. And it's true this agency probably won't get it right all the time, but I think it is important that they do get involved and make sure that households get what they pay for. The Federal Reserve also seems to be a bit reluctant to give up some of its policy sway in this area. I'm a little bit confused by that. You know, I think they showed a lack of interest in this area in the boom and bubble. They have a lot of things on their plate. They'll have even more things on their plate if this reform goes through. As a systemic risk regulator, I think it makes a lot of sense to organize all of these responsibilities in one agency, so that they can focus on it and make sure that it works right. Point number four: The reform proposal does have some serious limitations, in my view. The first limitation is it doesn't rationalize the current alphabet soup of regulators at the Federal and State level. That's a mistake. The one thing it does do is combine the OCC with the OTS. That's a reasonable thing to do, but that's it. And so we now have the same Byzantine structure in place, and there will be regulatory arbitrage, and that ultimately will lead to future problems. I can understand the political problems in trying to combine these agencies, but I think that would be well worth the effort. The second limitation is the reform does not adequately identify the lines of authority among regulators and the mechanisms for resolving difference. The new Financial Services Oversight Council, you know, it doesn't seem to me like it's that much different than these interagency meetings that are in place now, where the regulators get together and decide, you know, how they're going to address certain topics. They can't agree, and it takes time for them to gain consensus. They couldn't gain consensus on stating simply that you can't make a mortgage loan to someone who can't pay you back. That didn't happen until well after the crisis was underway. So I'm not sure that solves the problem. I think the lines of authority need to be ironed out and articulated more clearly. The third limitation is the reform proposal puts the Federal Reserve's political independence at greater risk, given its larger role in the financial system. Ensuring its independence is vital to the appropriate conduct of monetary policy. That's absolutely key; I wouldn't give that up for anything. And the fourth limitation is the crisis has shown an uncomfortably large number of financial institutions are too big to fail. And that is they are failure risks undermining the system, giving policy makers little choice but to intervene. The desire to break up these institutions is understandable, but ultimately it is feudal. There is no going back to the era of Glass-Steagall. Breaking up the banking system's mammoth institutions would be too wrenching and would put U.S. institutions at a distinct competitive disadvantage, vis-a-vis their large global competitors. Large financial institutions are also needed to back-stop and finance the rest of the financial system. It is more efficient and practical for regulators to watch over these large institutions, and by extension, the rest of the system. With the Fed as the systemic risk regulator, more effective oversight of too-big-to-fail institutions is possible. These large institutions should also be required to hold more capital, satisfy stiffer liquidity requirements, have greater disclosure requirements, and to pay deposit and perhaps other insurance premiums, commensurate with the risk they take and the risks that they pose to the entire financial system. Finally, let me just say I think the proposed financial system regulatory reforms are as wide-ranging as anything that has been implemented since the 1930's Great Depression. The reforms are, in my view, generally well balanced, and if largely implemented, will result in a more steadfast, albeit slower-paced, financial system and it will have economic implications. And I think that's important to realize, but I think necessary to take. The Administration's reform proposal does not address a wide range of vital questions, but it is only appropriate that these questions be answered by legislators and regulators after careful deliberation. How these are answered will ultimately determine how well this reform effort will succeed. Thank you. [The prepared statement of Mr. Zandi can be found on page 86 of the appendix.] " CHRG-111hhrg56776--258 Mr. Meltzer," Yes. First, let me just say about 13(3); 13(3) was passed in the Great Depression. It was there to help small and medium-sized borrowers who couldn't get accommodation, very much like some of them now. That was the idea of 13(3). It never was very important. The Fed made some loans under 13(3), but not very much. It was never intended to be used to bail out something like AIG. That's a complete perversion of the spirit of that legislation. What do I mean by a lender of last resort agreed to by the Congress? Well, if you don't agree to it, it won't--if Congress doesn't agree to it, it won't work. That is because you--the pressures on the Fed will be just too great. So you have to agree to it, what should you agree to. There was something called Bagehot's Rule, which the Bank of England used. The Bank of England was an international lender, similar to what the United States is now. It had loans all over the world. It said, look, if you have good collateral, you can borrow. If you don't, goodbye. They had bank failures, big ones in some cases, but no crises. Why? Because the borrowers knew that they had to come with collateral and they held collateral. We have to go back to a system in which the responsibility is on the banker. I want a system where the chairman of the bank goes in every morning and says to his number two guy, ``How the devil did we get that junk on our balance sheet? Get rid of it at once.'' That way, we'll have safety and soundness. " CHRG-110hhrg46596--64 Mr. Kashkari," Good morning, Mr. Chairman, Ranking Member Bachus, and members of the committee. Thank you for asking me to testify before you today regarding oversight of the Troubled Asset Relief Program. We are in an unprecedented period, and market events are moving rapidly and unpredictably. We at Treasury have responded quickly to adapt to events on the ground. Throughout the crisis, we have always acted with the following critical objectives: One, to stabilize financial markets and reduce systemic risk; two, to support the housing market by avoiding preventable foreclosures and supporting mortgage finance; and three, to protect the taxpayers. The authority and the flexibility granted to us by the Congress has been essential to developing the programs necessary to meet those objectives. Today, I will describe the many steps we are taking to ensure compliance with both the letter and the spirit of the law and what measurements we look at to gauge our success. A program as large and complex as the TARP would normally take many months or years to establish. Given the severity of the financial crisis, we must build the Office of Financial Stability, we must design our programs, and we must execute our programs all at the same time. We have made remarkable progress since the President signed the law only 68 days ago. The first topic I will address is oversight of the TARP. We first moved immediately to establish the Financial Stability Oversight Board. The board has already met 5 times in the 2 months since the law was signed, with numerous staff calls between meetings. We have also posted bylaws and minutes from those board meetings on the Treasury Web site. Second, the law requires an appointment of a Senate-confirmed special inspector general to oversee the program. We welcome the Senate's confirmation, just on Monday, of Mr. Barofsky as special IG. I spoke with him just yesterday, and we look forward to working closely with his office. In the interim, pending his confirmation, we have been coordinating closely with the Treasury's inspector general. We have had numerous meetings with Treasury's Inspector General to keep them apprised of all TARP activity. And we look forward to continuing our active dialogue with both the Treasury IG and the special IG as he builds up his office. Third, the law calls for the GAO to establish a physical presence at Treasury to monitor the program. We have had numerous briefings with GAO, and our respective staffs meet or speak on an almost daily basis to update them on the program and review contracts. The GAO published its first report on the TARP, as Mr. Dodaro said, on December 2nd. They provided a thorough review of the TARP program and progress to date, essentially a snapshot in time at the 60-day mark of a large, complex project that continues to be a successful work in progress. We are pleased with our auditors' recommendations, because the GAO has identified topics that we are already focused on. The report was quite helpful to us because it provided us with thoughtful, independent verification that we are, indeed, focused in the right topics. And we agree with the GAO on the importance of these issues. Our work continues. Finally, the law called for the establishment of a congressional oversight panel, the fourth oversight body to review the TARP. That oversight panel was recently formed, and we had our first meeting with them on Friday, November 21st. We look forward to having additional meetings with the congressional oversight panel. Now, people often ask, how do we know our programs are working? First, and this is very important, we did not allow the financial system to collapse. That is the most important information that we have. Second, the system is fundamentally more stable than it was when Congress passed the legislation. While it is difficult to isolate one program's effects, given the numerous steps that policymakers have taken, one indicator that points to reduced risk among default of financial institutions is the average credit default swap spread for the eight largest U.S. banks. That CDS spread has declined 200 basis points since before Congress passed the law. Another key indicator of perceived risk in the financial system is the spread between LIBOR and OIS. The 1-month and 3-month LIBOR-OIS spreads have each declined 100 basis points since the law was signed and 180 basis points from their peak before the CPP was announced on October 14th. People also ask, when will we see banks making new loans? First, we must remember that just over half the money allocated to the Capital Purchase Program is out the door. Although we are executing at report speed, it will still take a few months to process all of the remaining applications. The money needs to get into the system before it can have the desired effect. Second, we are still at a point of low confidence, both due to the financial crisis and due to the economic downturn. As long as confidence remains low, banks will remain cautious about extending credit, and consumers and businesses will remain cautious about taking on new loans themselves. As confidence returns, we expect to see more credit extended. We are actively engaged with regulators to determine the best way to monitor these capital investments in bank lending. We may utilize a variety of supervisory information for insured depositories, including the Home Mortgage Disclosure Act data, the Community Reinvestment Act data, call report data, examination information contained in CRA public evaluations, as well as broader financial data and conditions. In conclusion, while we have made significant progress, we recognize that challenges lie ahead. As Secretary Paulson has said, there is no single action the Federal Government can take to end the financial market turmoil or the economic downturn, but the new authorities that you provided, you and your colleagues provided in October, dramatically expanded the tools available to address the needs of our system. We are confident we are pursuing the right strategy to stabilize the financial system and support the flow of credit to the economy. Thank you again for having me here today, and I would be happy to take your questions. [The prepared statement of Mr. Kashkari can be found on page 115 of the appendix.] " fcic_final_report_full--375 Morgan Stanley] had consistently opposed Federal Reserve supervision—[but after Lehman,] those franchises saw that they were next unless they did something drastic. That drastic thing was to become bank holding companies,” Tom Baxter, the New York Fed’s general counsel, told the FCIC.  The Fed, in tandem with the Department of Justice, approved the two applications with extraordinary speed, waiving the stan- dard five-day antitrust waiting period.  Morgan Stanley instantly converted its  billion industrial loan company into a national bank, subject to supervision by the Office of the Comptroller of the Currency (OCC), and Goldman converted its  billion industrial loan company into a state-chartered bank that was a member of the Federal Reserve System, subject to supervision by the Fed and New York State. The Fed would begin to supervise the two new bank holding companies. The two companies gained the immediate benefit of emergency access to the dis- count window for terms of up to  days.  But, more important, “I think the biggest benefit is it would show you that you’re important to the system and the Fed would not make you a holding company if they thought in a very short period of time you’d be out of business,” Mack told the FCIC. “It sends a signal that these two firms are go- ing to survive.”  In a show of confidence, Warren Buffett invested  billion in Goldman Sachs, and Mitsubishi UFJ invested  billion in Morgan Stanley. Mack said he had been waiting all weekend for confirmation of Mitsubishi’s investment when, late Sunday afternoon, he received a call from Bernanke, Geithner, and Paulson. “Basically they said they wanted me to sell the firm,” Mack told the FCIC. Less than an hour later, Mitsubishi called to confirm its investment and the regulators backed off.  Despite the weekend announcements, however, the run on Morgan Stanley con- tinued. “Over the course of a week, a decreasing number of people [were] willing to do new repos,” Wong said. “They just couldn’t lend anymore.”  By the end of September, Morgan Stanley’s liquidity pool would be  billion.  But Morgan Stanley’s liquidity depended critically on borrowing from two Fed pro- grams,  billion from the PDCF and  billion from the TSLF. Goldman Sachs’s liquidity pool had recovered to about  billion, backed by . billion from the PDCF and  billion from the TSLF. OVERTHE COUNTER DERIVATIVES: “A GRINDING HALT ” Trading in the over-the-counter derivatives markets had been declining as investors grew more concerned about counterparty risk and as hedge funds and other market participants reduced their positions or exited. Activity in many of these markets slowed to a crawl; in some cases, there was no market at all—no trades whatsoever. A sharp and unprecedented contraction of the market occurred.  “The OTC derivatives markets came to a grinding halt, jeopardizing the viability of every participant regardless of their direct exposure to subprime mortgage-backed securities,” the hedge fund manager Michael Masters told the FCIC.  “Furthermore, when the OTC derivatives markets collapsed, participants reacted by liquidating their positions in other assets those swaps were designed to hedge.” This market was unregulated and largely opaque, with no public reporting requirements and little or no price discovery. With the Lehman bankruptcy, participants in the market became concerned about the exposures and creditworthiness of their counterparties and the value of their contracts. That uncertainly caused an abrupt retreat from the market. Badly hit was the market for derivatives based on nonprime mortgages. Firms had come to rely on the prices of derivatives contracts reflected in the ABX indices to value their nonprime mortgage assets. The ABX.HE.BBB- -, whose decline in  had been an early bellwether for the market crisis, had been trading around  cents on the dollar since May. But trading on this index had become so thin, falling from an average of about  transactions per week from January  to September  to fewer than  transactions per week in October , that index values weren’t informative.  So, what was a valid price for these assets? Price discovery was a guessing game, even more than it had been under normal market conditions. The contraction of the OTC derivatives market had implications beyond the valu- ation of mortgage securities. Derivatives had been used to manage all manner of risk—the risk that currency exchange rates would fluctuate, the risk that interest rates would change, the risk that asset prices would move. Efficiently managing these risks in derivatives markets required liquidity so that positions could be adjusted daily and at little cost. But in the fall of , everyone wanted to reduce exposure to everyone else. There was a rush for the exits as participants worked to get out of existing trades. And because everyone was worried about the risk inherent in the next trade, there often was no next trade—and volume fell further. The result was a vicious circle of justifiable caution and inaction. CHRG-111hhrg55814--135 Secretary Geithner," What you have is the authority to wind them down, to separate the bad from the good. To sell the good businesses, to put them out of existence in a way that doesn't cause catastrophic damage to the economy. And if in that process, the taxpayer is exposed to any losses, then we propose to recoup those losses, as we do now for banks and thrifts, by imposing a fee on banks-- Ms. Waters. Okay. I think I have the answer. You're not asking for any monetary bailout authority, as you do the resolving of any of these systemically significant institutions. That's what you're saying. " CHRG-111hhrg56776--276 Mr. Kashyap," Many more regulatory problems, I mean, the banks ate their own cooking. You have to remember the most financially sophisticated banks ended up sitting on these AAA sub-prime securities that ended up coming back to haunt them. And I think if we had somebody looking out across the system seeing those concentrations of risks and being able to adjust things like loan to value ratios in the housing market and also haircuts and margins on those securities, you would not have the deleveraging that I think was so dangerous. " CHRG-111hhrg53238--17 Mr. Scott," Thank you, Mr. Chairman, and thank you for this hearing. This is an important hearing. As I have often said, the banking industry is the heart of our financial system, and through it, everything flows. We have so much on our plate as we deal with the President's regulatory reforms: the new financial oversight agency, the Consumer Financial Protection Agency; the Federal Reserve and its role as systemic regulator; the creation of a council of regulators; the FDIC's role; the merger of the Office of Thrift Supervision into the OCC; title rules on banks that package and sell securities backed by mortgages and other debt; proposals that companies issuing their mortgages retain at least 5 percent on their books; and the requirement that hedge funds and private equity funds register with the SEC and open their books to regulation. We have a lot on our plate to deal with in this regulatory reform. And on top of that, how do we make this work with our State, our Federal, and international regulators, all in our efforts to ensure the stability of the financial services sector and protection of the financial consumer? What a challenge we have. It is the banking community that is at the heart of it, and this is why this hearing is so vital and so important. Thank you, Mr. Chairman. " CHRG-111shrg53085--34 MANAGER, CONSUMERS UNION OF UNITED STATES, INC. Ms. Hillebrand. Thank you, Mr. Chairman, Ranking Member Shelby, and Senators. I am Gail Hillebrand, Financial Services Campaign Manager for Consumers Union. You know us as the nonprofit publisher of Consumer Reports magazine, and we also work on consumer advocacy. I am happy to be here today to discuss how we are going to fix what is broken in our bank regulatory structure. Americans are feeling the pain of the failures in the financial markets. We are worried about whether our employers will get credit so that they can keep us in our jobs. Many households have lost home equity because someone else pumped up housing values by loaning money to people who could not afford to pay it back and made loans that no sensible lender would have made if they were lending their own money rather than putting the money out, taking the fee, and passing on the risk. We also have pain in households because of the abrupt increases in credit card interest rates. We have to start with consumer protection because the spark that caused our meltdown was a lack of consumer protection in mortgages. I am not going to talk generally about credit reform, but it will not be enough if we do stronger regulation and systemic risk regulation and we do not also do real credit reform. That would be like replacing all the pipes in your house and then letting poison water run through those pipes. We are going to have to deal with credit reform. We have two structural recommendations in consumer protection. The first one is for better Federal standards, and the second one is to acknowledge that the Federal Government cannot do it all and to let the States come back into consumer protection in enforcement and in the development of standards. We do not have one Federal banking agency whose sole job is protecting the financial services consumer, and we believe that the Financial Product Safety Commission will serve that role. It does not involve moving oversight of securities. That would stay where it is. But for credit, deposit accounts, and these new payment products, the Financial Product Safety Commission could set basic rules, and then the States could go further. Consumers know we have to pay for financial products, but we want to get rid of the tricks, the traps, and the ``gotcha's'' that make it very hard to evaluate the product and that make the price of the product change after we buy it. Our second structural recommendation in consumer protection is for Congress to recognize that the Feds cannot do it all and to bring States back into consumer protection in financial services regardless of the nature of the charter held by the financial institution. We have 50 State Attorneys General. That is a powerful army for enforcement of both State and Federal standards, and we have State legislatures who often will hear about a problem when it is developing in one corner of the country or one segment of consumers, before it is big enough to come to the attention of unelected bank regulators, and even before it is big enough to come to your attention. At the very time that States were beginning to try to address subprime lending by legislation in the early 2000s, the OCC was actively issuing interpretations in 2003, and then in 2004 a rule that said to national banks, ``You are exempt from whatever consumer protections States want to apply in the credit markets.'' We have to get rid of that form of Federal preemption; including the OCC preemption rule. Congress needs to clarify that the National Bank Act really just means ``do not discriminate against national banks,'' but not give them a free pass to do whatever they like in your State; and to eliminate the field preemption for thrifts in the Homeowners Loan Act. Those are going to have to go. We have already tried the system where Feds regulated Federal institutions and States regulated State institutions, and it did not work partly because these institutions are competing in the same market, and a State legislature cannot regulate just some of the players in the market. Turning to systemic risk, we do believe the most important step is to close all the regulatory gaps and to strengthen both the powers and the attitudes--the skepticism, if you will--of the direct prudential regulators. Every gap is a vulnerability for the whole system, as we have learned the hard way, and more attention needs to be paid to risk. We agree with many others who have said we need an orderly resolution process for nondepository institutions. There should be clear rules on who is going to get paid and who is not going to get paid. These institutions should pay an insurance premium in some way to pay for that program themselves. We do agree there will be a need for a systemic risk regulator. No matter who gets that job, it must involve a responsible and phased transition to get rid of ``too big to fail.'' Either regulation has to make these complex institutions too strong to fail, or if private capital does not want to put their money in these complex institutions, then we have to phase them into smaller institutions that do not threaten our system. In closing, we have got to get the taxpayer out of the systemic risk equation, and we have got to put consumer protection back into the center of bank regulation. Thank you. " FOMC20080916meeting--22 20,MR. KOHN.," Just to note that we did have a discussion of foreign exchange swaps in the Committee on the Global Financial System a week and a half ago, and the general consensus was that these had been very handy in damping pressures in money markets--dollar funding markets in particular--when the foreign exchange swap market isn't working very well in Europe and in Switzerland. The central banks around the table, which are all the major central banks, are quite supportive of expanding the facility. We were talking about putting something on a standby basis for use in situations just like this. So the other central banks view this as very helpful to them in containing pressures in their own markets. " FOMC20071211meeting--68 66,VICE CHAIRMAN GEITHNER.," May I ask one follow-up question? In the note for the Board that you circulated on Monday, Dave, you said that the magnitude of the credit crunch you’re contemplating is roughly comparable to the unusual weakness of private spending seen during the headwinds episode of the early 1990s. So I was curious. It is sort of interesting because you think that capital at banks going into this period is much stronger than going into the 1990–91 period. Corporate balance sheets, based just on the crude leverage ratios, are much healthier today than they were then. On the other hand, banks are a smaller share of the financial system, and you could say that the nonbank part looks kind of weak. The FHLB is growing very dramatically, taking up a fair amount of the room left by the shrinking of the nonbank sector. I don’t know. GSEs have less room to grow. It’s sort of mixed. It’s complicated. I was curious about how you thought about the comparison. You didn’t seem to like the comparison." CHRG-111hhrg48873--231 Mr. Castle," Mr. Bernanke, you indicated in your opening about some of the pure lessons. There is an urgent need for systemic regulation on nonbanks. And I am not sure exactly what you meant by that, but I think of investment banks and hedge funds and private equity insurance companies, and maybe people like Warren Buffett, for all that matters, and maybe other corporations. But exactly what did you mean by that in terms of the kind of regulation that could be imposed? Some of these are unregulated entities altogether at this point. So if we were to have a systemic regulator, what should we be doing in that capacity? " CHRG-111shrg50814--206 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. The Federal Reserve announced the creation of a $200 billion Term Asset-Backed Securities Loan Facility in November 2008. Just 2 weeks ago, the Federal Reserve in conjunction with the Treasury Department, announced the expansion of the program to up to $1 trillion and the possible expansion of eligible collateral. Given that we have not yet seen the first part of the program be an operational success, why did the Federal Reserve feel that it was necessary to announce an expansion of both volume and scope? Why should we be convinced that this program is the most effective mechanism to unthaw securitization markets? Do we have a true understanding of why investors have pulled away to the degree they have? And if we don't know the reason, then how can we expect to design an appropriate remedy?A.1. The Term Asset-Backed Securities Loan Facility (TALF) was initially announced on November 25, 2008. In its initial stage, eligible collateral for TALF loans included AAA-rated newly issued asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, and Small Business Administration (SBA) guaranteed loan. The first TALF operation took place on March 17, 2009. The 4 months between announcement and operation reflected in part the time necessary to design the operational infrastructure of the program, but during that period the Federal Reserve also consulted with investors, issuers, and rating agencies about the asset classes included as eligible collateral as we developed the specific terms and conditions for the program. The initial set of eligible collateral was chosen with a view toward increasing the availability of credit to small businesses and households. The initial $200 billion ceiling for the program reflected our estimate of the likely activity with the approved collateral list over the announced period of operation--through December 31, 2009. The dysfunction in the asset-backed securities markets has had adverse effects on credit markets other than those for consumer and small business credit. For example, secondary markets for securities backed by commercial and nonconforming residential mortgages have been experiencing severe strain, and the availability of other certain types of business credit that has often been securitized in the past has diminished greatly. The announced expansion of the program is intended to facilitate issuance of securities backed by loans to those other sectors. We recognized that in order to accommodate the potential lending against the broader set of collateral, an increase in the overall size of the facility could be necessary. The announcement of the expansion preceded the first initial operation because of the urgency of encouraging lending to these other sectors. Our announcement that consideration was being given to expanding the facility likely provided some additional support, at the margin, for the residential and commercial mortgage-backed securities markets. Also, given the considerable lead time that it takes to develop terms and conditions for each asset class that both encourage ABS issuance and protect the taxpayer, it was important to announce the possible expansions as quickly as possible. The abrupt decline in new issuance of ABS reflected in large part two developments. First, the availability of leverage to ABS investors has contracted significantly because of the balance-sheet constraints now being faced by many major banking firms. Second, many traditional investors in AAA tranches of ABS have exited the market because of concern about the possibility of a severe recession and a sharp rise in defaults on loans to business and households. The TALF provides leverage to encourage new investors to purchase ABS. In addition, because the loans are provided on a non-recourse basis, the facility limits the potential losses of the investors to the amount by which the value of the ABS financed by the TALF loan exceeded the loan amount (the haircut). Although those haircuts have been chosen to reduce to only negligible levels the odds that the government will incur a loss on the facility overall, the program provides a degree of downside protection for investors on each asset financed.Q.2. According to information already released, the Term Asset-Backed Securities Lending Facility (TALF) will only accept newly originated assets and would require the credit rating agencies to rate the underlying securities. This system seems to attempt to mirror the general structure of the securitization market. There is concern, however, that the same credit rating agencies who were responsible for placing a ``AAA'' rating on now toxic structured products will be relied on once again to rate these securities. What steps is the Federal Reserve taking to ensure that underlying assets are appropriately underwritten? Is the Fed prepared to dictate the terms to ensure that these loans, at minimum, comply with federal underwriting guidelines?A.2. The Federal Reserve has discussed with the rating agencies the methodologies that they follow to rate the ABS accepted as collateral at the program. In general, rating agencies have taken steps that have led to tighter underwriting standards and stricter ratings criteria. In addition, the Federal Reserve requires that each ABS issuer hire an external auditor that must provide an opinion, using examination standards, that management's assertions concerning key collateral eligibility requirements are fairly stated in all material respect. TALF investors also serve an important ongoing role in price discovery and assessing risk through their ability to demand greater credit enhancements or price concessions. In particular, the sale of securities through TALF in an arms-length transaction is an independent check not only on the underwriting practices of the issuer, but also of the efficacy of rating agency methodologies. There are no Federal underwriting standards for the loans backing the collateral accepted at the TALF. The TALF does not currently accept collateral backed by home mortgages. If residential mortgage-backed securities were to become eligible collateral for the TALF, we would require that the loans backing the securities comply with Federal underwriting standards.Q.3. Your testimony notes that the United States has no well-specified set of rules for dealing with the potential failure of a systemically critical non-depository financial institution. I would agree that we need to address the too-big-to-fail issue, both for banks and other financial institutions. You have suggested the need for a resolution regime that allows the government to have a pre-defined process for resolving a non-bank financial firm that is systemically critical. Are you suggesting that non-bank financial firms must be dealt with in a manner other than changes to the bankruptcy process; that is, do we have to go to a receiver-like approach similar to FDIC? If so, how do we deal with the moral hazard implications? If not, what are other tools we could look at to address the current lack of resolution regime?A.3. Although the Bankruptcy Code works well in the vast majority of situations, it is not designed to mitigate systemic consequences and, in some cases, the bankruptcy process may exacerbate the shocks to the financial system that may result from the failure of a systemically important nonbank financial institution. For example, the delays in the bankruptcy process that are designed to give the debtor ``breathing room'' to develop and propose a reorganization plan can be especially harmful to financial firms because uncertainty with respect to any large financial firm can have negative consequences for financial markets which are compounded as the uncertainty persists. In addition, the bankruptcy process does not currently provide a clear mechanism for the government to ensure that the institution is resolved in a way that achieves financial market stability and limits costs to taxpayers. Congress has in the past established alternative resolution regimes outside of the Bankruptcy Code for financial institutions where the public has a strong interest in managing and ensuring an orderly resolution process, such as in the Federal Deposit Insurance Act for insured depository institutions and in the Housing and Economic Recovery Act for government-sponsored enterprises. As I have indicated, these frameworks can serve as a useful model for developing a framework for the resolution of systemically important nonbank financial institutions. The issue of moral hazard is an extremely important consideration in developing any such regime for resolving systemically important nonbank financial institutions. Any proposed regime must carefully balance the need for swift and comprehensive government action to avoid systemic risk against the need to avoid creating moral hazard on the part of the large institutions that would be subject to the regime. A proposed regime could require a very high standard for invoking the resolution authority, because of the potential cost and to mitigate moral hazard. The process to invoke the authority could also include appropriate checks and balances, including input from multiple parts of the government, to ensure that it is invoked only when necessary while still maintaining the ability to act swiftly when needed to minimize systemic risk. The systemic risk exception to the least-cost resolution requirements of the Federal Deposit Insurance Act could provide a good example of the embodiment of such a process in existing law. Importantly, the establishment of a new resolution process for systemically important nonbank financial institutions may help reduce moral hazard by providing the government with the tools needed to resolve even the largest financial institutions in a way that both addresses systemic risks and allows the government to impose haircuts on creditors in appropriate circumstances. While a new framework for systemically important nonbank financial institutions is a critical component of any agenda to address systemic risk and the too-big-to-fail problem, other steps also need to be taken to address these issues. These include ensuring that all systemically important nonbank financial institutions are subject to a robust framework for consolidated supervision; strengthening the financial infrastructure; and providing the Federal Reserve explicit authority to oversee systemically important payment, clearing and settlement systems for prudential purposes.Q.4. The Obama administration, along with several of my colleagues here in the Senate, have proposed allowing bankruptcy judges to cramdown the value of mortgages to reflect declines in home prices. The Federal Reserve, primarily through its purchases of GSE MBS, is becoming one of the largest holders of residential MBS. Has the Federal Reserve estimated the size of potential losses to the Fed's MBS holdings, if judges were allowed to cramdown mortgages? What signal do you believe this sends to potential investors in MBS, were Congress to re-write the contractual environment underlying these mortgages?A.4. As noted by your question, the vast majority of mortgage-backed securities (MBS) held by the Federal Reserve are agency MBS. The payment of principal and interest on agency MBS is guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. Bankruptcy cramdowns do not affect investors in MBS guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae because the agency MBS investors would be made whole by the government-sponsored enterprises. Thus, the Federal Reserve holdings of agency MBS would not be affected by bankruptcy cramdowns for mortgages, although such legislation might have negative consequences for Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA). (The FHA insures the mortgages securitized by Ginnie Mae.) Private-label MBS are governed by trust agreements. Some private-label MBS contain so-called ``bankruptcy carve-out'' provisions requiring that losses stemming from bankruptcies be shared across the different tranches of the securities. The implication is that the investors holding the AAA-rated tranches would bear some of the losses from these principal write-downs, depending on the nature of the trusts agreements. The Federal Reserve has made loans to support its Maiden Lane Facilities, which were used to offset the systemic risks associated with recent financial market disruptions. Among the collateral for these loans are AAA-rated tranches of private-label securities, as well as some collateralized debt obligations (CDOs) that are backed by AAA-rated tranches of private-label securities. At present, our assessment is that the possible loss associated with these MBS holdings from possible bankruptcy cramdown legislation is relatively small. With respect to current mortgage borrowers, providing bankruptcy judges with the ability to adjust mortgage terms and reduce outstanding principal could potentially result in more sustainable mortgage obligations for some borrowers and thus help reduce preventable foreclosures. Such an approach has several advantages. In particular, because of the costs and stigma of filing for bankruptcy, mortgage borrowers who do not need help may be unlikely to turn to the bankruptcy system for relief. In addition, bankruptcy judges may also be able to assess the extent to which a borrower truly needs assistance. Moreover, because the bankruptcy system is already in place, this approach could be implemented with little financial outlay from the taxpayer. Whether mortgage cramdowns are advantageous in the long-run is less clear. Such cramdowns could potentially restrict access to mortgage credit for some borrowers, and might have implications for investors in other types of loans because of the change in the loan's relative status during the course of bankruptcy. Potential investors, either in private-label MBS investors or in other types of loans, might view these changes in the bankruptcy code as raising the costs associated with servicing defaulted borrowers in the future if investors perceived such changes as permanent and broad-ranging, or if these changes altered investors' expectations about the government's willingness to make similar changes in the future. In this case, mortgage cramdowns might have longer-lasting effects on credit availability, and possibly impose higher costs on future borrowers through higher interest rates and more stringent lending standards.Q.5. In a recent speech, you stated that the Fed's new longer-term projections of inflation should be interpreted as the rate of inflation that FOMC participants believe will promote maximum sustainable employment and reasonable price stability. Some commentators have said that central banks using a long-term inflation target should incorporate the adverse consequences of asset-price bubbles in their deliberations. Does the FOMC presently incorporate the possibility of asset price bubbles during deliberations on the inflation target? Did the FOMC include asset price bubbles in past deliberations?A.5. Conditions in financial markets, including the possibility that asset prices exceed fundamental values, are always discussed at FOMC meetings. High asset values tend to put upward pressure on economic activity and the broader price level. In order to achieve its mandated objectives, the FOMC may need to tighten policy when this pressure threatens to push inflation above desired levels. However, it is exceedingly difficult to judge in real time whether asset prices are deviating from their fundamental values. Indeed, if such a judgment were easy, bubbles would never happen. However, regardless of whether a bubble exists or not, the FOMC does factor in the effects of asset prices on the economy when it sets monetary policy. Generally speaking, this means that interest rates tend to rise when asset prices are increasing to offset the inflationary impact of high asset prices and that interest rates tend to fall after bubbles burst to offset the contractionary effects of falling asset prices on employment.Q.6. I have some concerns about the pro-cyclicality 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 to not 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 the Federal Reserve would take a position on the merits of counter cyclical regulatory policy?A.6. The Federal Reserve has long advocated the need for banks to maintain sufficient levels of capital so they can weather unexpected shocks without interrupting the provision of credit and other financial services to customers. Historically, the challenge has been translating this broad principle into regulatory and supervisory standards that are workable, balanced, and compatible with a level, competitive playing field, both domestically and internationally. Capital is a relatively costly source of funding for banks, and higher capital requirements for banks will tend to raise their costs relative to those of competitors. Against this cost, there is a need to balance the benefits of higher capital in terms of lower risk to the safety net and enhanced financial and economic stability. However, these benefits are more uncertain and difficult to quantify. Likewise, while most would agree that a bank should maintain capital commensurate with its underlying risk taking, the quantification of risk is imprecise and inherently subjective. There is also uncertainty regarding how financial markets would react to changes in the capital framework and, in particular, whether higher capital buffers accumulated in good times would simply result in higher de facto minimum standards during downturns. In the past, it has been difficult reaching agreement on major changes to the bank capital framework, reflecting different views on how best to deal with these uncertainties (e.g., Pillar 1 versus Pillar 2 versus Pillar 3; hardwired formulas versus discretion; simple rules-of-thumb versus sophisticated risk models). Nevertheless, an international consensus appears to be emerging that the bank regulatory capital framework needs to be made more counter-cyclical, and such an initiative is currently being undertaken by the Basel Committee on Banking Supervision and Regulation. The Federal Reserve strongly supports and is actively involved in this initiative. While this effort faces many of the same challenges noted above, there is now greater appreciation of both the importance of promoting more counter-cyclical capital policies at banks and, we believe, the need to find a workable way forward on this issue. The Federal Reserve also supports initiatives currently under way at the Financial Accounting Standards Board and the International Accounting Standards Board (consistent with the recommendations of the Financial Stability Forum, now Financial Stability Board) to consider improvements to loan loss provisioning standards. These improvements would consider a broader range of credit quality information over the economic cycle to recognize losses earlier in the cycle. Similar to the requirements for capital buffers, the requirements for provisions would need to be set at a practical level and calculated in a readily transparent manner. Ideally, the requirement would need to be applied internationally to have the desired effect. In addition, enhancements to the income tax code to allow greater deductibility of provisions in line with the accounting treatment would also aid in this effort. ------ CHRG-111hhrg54872--22 Mr. Garrett," Thank you, Mr. Chairman, and the ranking member, for holding this important hearing today. Last week, the chairman circulated a new discussion draft of legislation to create a whole new Federal agency to oversee all individuals in their financial decisions. Now, there are some new provisions in this draft that seek to clarify what products and what agencies and entities are covered. Most changes really are pretty much cosmetic and little more than attempts to make it a little bit more politically palatable for some of the concerned Members of the other party to pass it. This legislation still separates consumer protection from safety and soundness regulation, much like Fannie Mae and Freddie Mac did. And we all know how that turned out. This legislation still creates an uber regulator with essentially no bounds or limits on authority. This legislation still limits consumer choices and reduces consumer credit. And this legislation still does absolutely nothing to address the problems that caused our financial collapse. So this legislation really hasn't changed that much, and my opinion of it really hasn't changed that much either. It is simply another example of something taxpayers can't afford, simply another example of government overreach, simply another example of increasing the power of the Federal bureaucrats at the expense of the individuals. It is also really another example of the Federal Reserve being held out as a personal piggybank, if you will, of the current powers that be in Washington, D.C. So maybe to some, the idea of creating a whole new entity in the Federal bureaucracy, with dubious benefits to society, sounds like a political winner, but it is clear that the more people concentrate on the consequences of that idea, the less likely it will be. We really must not push through a bad idea that will limit consumer choice and credit availability and encourage and increase costly and unnecessary litigation and potentially decrease the safety and soundness of our very basic banking system in this country. Thank you, Mr. Chairman. With that, I yield back. " CHRG-111hhrg53234--164 Mr. Meltzer," Thank you, Chairman Watt. And greetings to my old friend, Congressman Ron Paul, and to the members. Thank you for the opportunity to present my appraisal of the Administration's proposal for regulatory changes. I will confine most of my comments to the role of the Federal Reserve as a systemic regulator, and will offer an alternative proposal much closer to the Republican proposal. I share the belief that change is needed and long delayed, but appropriate change must protect the public, not the bankers. During much of the past 15 years, I have written three volumes entitled, ``A History of the Federal Reserve.'' Working with two assistants, we have read virtually all of the of the minutes of the Board of Governors, the Federal Open Market Committee, and the Directors of the New York Federal Reserve Bank. We have also read many of the staff papers and the internal memos supporting decisions. I speak from that perspective. Two findings are very relevant for the role of the Federal Reserve. First, I do not know of any single clear example in which the Federal Reserve acted in advance to head off a crisis or a series of banking and financial failures. We all know of several where it failed to act in advance. Members of Congress should ask themselves this question: Can you expect the Federal Reserve or anyone else as systemic regulators to close Fannie Mae and Freddie Mac after Congress has decided that it declined to act? What kind of a conflict is that going to pose? And how is it going to be resolved? Second, in its 96-year history, the Federal Reserve has never announced a lender of last resort policy. It has discussed internally the content of such a policy several times, but it rarely announced what it would do. And the announcements that it made, as in 1987, were limited to the circumstances of that time. Announcing and following a policy would alert financial institutions to the Fed's expected actions and might reduce pressures on Congress to aid failing entities. Following the rule in a crisis, the lender-of-last-resort rule in a crisis would change bankers' incentives and reduce moral hazard. A crisis policy rule is long overdue. The Administration proposal recognizes the need, but doesn't propose the rule. Experiences in the past from the history suggest three main lessons: First, we cannot avoid banking failures, but we can keep them from spreading and creating crises; Second, neither the Federal Reserve nor any other Agency has succeeded in predicting crises or anticipating systemic failure. It is hard to do, in part because systemic risk is not well defined. Reasonable people will differ, and since much is often at stake, some will fight hard to deny that there is a systemic risk. One of the main reasons that Congress in 1991 passed FDICIA, the Federal Deposit Insurance Corporation Improvement Act, was to prevent the Federal Reserve from delaying closure of failing banks, increasing losses, and weakening the FDIC fund. The Federal Reserve and the FDIC have not used FDICIA against large banks in this crisis. That should change. The third lesson is that a successful policy will alter bankers' incentives and avoid moral hazard. Bankers must know that risk-taking brings both rewards and costs, including failure, loss of managerial position and equity, followed by sale of continuing operations. Several reforms are needed to reduce or eliminate the cost of financial failure to the taxpayers. Members of Congress should ask themselves and each other, is the banker or the regulator more likely to know about the risks on the bank's balance sheet? Of course, it is the banker, and especially so if the banker is taking large risks that he wants to hide. To me, that means the reform should start by increasing the banker's responsibility for losses. The Administration proposal does the opposite, by making the Federal Reserve responsible for systemic risk. Systemic risk is a term of art; I doubt that it can be defined in a way that satisfies the many parties involved in regulation. Members of Congress will properly urge that any large failure in their district is systemic. Administrations and regulators will have other objectives. Without a clear definition, the proposal will bring frequent controversy, and without a clear definition, the proposal is incomplete. Resolving the conflicting interests is unlikely to protect the general public. More likely, regulators will claim that they protect the public by protecting the banks. I think that is wrong. I believe there are better alternatives than the Administration's proposal. First step, end ``too big to fail.'' Require all financial institutions to increase capital more than in proportion to the increase in the size of their assets. ``Too big to fail'' is perverse; it allows banks to profit in good times and shifts the losses to the taxpayers when crises or failures occur. Second step, require the Federal Reserve to announce a rule for ``lender of last resort.'' Congress should adopt a rule that they are willing to sustain. The rule should give banks an incentive to hold collateral to be used in a crisis period. Bagehot's Rule from the 19th Century Bank of England is a great place to start. Third step, recognize that regulation is an ineffective way to change behavior. My first rule of regulation states that lawyers regulate, but markets circumvent burdensome regulation. The Basel Accord is a current example. It told banks to hold more reserves if they held more risky assets. So they put the assets off their balance sheets. Later, after the fact, they had to take them back, but that was after the fact. Fourth step, recognize that regulators do not allow for the incentives induced by their regulations. In the dynamic financial markets, it is difficult, perhaps impossible, to anticipate how clever market participants will circumvent the rules without violating them. The fifth step, either extend FDICIA to include holding companies or subject financial holding companies to bankruptcy law. Make the holding company subject to early intervention either under FDICIA or under bankruptcy law. That not only reduces or eliminates taxpayer losses, but it also encourages prudential behavior. Other important changes should be made. Congress should close Fannie Mae and Freddie Mac and put any subsidy for low-income housing on the budget. The same should be done to other credit market subsidies. The budget is the proper place for subsidies. Three principles should be borne in mind: First, banks borrow short and lend long. Unanticipated large changes can and will cause failures. Our problem is to minimize the costs of failures to society. Second, remember that capitalism without failure is like religion without sin. It removes incentives for prudent behavior. Third, those that rely on regulation to reduce risks should recall that this is the age of Madoff. The Fed, too, lacks a record of success in managing large risks to the financial system, the economy, and the public. Incentives for fraud, evasion, and circumvention of regulation often have been more powerful than incentives to enforce regulation that protects the public. Thank you, sir. [The prepared statement of Dr. Meltzer can be found on page 71 of the appendix.] " CHRG-111shrg53085--36 Mr. Whalen," Well, I am kind of old fashioned. I start with the U.S. Constitution, and in the Constitution, it told the Congress you will have Federal Bankruptcy Courts, and in the 18th century, that basically meant that bankruptcy was remote from politics. Over the last two centuries, we have politicized insolvency. In the 1930s, we had the Federal Deposit Insurance Act, which is, if you think about it, an extra chapter of bankruptcy, special to deal with financial depositories. But at the end of the day, we have the mechanisms today to deal with these issues. We just don't have the political will. And you hear excuses coming from various quarters that say, oh, you can't resolve these big entities. They have complex financial relationships with other entities, dah, dah, dah, dah, dah. Well, if that is the case, then private property is gone. We have socialized our entire society and we might as well just dispense with it, nationalize the banks, and get on with ordering them in an efficient manner in a socialist sense. But that is not American. Americans are meant to be impractical because the Founders knew that inefficiency is a good thing. So how do we, on the one hand, keep our efficient market, keep markets disciplined, but don't destroy ourselves, and I think it comes back to limiting the activities and the behavior of the institutions. Don't think about systemic risk as a separate entity. It grows out of the activities of the institutions. And I will tell you honestly that our work, we did a lot of research on the profitability of banks, on the behavior of banks, their business model characteristics. The larger banks are not very profitable. I mean, they are almost utilities now. So what was the answer by the Fed? Let us take more risk. The Fed wants to keep their constituents profitable, healthy, liquid. They would push them up the risk curve in terms of trading activities, over-the-counter derivatives, what have you. But then you look at the little bank that has 80 percent assets and loans and they are more profitable. In fact, on a risk-adjusted basis, they are three times more profitable than a big bank. So what I am saying to you is that if you want to fix systemic, look at the particular. " CHRG-110hhrg45625--105 Secretary Paulson," I agree with that, and again to your free market; we let a system grow up where it is out of balance. For markets to work, you need regulation, but you also need market discipline. Institutions need to be able to fail. Too big to fail is a serious problem. But we can't deal with this until we, as the Chairman said, put out the fire, and then there are authorities we need that we don't have, there are problems that need to be cleaned up, there are wind-down authorities and ways to let institutions with Federal deposit insurance to protect the depositors and wind down banks, without causing the havoc that you have with non-bank financial institutions that go through bankruptcy. There are huge issues that need to be dealt with to get the system back in balance. It is going to take years to have that happen, but it can happen. We can learn from the lessons. But first we need to deal with the consequences of the past and stabilize the financial markets. " CHRG-111shrg55278--34 Mr. Tarullo," I think that is a very good point, and so I think the question for you will be: In the architecture that you all may choose to legislate, do you provide that somewhere there is going to be a residual or default authority to address the unanticipated? Senator Tester. OK. Chairman Bair, the Administration proposes factoring in a firm's size and leverage and the impact its failure would have on the financial system and the economy when determining if a firm is systemically important. It is kind of a two-edged sword once again, but if the firm size is--and the metrics are developed around that--and we can talk about what those metrics might be, and we might if we have time. But wouldn't that provide--from a safety standpoint, wouldn't that provide a competitive advantage for those bigger banks versus the community banks if, in fact, their size and leverage determined them to be--they cannot fail, so we are going to make sure that they do not through the regulation? Ms. Bair. Well, we think any designation of ``systemic'' should be a bad thing, not a good thing. That is one of the reasons why we suggest there should be a special resolution regime to resolve large, interconnected firms. It is the same as the regime that applies to small banks. Also, they should have to pay assessments to prefund a reserve that could provide working capital if they have to be resolved. We are not sure you need a special Tier 1 category. We think the assessment, for instance, could apply to any firm that could be systemic, perhaps based on some dollar threshold or some other criteria that could be used as a means of the first cut of who should pay the assessment. But you are right, if you have any kind of systemic determination, without a robust resolution authority--and, again, we think assessments for a prefunded reserve would be helpful as well--it is going to be viewed as a reward. It is going to reinforce ``too-big-to-fail,'' not end it, and you want to end it. Senator Tester. So I am not tracking as a consumer. How would you stop it from being a reward and not---- Ms. Bair. You would need a resolution mechanism that works. So if they become nonviable, if they could not exist without Government support, the Government would not support them. They would close them. They would impose losses on their shareholders and creditors. The management would be gone, and they would be sold off. That is what we do with---- Senator Tester. So too big---- Ms. Bair. ----smaller banks. Senator Tester. Excuse me, but ``too-big-to-fail'' would go away? Ms. Bair. Well, I hope so. I certainly hope so. I think that should be the policy goal. Right now it was a doctrine that fed into lax market discipline that contributed to this crisis. I think the problem is even worse now because, lacking an adequate resolution mechanism, we have had to step in and provide a lot of open bank assistance. Senator Tester. And I have heard from other participants, and I would just like to get your perspective. They would go away by increased regulation---- Ms. Bair. No. I think ``too-big-to-fail'' would be addressed by increased supervision combined with increased market discipline, which we think you can get through a resolution mechanism. Senator Tester. Thank you. Thank you very much. Senator Johnson. Senator Johanns. Senator Johanns. Let me just say this has been just a very, very interesting discussion. I appreciate you being here. I will tell you what I said a few weeks back, maybe a couple months back. I tend to favor the council. The idea of the Federal Reserve I think is just fraught with a lot of problems, so at least today that is where I am thinking about this. But the discussion today has really raised, I think--in my mind at least--some very important fundamental questions. It seems to me if you have a council, Chairman Bair, I would tend to agree with you that the council would designate who is classified as somebody who would fit within this. But that raises the issue: How broad is that power? Which probably brings us back to even a more fundamental question of what are we meaning by systemic risk. Is that an institution that is so entangled with the overall economy that if they go down, it could literally shake the economy or bring the economy down? Is that what we are thinking about here? Ms. Bair. I think you are, and I think it should be a very high standard. I also believe through more robust regulation, higher standards for large, complex entities, a robust resolution mechanism, as well as an assessment mechanism, that you will provide disincentives for institutions to become that large and complex as opposed to now where all the incentives are to become so big that they can basically blackmail us because of a disorderly resolution. This is one of the things that we lack, a statutory scheme that allows the Government the powers it needs to provide a resolution on an orderly basis. It rewards them for being very large and complex. Senator Johanns. So under that analysis, very, very clearly you could have a large banking operation fall within that. But you could also have a very large insurance company fall within that. Ms. Bair. You could. That is right. Senator Johanns. You could have a very large power generating company fall within that. What if I somehow have the wealth and capital access to start buying power generation, and all of a sudden, someday you kind of look up and I own 60 percent of it. Now, that is a huge risk to the economy. If I go under, power generation is at risk. Is that what we are talking about? Ms. Bair. No. I think we are talking about financial intermediaries. There are things that need to be addressed with respect to financial intermediaries such as the reliance on short-term liabilities to fund themselves as well as the creditors, and the borrowers, who are dependent on financial intermediaries for continuing credit flows. So there are things that are different about financial intermediaries that make it more difficult to go through the standard bankruptcy process, which can be uncertain. You cannot plan for it. The Government cannot plan for it. They cannot control the timing for it, and it can be very protracted and take years. And the banking process is focused on maximizing returns for creditors as opposed to our resolution mechanism, which is designed to protect insured depositors, but also to make sure there is a seamless transition so there are no disruptions, especially for insured depositors, but also for borrowers. Through that process, through the combination of the supervisory process plus our legal authorities for resolution, we are able to plan for these failures and deal with them in advance. And I would assume that this would be the same situation you would have--as Senator Reed pointed out, with the Federal Reserve that virtually regulates almost every financial holding company already. Certainly if you do away with the thrift charter, that would be the case. I would also say that I really do not think a very large plain-vanilla property and casualty insurer would be systemic. I think AIG got into trouble because it deviated from its bread-and-butter property and casualty insurance and went into very high-risk, unregulated activities. But if you penalize institutions for being systemically significant, you will reinforce incentives to stick to your knitting, stick to more basic lower-risk activities as opposed to getting into the higher-risk endeavors that can create systemic risk for us all, as we have seen. Senator Johanns. Chairman Schapiro, do you agree with that? Ms. Schapiro. I do agree with that. I think if you have an adequate resolution mechanism that the marketplace understands will, in fact, be used, it can cancel out effectively the competitive advantage that might be perceived to exist for an institution that is systemically important and, therefore, the Government will not let it fail. If people understand in the marketplace the institutions will be unwound, they will be permitted to fail, then they should not have that competitive advantage that ``too-big-to-fail'' would give them. I also think that a council will be much better equipped to make an expert judgment across the many different types of financial institutions that we have in this country about which ones are systemically significant and important. Senator Johanns. Governor, what are your thoughts? " CHRG-111hhrg53245--108 Mrs. Maloney," Thank you, Mr. Chairman. I truly believe that our government was at its best following the 9/11 crisis, when we came together and created a bipartisan professional commission to study exactly what went wrong. They came forward with a professional report that sold more copies than Harry Potter. It pointed out 53 direct areas that they thought needed to be corrected. We then proceeded to react to their recommendations, and this Congress passed 47 of their recommendations. I do not believe that we were aware of what the true problems were until we got that report. I for one would like to see the report coming back from the bipartisan commission on what really caused this crisis, and their ideas of what we need to do to reform our system and to go through that process. We now have a blueprint that in many ways looks like the problems that we confronted. Many people say Fannie and Freddie with their implicit government guarantee caused many of the problems. What are we going to come back with? An implicit guarantee that tier one too-big-to-fail banks are going to be guaranteed. Therefore, everyone is going to want to do business with the guaranteed bank, and every bank is going to want to be a tier one in order to have that implicit guarantee that gives them an advantage in business, lower rates, more prestige. I am not so sure that is the direction we want to go in. Then the other idea is that we have a systemic risk regulator under the Federal Reserve. I would argue we have a systemic risk regulator now under the Federal Reserve. They have tremendous power to look anywhere they want. The prior Administration before Mr. Bernanke was criticized for never having taken a step on the subprime crisis, never coming forward with a directive, never pointing out what needed to be done. I am not so sure a systemic regulator, which is very much dependent on the ability and drive of the person in the position, is the exact answer to our problem. The only thing that we seem to totally agree on is that regulation failed, yet the regulation they are proposing is very similar to the regulation we already have right now. I would build on really a question the chairman brought up earlier, what happens when you disagree? When we have this council of regulators and they disagree, how do you come to the conclusion? Many people say Lehman brought down the stability of our financial sector in many ways. Where was the way to counter the decision of whomever made that decision? How would you agree with these councils? You have to have a specific way that you agree because you know they are going to disagree. I see it every day. There was tremendous disagreement recently over how to respond to other challenges in the private sector with various businesses that was played out in the press. My time has expired. " CHRG-110shrg50416--47 Mr. Kashkari," So the 125 seems like a lot for nine institutions, but those nine institutions have 50 percent of the deposits in the country. So it is the same proportion for the first nine and number 4,000. There is no preference, first of all. Second, again, this is a program, we want healthy institutions to use the capital. And we encourage the institutions to participate so that there would be no stigma. The healthy institutions who were in a strong position today can become even stronger and make even more loans. That is better for our system as a whole, Senator. Senator Shelby. But the Comptroller of the Currency, FDIC, the Federal Reserve--we have Governor Duke here--these are all regulators of the banking system. When one bank acquires another one, you have to get approval from the regulator. So you still have that whip in there to deal with any acquisition of any bank, either kind of suggested, forced, or voluntary, do you not? All of you. Is that fair, Chairman? Allowing firms to fail, Mr. Secretary, over the past year, Treasury, the Fed, and FDIC have devised a broad array of programs to help prevent the failure of various financial institutions, including banks, money market funds, broker-dealers, and insurance companies. To what extent have these programs propped up insolvent firms and prolonged the current economic crisis by delaying their inevitable failure? Because some firms are going to fail whatever you do to them. How long can we--the Government, the taxpayer--continue to prop up so many institutions? And at what point does it become more cost-effective to allow firms to fail? Chairman Bair, you have to do that from time to time, and you have. First, you. Ms. Bair. Well, we do, and it is always a difficult decision, and the primary federal regulator actually is one that makes the decision. We have back-up authority to close banks, but we almost always defer to the primary regulator. The primary regulator makes the decision. I think banks are a little different than other sectors of the financial services system. I think it needs to be repeated, reiterated that banks overall are very well capitalized. Yes, we have some banks with some challenges, but the vast majority are well capitalized. This is not a solvency crisis along the lines of what we saw during the S&L days. We are dealing with liquidity issues right now, and liquidity issues are harder. Sometimes the liquidity issue is the market signaling a longer-term capital solvency problem. But as the confidence problem has grown and grown, irrational fear has overtaken us somewhat. So we see institutions that otherwise are viable being threatened with closure because they cannot meet their obligations. So that is the balancing act we are trying to strike here. With the additional liquidity guarantees and the additional capital infusion, we are trying to keep banks, that are otherwise viable, healthy and lending and to prevent unnecessary closures because of liquidity drains for institutions that otherwise have plenty of capital. Senator Shelby. But there are still going to be plenty of failures out there---- Ms. Bair. There will be. Senator Shelby [continuing]. Whatever you do. Correct? Ms. Bair. And we agree with you, Senator. When it is there and it is clear, we want them closed early, because if we wait it will increase our resolution costs. We absolutely agree with that. Senator Shelby. Secretary Kashkari, as the Treasury moves assets from institutions by way of the TARP program, the participating institutions will have already taken out insurance on those assets in the form of credit default swaps. Will Treasury allow firms to retain the credit default swaps that they have used to hedge the securities that they sell to the Government? " CHRG-111shrg52619--210 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM GEORGE REYNOLDSQ.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. A separate consumer protection regulation regime would not recognize state law. State legislators and regulators are in the first and best position to identify trends and abusive practices. One regulator for consumer protection eliminates the dual oversight that is made possible by state and federal laws and regulations. It would also inhibit coordination and cooperation between regulators or worse, provide a gap in regulation and oversight by the state regulatory system. The Treasury Blueprint for a Modernized Financial Regulatory Structure, presented in March 2008, suggests the creation of a business conduct regulator to conduct regulation across all types of financial firms. The business conduct regulator would include key aspects of consumer protection, including rule writing for disclosures and business practices. This structure proposes to eliminate gaps in oversight and provide effective consumer and investor protections. The proposed business conduct regulator at the federal level would be separate and distinct from the suggested prudential regulator. NASCUS \1\ believes such a system would curtail, not enhance, consumer protections.--------------------------------------------------------------------------- \1\ NASCUS is the professional association of state credit union regulatory agencies that charter, examine and supervise the nation's 3,100 state-chartered credit unions. The NASCUS , mission is to enhance state credit union supervision and advocate for a safe and sound credit union system.--------------------------------------------------------------------------- The Treasury Blueprint would create a new federal bureaucracy, taking away most supervisory, enforcement and rule making authority from the states and federalizing those authorities in a new business conduct regulator. Much of the focus of attention of the OCC, OTS and NCUA has been on seeking preemption from state consumer protection laws. An example of this is the preemption efforts undertaken by these agencies regarding the Georgia Fair Lending Act (GFLA). It is vital that consumer protection statutes adopted at the state level apply consistently to all financial institutions 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?A.2. NASCUS members do not have regulatory oversight of AIG. The answers provided by NASCUS focus on issues related to our expertise regulating state credit unions and issues concerning the state credit union system.Q.3. Was there dialogue between the banking regulators and the state insurance regulators? What about the SEC?A.3. This question does not apply to state credit union regulators. The answers provided by NASCUS focus on issues related to our expertise regulating state credit unions and issues concerning the state credit union system.Q.4. 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.4. Credit unions did not and currently do not engage in credit default swap contracts to the best of our knowledge.Q.5. 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.5. Most credit unions supervised by state regulators have strong core liquidity funding in the form of member deposits. Unlike other financial institutions which use brokered funding, Internet deposit funding and other noncore funding, these practices are rare in credit unions. Many credit unions' liquidity position would be favorably impacted if they had access to supplemental capital. Supplemental capital would bolster the safety and soundness of credit unions and provide further stability in this unpredictable market. It would also provide an additional layer of protection to the NCUSIF thereby maintaining credit unions' independence from the federal government and taxpayers. Credit union access to supplemental capital is more important than ever given the impact of losses in the corporate system on federally insured natural-person credit unions. Stabilizing the corporate credit union system requires natural-person federally insured credit unions to write off their existing one percent deposit in the NCUSIF, as well as an assessment of a premium to return NCUSIF's equity ratio to 1.3 percent. Additionally, credit unions with capital investments in the retail corporate credit union could be forced to write-down as much as another $2 billion in corporate capital. This will impact the bottom line of many credit unions, and supplemental capital could have helped their financial position in addressing this issue. State regulators are committed to taking every feasible step to protect credit union safety and safety and soundness--we must afford the nation's credit unions with the opportunity to protect and grow liquidity as well as the tools to react to unusual market conditions. The NASCUS Board of Directors and NASCUS state regulators urge you to enact legislation allowing supplemental capital.Q.6. 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?A.6. While relatively few credit unions fall into the category of ``too big to fail,'' with the exception perhaps of some of the larger corporate credit unions, I believe as a general rule that if an institution is too big to fail, then perhaps it is also too large to exist. Perhaps the answer is to functionally separate and decouple the risk areas of a ``too big to fail'' organization so that a component area can have the market discipline of potential failure, without impairing the entire organization. Financial institutions backed by federal deposit insurance need to have increased expectations of risk control and risk management.Q.7. 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.7. Again this area has relatively little application to state-chartered credit unions. But the most effective message can be conveyed to the marketplace by clearly indicating that these riskier decoupled operations will not be supported by taxpayer resources and then following through by letting these entities enter bankruptcy or fail without government intervention.Q.8. 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.8. Perhaps the most needed measure relative to a counter-cyclical system of regulation is the need to increase deposit insurance premiums during periods of heightened earnings, as opposed to the current practice of basing these assessment on deposit insurance losses. Financial institutions end up with high assessments typically at the same time that their capital and earnings are under pressure due to asset quality concerns. The deposit insurance funds need to be built up during the good times and banks and credit unions need to be able to have lower assessments during periods of economic uncertainty. It would also be wise to review examination processes to see where greater emphasis can be placed on developing counter-cyclical processes and procedures. This will always be a challenge during periods of economic expansion, where financial institutions are experiencing low levels of nonperforming loans and loan losses, strong capital and robust earnings. Under these circumstances supervisors are subject to being accused by financial institutions and policy makers as impeding economic progress and credit availability. It would be beneficial to take a stronger and more aggressive posture regarding concentration risk and funding and asset/liability management risk during periods of economic expansion.Q.9. 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.9. To ensure a comprehensive regulatory system for credit unions, Congress should consider the current dual chartering system as a regulatory model. Dual chartering and the value offered to consumers by the state and federal systems provide the components that make a comprehensive regulatory system. Dual chartering also reduces the likelihood of gaps in financial regulation because there are two interested regulators. Often, states are in the first and best position to identify current trends that need to be regulated and this structure allows the party with the most information to act to curtail a situation before it becomes problematic. Dual chartering should continue. This system provides accountability and the needed structure for effective and aggressive regulatory enforcement. The dual chartering system has provided comprehensive regulation for 140 years. Dual chartering remains viable in the financial marketplace because of the distinct benefits provided by each charter, state and federal. This system allows each financial institution to select the charter that benefits its members or consumers the most. Ideally, for any system, the best elements of each charter should be recognized and enhanced to allow for competition in the marketplace so that everyone benefits. In addition, the dual chartering system allows for the checks and balances between state and federal government necessary for comprehensive regulation. Any regulatory system should recognize the value of the dual chartering system and how it contributes to a comprehensive regulatory structure. Regulators should evaluate products and services based on safety and soundness and consumer protection criterion. This will maintain the public's confidence. ------ CHRG-111shrg53822--50 Mr. Stern," Well, I think that is a potential reaction and something of potential concern, and that is why I have advocated not relying just on capital or just on one or two approaches to dealing with ``too big to fail.'' I think this has to be a multifaceted approach with a number of initiatives that straighten out the best we can the incentives and improved market discipline as well as doing things like improving capital and so forth, because this is a difficult issue to address. Its consequences are potentially very serious, and so I think we need to address it across a number of fronts. Senator Merkley. Do you wish to add anything on that? Ms. Bair. Well, I think that is a risk. We have capital standards based on the riskiness of assets in addition to the leverage ratio, which is core capital to total assets. So through our risk-based capital system, we try to address that problem. But it is imprecise, necessarily imprecise, and so it is something that supervisors have to be constantly vigilant of. Senator Merkley. To follow on, Mr. Stern, I think another point you have made is that we in some degree already have a systematic risk regulator in the Fed. But can the Fed really balance its various requirements and play that role? Mr. Stern I do not think I have suggested that the Fed is the systemic risk regulator. Obviously, that is an issue that is under discussion and consideration at the moment. I do think the Federal Reserve, because we have longstanding responsibilities in holding computer and bank supervision, as well as experience in payment systems and because we are ultimately the last provider of liquidity in the system, have a role to play in this, clearly. But I have not tried to weigh in exactly on what the exact structure of the systemic risk regulator ought to be. Senator Merkley. And I apologize if you have already been asked this question before, but I think you have emphasized--and correct me if I am wrong--that policymakers should focus on counterparty risk and not risking shareholders, but that one of our challenges is to convince uninsured creditors that they will bear losses when their financial institution gets into trouble. Do we need to do that in a statutory sense to address the moral hazard, if you will, of expectations that shareholders will be bailed out? " CHRG-111shrg57709--2 Chairman Dodd," The Committee will come to order, and let me welcome our very distinguished witnesses this afternoon and the audience who is here and my colleagues, and I am sure there will be more coming in. This is a little out of the ordinary. Normally hearings like this we conduct in the morning, but I know that Chairman Volcker had conflicts in the schedule, so we are very grateful to you, Mr. Chairman, for accommodating us this afternoon and meeting with us here. And Neal Wolin we always welcome back. He does a great job at the Department of the Treasury, and it is an honor to have you here as well. As many of you may know, we are going to have a hearing on Thursday as well to follow up and hear from industry and other people talk about these ideas that have been proposed by the Administration, particularly by Chairman Volcker. So we are grateful to you for being with us this afternoon. What I will do is make a few brief opening comments myself. I will turn to Senator Shelby for any opening comments he may have, and then following what I now affectionately call the Corker rule, we will go right to our witnesses, unless some member here feels absolutely compelled to want to be heard before they are heard. Then we will accept any and all supporting documents and information you think would be worthwhile for the Committee to have. And then we will begin a line of questioning, and depending upon the number of people here, we will try and make enough time available so we have a thorough discussion of these ideas. With that, today's hearing is entitled ``Prohibiting High-Risk Investment Activities by Banks and Bank Holding Companies.'' And, again, Chairman Paul Volcker and Neal Wolin are here as our witnesses, so I thank all of you for joining us. We meet today, as we have over these past number of months, in the shadow of a financial crisis that nearly toppled the American economy. It is worth repeating again the cost of the greed and recklessness that brought us here. Over 7 million jobs in our country have been lost. The retirement plans of millions of Americans have been dashed. Trillions of dollars of household wealth and GDP are gone. And, obviously, all of us, regardless of what your political party is or affiliation, we cannot allow this to happen again. The Obama administration has proposed bold steps to make the financial system less risky, and we welcome those ideas. The first would prohibit banks or financial institutions that contain banks from owning, investing in, or sponsoring a hedge fund, a private equity fund, or any proprietary trading operation unrelated to serving its customers. The President of the United States has called this the Volcker rule, and today Chairman Paul Volcker himself will make the case for it. I strongly support this proposal. I think it has great merit. The second would be a cap on the market share of liabilities for the largest financial firms which would supplement the current caps on the market share of their deposits. I think the Administration is headed in the right direction with these two proposals. Now, I know the timing of them and how they have been proposed at a critical time when we have been deeply engaged on this Committee on proposing ideas to reform the financial services sector has raised the eyebrows and other considerations by people. But I think we need to get past that, if we can, and think about the merits of these ideas and how they would work if they could, in fact, be put in place. So I would welcome the conversation we are going to have today and the remainder of this week on these issues. These proposals deserve our serious consideration, and so today we will have from the Chairman and the Deputy Secretary of the Treasury, Neal Wolin, and on Thursday we will hold another hearing with business and academic experts. These proposals were born out of a fear that a failure to act would leave us vulnerable to another crisis and a frustration at the refusal of financial firms to rein in some of these more reckless behaviors. I share that fear, and I share that frustration as well. And I strongly oppose those who would argue that the boldness of these proposals is out of scale with the need for reform. We need to take action, and we must consider scaling back the scope of activities banks may engage in while they are using deposits. And so today I look forward to hearing how these proposals may be most effectively applied to protect consumers and our economy and also, as a devil's advocate, why these ideas may not work and what risks they may pose if adopted. Some have objected to the Volcker rule on the grounds that it might not have prevented the crisis or that these particular limits are unwise. I think those objections are worth discussing, and I am interested in giving our witnesses and our colleagues here a chance to raise these items and a chance to have the kind of vibrant, robust debate and discussion about them. But we must take steps, I believe, to change the culture of risk taking in our financial sector, including the management and compensation incentives that drove so much of the bad decisionmaking. I applaud the Administration's commitment to scaling back risky behavior on Wall Street, and I thank Chairman Volcker and Deputy Secretary Wolin for joining us today to share their thoughts and ideas on these proposals. And I look forward to working with them and, of course, my colleagues here on this Committee, Democrats and Republicans, as we have been working over these past many weeks and months, to fashion a reform package that would allow us to step forward on a bipartisan basis here, a consensus bill that we could bring to our other 87 colleagues in the Senate for their consideration and ultimately a conference with the other body and ultimately, of course, for the signature of the President of the United States. We have a lot of work left to be done, so this debate is an important one, and we welcome you today to share your thoughts and ideas on these proposals. Senator Shelby. CHRG-111shrg56415--35 Mr. Tarullo," What I hope is that this Committee and the Congress as a whole will pass a strong set of reforms, no matter what other people out there are saying. Senator Tester. OK. Thank you very much. Thank you, Mr. Chairman. Senator Johnson. Senator Gregg. Senator Gregg. Thank you, Mr. Chairman, and I want to thank the panel for their excellent testimony. It has been most interesting. First off, I want to congratulate the FDIC for deciding to forward-fund the fees. I think that is the right approach. You do a lot of things right. You have done a lot of things right during this problem. You did a lot of things right when I was Governor in 1989 in New Hampshire and five of our seven largest banks closed. Mr. Seidman came in and basically was our white knight. But you did say something that really concerns me, and that is, how you interpret the TARP, this idea that the TARP should be now used as a capital source for a lot of smaller banks that are having problems raising capital. I think all of you basically in your testimony have said we are past the massive systemic risk of a financial meltdown that would have caused a cataclysmic event. TARP came about because of that massive potential cataclysmic event, and its purpose was to basically stabilize the financial markets and be used in that manner in order to accomplish that. As one of the authors, along with Senator Dodd--we sat through the negotiations of that--I think I am fairly familiar with that purpose. That was the goal. It should not now be used as a piggy bank for housing. It should not be used as a piggy bank for whatever the interest of the day is that can be somehow--it should not have been used for the automobile industry, and it really should not be used in order to have a continuum of capital available to smaller banks who have problems, in my opinion, because then you are just going to set up a new national program which will essentially undermine the forces of the market, and that would be a mistake. I did hear you say, Madam Chairman, that you expect $100 billion in losses. Is that a net number? Or do you expect to recoup some percentage of that? Ms. Bair. No, that is what we project our losses to be over the next 5 years. Senator Gregg. So that is a net number after recoupment? Ms. Bair. Yes. Senator Gregg. Well, is it--do you expect of that $100 billion in bad loans to be getting back 30 percent of---- Ms. Bair. The $100 billion would be our losses. So let us say we had a 25-percent loss rate on our bank failures so far, so you would be talking about $400 billion in failed bank assets. Senator Gregg. Well, OK, so it---- Ms. Bair. That is since the beginning of 2009, though. And, again, a lot of that has already been realized and reserved for. Senator Gregg. And you have got $64 billion, you said, or something, that has been realized and reserved against, so you have got about---- Ms. Bair. That is right, yes. Senator Gregg.----$36 billion to go. OK. I have got a philosophical question here. If we look at this problem--granted, commercial real estate is now the problem, but commercial real estate, as I understand it from your testimony, is not--it is a serious problem. It is just not a systemic event. It is not going to cause a meltdown of our industries--of our financial industry. It may impact rather significantly especially the middle-sized regional banks and some of the smaller banks, but it is not systemic. The systemic event was caused in large part in the banking industry by the primary residence lending activity--subprime, Alt-A, and regular loans. And all I heard about as the proposals for getting at this is regulatory upon regulatory layers to try to figure out a way to basically protect ourselves from having that type of excess in this arena occur again. But when you get down to it, it is all about underwriting. I mean, the bottom line is this is about underwriting. It is about somebody lent to somebody who either did not have the wherewithal to pay it back or who had an asset which was not worth what they lent on that asset. And probably the person who lent it did not really care because they were just getting the fee and they were going to sell it into the securitized market anyway. So if you really want to get at this issue, wouldn't it be more logical and simpler and--it is not the whole solution. Clearly, there has to be regulatory reform. But shouldn't we look at the issue of having different underwriting standards, both of which the OCC and the FDIC have the authority over, in the area of what percentage to asset can you lend? You know, do you have to have 90 percent, 80 percent? Shouldn't we have an underwriting standard that says you either get--that there is recourse? Shouldn't we have underwriting standards that gives you the opportunity to either have an 80-percent or 90-percent choice or a covered loan, something like that? Isn't that really a simpler way from a standpoint of not having--granted, it would chill the ability to get a house because people who could not afford to buy the house and could not afford to pay the loan back probably would not be able to get the loan. But isn't that where we should really start this exercise, with recourse and 80 percent or 90 percent equity--10, 20 percent equity value and/or, alternatively, covered funds? I would ask everybody who actually is on the front lines of lending today. Ms. Bair. Certainly underwriting is key, but poor underwriting is not necessarily the driver of future losses now. We are seeing loans go bad now that were good when they were made. But because of the economy--because people are losing their jobs, or retailers are having to close, or hotels cannot fill up--those loans are going bad. The economic dynamic is kicking in in terms of the credit distress that we are increasingly seeing on bank balance sheets. You are right, the subprime mortgage mess got started with very weak underwriting. It started in the non-bank sector. It spilled back into the banking sector. I think all of us wish we had acted sooner, but we did move to tighten underwriting standards, and strongly encouraged the Federal Reserve Board to impose rules across the board for both banks and non-banks. This, again, is the reason why you need to make sure that the stronger underwriting standards going forward apply to both banks and non-banks. Senator Gregg. Well, what should those underwriting standards be? Ms. Bair. You should have to document income. You should do teaser-rate underwriting. The Federal Reserve Board has put a lot of these in effect now under the HOEPA rules. You have to document income. You cannot do payment shock loans. You have got to make sure the borrower can repay the loan if it is an adjustable rate mortgage that resets. These are just common-sense underwriting principles that have applied to banks for a long time. Senator Gregg. Or should there be recourse? Ms. Bair. That has been a prerogative of the States. Some mortgage lending is recourse, some is non-recourse, depending on the State. Senator Gregg. Should there be a requirement that you cannot lend to 100 percent of value? Ms. Bair. I think there is a strong correlation with loan-to-value ratios (LTVs). We actually recognize that in our capital standards that we are working on now. We would require a much higher risk weighting of loans which have high LTVs. So through capital charges, we are recognizing and trying to incent lower LTVs. Senator Gregg. I am running out of time unfortunately. " CHRG-111shrg62643--231 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON FROM BEN S. BERNANKEQ.1. During initial Senate consideration of financial regulatory reform legislation, I was very concerned that State-chartered community banks and small-and medium-sized bank holding companies would no longer be able to choose supervision from the Federal Reserve. I worried that community banks in Texas and across the country would lose access to the Federal Reserve, and, likewise, that the Fed would lose the important data that these important financial institutions provide on economic and banking conditions in communities in Texas and across the country. I was proud to sponsor Amendment 3759 during Senate consideration to ensure that State-chartered banks and small- and medium-sized bank holding companies could retain Federal Reserve supervision. I appreciate the support that you and many of the regional Federal Reserve presidents demonstrated to help my amendment pass with overwhelming support; I worked hard to ensure that community banks would not be unduly penalized as a result of the new regulations which will come from the Dodd-Frank Wall Street Reform and Consumer Protection Act. However, I continue to hear from many Texas community bankers sharing concerns about the possible effects of this legislation. The regulatory burden on community banks, particularly small banks in rural locations, was already significant prior to the enactment of legislation. Many in the Texas banking community fear that the rules soon to be written by the new Consumer Financial Protection Agency will be the tipping point for many community banks, making the regulatory burden too great to operate effectively. Texas community bankers are concerned that greater regulation will ultimately lead smaller community banks to succumb to larger banks, which would make the big bigger and wipe out the smaller banks. As a Member of the Committee on Banking, Housing, and Urban Affairs having oversight over the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, I respectfully ask the following: Which provisions of the Dodd-Frank Act require careful monitoring from the Committee because their respective implementation could be especially burdensome to community banks?A.1. Although adjustments were made to moderate the impact of the Collins amendment, the effect of this provision (section 171) on the ability of smaller banking organizations to access capital from the public markets warrants close monitoring. You are correct that the impact on community banks of various portions of the Dodd-Frank Act, such as the Title VII derivatives provisions and the Title X Consumer Financial Protection Bureau provisions, will depend in part on the regulatory implementation of those provisions. As I mentioned often during the debate, small community banks play a key role in our financial system. Close connections with community bankers enable the Federal Reserve to better understand the full range of financial concerns and risks facing the country. The community banking perspective is also critical as we assess the burden and effectiveness of financial regulation.Q.2. What proposals do you have to help our Nation's community banks withstand the onslaught of new regulations so that they can remain competitive and avoid potential arbitrage in the future by larger banks?A.2. Through implementation of provisions addressing the ``too-big-to-fail'' problem, the Dodd-Frank Act should help to level the playing field between small and large banks. The Federal Reserve supported such provisions--including implementation of a resolution regime for large, interconnected firms and the imposition of more rigorous capital, liquidity, and supervisory requirements for large systemically important banking firms and nonbank financial institutions--in part because of the disparate treatment that resulted for banks of different sizes. Under the new law, the competitive position of community banks may be improved as implicit ``too-big-to-fail'' subsidies from which the largest banks previously benefited are removed through the higher supervisory costs and requirements placed on institutions that are or become large and systemically important. Additional Material Supplied for the Record" CHRG-111shrg53176--156 PREPARED STATEMENT OF RICHARD BAKER President and Chief Executive Officer, Managed Funds Association March 26, 2009 Managed Funds Association (``MFA'') is pleased to provide this statement in connection with the Senate Committee on Banking, Housing, & Urban Affairs hearing, ``Enhancing Investor Protection and the Regulation of Securities Markets--Part II'' held on March 26, 2009. MFA represents the majority of the world's largest hedge funds and is the primary advocate for sound business practices and industry growth for professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. MFA's members manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies around the world. MFA appreciates the opportunity to express its views on the important subjects of investor protection and the regulation of securities markets. In considering theses issues, it is important to remember that vibrant, liquid markets are important to investors and that for these markets to work, financial institutions need to be able to perform their important market functions. Hedge funds play an important role in our financial system, as they provide liquidity and price discovery to capital markets, capital to companies to allow them to grow or turn around their businesses, and sophisticated risk management to investors such as pension funds, to allow those pensions to meet their future obligations to plan beneficiaries. Hedge funds engage in a variety of investment strategies across many different asset classes. The growth and diversification of hedge funds have strengthened U.S. capital markets and allowed investors means to diversify their investments, thereby reducing their overall portfolio investment risk. As investors, hedge funds help dampen market volatility by providing liquidity and pricing efficiency across many markets. Each of these functions is critical to the orderly operation of our capital markets and our financial system as a whole. In order to perform these important market functions, hedge funds require sound counterparties with which to trade and stable market structures in which to operate. The recent turmoil in our markets has significantly limited the ability of hedge funds to conduct their businesses and trade in the stable environment we all seek. As such, hedge funds have an aligned interest with other market participants, including retail investors, and policy makers in reestablishing a sound financial system. We support efforts to protect investors, manage systemic risk responsibly, and ensure stable counterparties and properly functioning, orderly markets. Hedge funds were not the root cause of the problems in our financial markets and economy. In fact, hedge funds overall were substantially less leveraged than banks and brokers, performed significantly better than the overall market and have not required, nor sought, federal assistance despite the fact that our industry, and our investors, have suffered mightily as a result of the instability in our financial system and the broader economic downturn. The losses suffered by hedge funds and their investors did not pose a threat to our capital markets or the financial system. Although hedge funds are important to capital markets and the financial system, the relative size and scope of the hedge fund industry in the context of the wider financial system helps explain why hedge funds did not pose systemic risks despite their losses. With an estimated $1.5 trillion under management, the hedge fund industry is significantly smaller than the U.S. mutual fund industry, with an estimated $9.4 trillion in assets under management, or the U.S. banking industry, with an estimated $13.8 trillion in assets. According to a report released by the Financial Research Corp., the combined assets under management of the three largest mutual fund families are in excess of $1.9 trillion. Moreover, because many hedge funds use little or no leverage, their losses did not pose the same systemic risk concerns that losses at more highly leveraged institutions, such as brokers and investment banks, did. A study by PerTrac Financial Solutions released in December 2008 found that 26.9 percent of hedge fund managers reported using no leverage. Similarly, a March 2009 report by Lord Adair Turner, Chairman of the U.K. Financial Services Authority (the ``FSA''), found that the leverage of hedge funds was, on average, two or three-to-one, significantly below the average leverage of banks. Though hedge funds did not cause the problems in our markets, we believe that the public and private sectors (including hedge funds) share the responsibility of restoring stability to our markets, strengthening financial institutions, and ultimately, restoring investor confidence. Hedge funds remain a significant source of private capital and can continue to play an important role in restoring liquidity and stability to our capital markets. The value of hedge funds (and other private pools of capital) as private investors has been recognized by Treasury Secretary Geithner in his proposals for the recently announced Public Private Partnership Investment Program (the ``PPIP'') and implementation of the Term Asset-Backed Securities Loan Facility, each of which is dependent on private investor participation to be successful. In addition to providing liquidity, managers of private pools of capital have significant trading and investing experience and knowledge that can assist policy makers as they continue to contemplate the best way to implement the Administration's Financial Stability Plan. MFA is supportive of the new PPIP. We share Secretary Geithner's commitment to promote efforts that will stabilize our financial markets and strengthen our Nation's economy. MFA and its members look forward to working with Secretary Geithner, Congressional leaders, and members of President Obama's economic team on this and other important issues in order to achieve the shared objective of restoring stability and investor confidence in our financial markets. Regulatory reform also will be an important part of stabilizing markets and restoring investor confidence, but it will not, in and of itself, be sufficient to do so. The lack of certainty regarding major financial institutions (e.g., banks, broker dealers, insurance companies) and their financial condition has limited the effectiveness of government intervention efforts to date. Investors' lack of confidence in the financial health of these institutions is an impediment to those investors' willingness to put capital at risk in the market or to engage in transactions with these firms, which, in turn, are impediments to market stability. The Treasury Department's plan to conduct comprehensive stress tests on the 19 largest bank holding companies is designed to ensure a robust analysis of these banks, thereby creating greater certainty regarding their financial condition. Treasury's announcement that it plans to involve private asset managers in helping to value illiquid assets held by banks as part of the PPIP recognizes the beneficial role that private asset managers can play in helping provide that certainty. We believe that, to achieve this certainty, it is also important for policy makers and regulators to ensure that accounting and disclosure rules are designed to promote the appropriate valuation of assets and liabilities and consistent disclosure of those valuations. Though ``smart'' regulation cannot, in and of itself, restore financial stability and properly functioning markets, it is a necessary component of any plan to achieve those ends. ``Smart'' regulation would include appropriate, effective, and efficient regulation and industry best practices that better monitor and reduce systemic risk and promote efficient capital markets, market integrity, and investor protection. Regulation that addresses these key issues is more likely to improve the functioning of our financial system, while regulation that does not address these key issues can cause more harm than good. We saw an example of the latter with the significant, adverse consequences that resulted from the SEC's bans on short selling last year. A smart regulatory framework should include comprehensive and robust industry best practices designed to achieve the shared goals of monitoring and reducing systemic risk and promoting efficient capital markets, market integrity, and investor protection. Since 2000, MFA has been the leader in developing, enhancing and promoting standards of excellence through its document, Sound Practices for Hedge Fund Managers (``Sound Practices''). As part of its commitment to ensuring that Sound Practices remains at the forefront of setting standards of excellence for the industry, MFA has updated and revised Sound Practices to incorporate the recommendations from the best practices report issued by the President's Working Group on Financial Markets' Asset Managers' Committee. Because of the complexity of our financial system, an ongoing dialogue between market participants and policy makers is a critical part of the process of developing smart, effective regulation. MFA and its members are committed to being active, constructive participants in the dialogue regarding the various regulatory reform topics.I. Systemic Risk Regulation The first step in developing a systemic risk regulatory regime is to determine those entities that should be within the scope of such a regulatory regime. There are a number of factors that policy makers are considering as they seek to establish the process by which a systemic risk regulator should identify, at any point in time, which entities should be considered to be of systemic relevance. Those factors include the amount of assets of an entity, the concentration of its activities, and an entity's interconnectivity to other market participants. As an Association, we are currently engaged in an active dialogue with our members to better understand how these factors, among others, may relate to the systemic relevance of all financial market participants--including our industry and its members. MFA and its members acknowledge that at a minimum the hedge fund industry as a whole is of systemic relevance and, therefore, should be considered within the systemic risk regulatory framework. We are committed to being constructive participants in the dialogue regarding the creation of that framework.A. Central Systemic Risk Regulator Under our current regulatory structure, systemic risk oversight is the responsibility of multiple regulatory entities, or worse, no one's responsibility. For systemic risk oversight to be effective, there must be oversight over the key elements of the entire financial system, across all relevant structures, classes of institutions and products, and an assessment of the financial system on a holistic basis. We believe that a single central systemic risk regulator should be considered to accomplish this goal. This central regulator should be responsible for oversight of the structure, classes of institutions and products of all financial system participants. MFA is engaged in discussions with its members with respect to which regulatory entity, whether new or existing, would be best suited for this role. We believe that having multiple regulators with responsibility for overseeing systemic risk likely would not be an effective framework. Jurisdictional conflicts, unintended gaps in regulatory authority, and inefficient and costly overlapping authorities likely would inhibit the effectiveness of such a regulatory framework. Moreover, in a framework with multiple systemic risk regulators, no one regulator would be able to assess potential systemic risks from a holistic perspective, as no regulator would oversee the entire system.B. Confidential Reporting to Regulator MFA and its members recognize that for a systemic risk regulator to be able to adequately assess potential risks to our financial system, that regulator needs access to information. We support a systemic risk regulator having the authority to request and receive, on a confidential basis, from those entities that it determines (at any point in time) to be of systemic relevance, any information that the regulator determines is necessary or advisable to enable it to adequately assess potential risks to the financial system. In considering the appropriate scope of this authority, we believe that it is important for the systemic risk regulator to have sufficient authority and flexibility to adapt to changing conditions and take a forward-looking view toward risk regulation. Attempting to pre-determine what information a regulator would need would not provide sufficient flexibility and likely would be ineffective as a tool to address potential future risks. We believe that granting the systemic risk regulator broad authority with respect to information gathering, along with ensuring that it has the appropriate resources and capabilities to effectively analyze that information, would be a more effective framework. While we support a systemic risk regulator having access to whatever information it deems necessary or advisable to assess potential systemic risks, we believe that it is critical for such information to be kept confidentially and granted full protection from public disclosure. We recognize the benefit of a regulator having access to all important data, even potentially sensitive or proprietary information from systemically relevant entities. A systemic risk regulator can fulfill its mandate to protect the financial system without publicly disclosing all the proprietary information of financial institutions. We do not believe that there is a public benefit to such information being publicly disclosed. Moreover, public disclosure of such information could be misleading, as it would likely be incomplete data that would be viewed by the public outside of the proper context. Public investors may be inclined to take action based on this data without fully understanding the information, which could lead to adverse consequences for those investors, for the investors in systemically relevant entities, and for the stability of the financial system as a whole. Public disclosure of proprietary information also harms the ability of market participants to establish and exit from investment positions in an economically viable manner. Such disclosure also could lead to systemically relevant entities being placed at an unfair competitive disadvantage compared to nonsystemically relevant entities, as sensitive and proprietary information of only the systemically relevant entities would be publicly available.C. Mandate To Protect the Financial System Setting a clear and specific mandate is important for any regulator to be effective. This is particularly true in a regulatory framework that has multiple regulatory entities, as a lack of clarity in the mandates of regulators can lead to gaps in oversight, or costly and inefficient overlapping regulation. We believe that the systemic risk regulator's mandate should be the protection of the financial system. Investor protection and market integrity should not be part of its mandate, but should instead be addressed by other regulatory entities. Congress should be clear in stating that the risk regulator should collect information only for its mandate to protect the financial system, and should not use that authority for other purposes. To fulfill its mandate to protect the financial system, we recognize that the regulator would need to take action if the failure of a systemically relevant firm would jeopardize broad aspects of the financial system. Absent such a concern about broad systemic consequences, however, the systemic risk regulator should not focus on preventing the failure of systemically relevant entities. Systemically relevant market participants do not necessarily pose the same risks or concerns as each other. There likely are entities that would be deemed systemically relevant for purposes of reporting information, but whose failure would not threaten the broader financial system. For this reason, we believe that the systemic risk regulator should focus on preventing failures of market participants only when there is concern about the consequences to the broader financial system, and should not focus on preventing the failure of all systemically relevant entities. Consistent with this mandate, the systemic risk regulator should not equate systemically relevant entities with entities that are too big, or too interconnected, to fail. An entity that is perceived by the market to have a government guarantee, whether explicit or implicit, has an unfair competitive advantage over other market participants. We strongly believe that the systemic risk regulator should implement its authority in a way that avoids this possibility and also avoids the moral hazards that can result from a company having an ongoing government guarantee against its failure.D. Scope of Regulatory Authority The last part of systemic risk regulation that I would like to address in my testimony is the scope of authority that a systemic risk regulator should have to fulfill its mandate to protect our financial system. There are a number of suggestions that various people have made as to the type of authority a systemic risk regulator should have. We continue to discuss with our members what the appropriate scope of authority should be for such a regulator. We believe that whatever authority the regulator has should ensure that the regulator has the ability to be forward-looking to prevent potential systemic risk problems, as well as the authority to address systemic problems once they have arisen. The systemic risk regulator's authority must be sufficiently flexible to permit it to adapt to changing circumstances and address currently unknown issues. An attempt to specifically define the regulator's authority must avoid unintentionally creating gaps in authority that would prevent the systemic risk regulator from being able to fulfill its mandate to protect the financial system in the future. We do believe that the systemic risk regulator needs the authority to ensure that a failing market participant does not pose a risk to the entire financial system. In the event that a failing market participant could pose such a risk, the systemic risk regulator should have the authority to directly intervene to ensure an orderly dissolution or liquidation of the market participant. The significant adverse consequences that resulted from the failure of Lehman Brothers, Inc. this past fall is an example of what can happen when there is not an intervention to prevent a disorderly dissolution of such a market participant. The continuing market disruption caused by the failure of Lehman Brothers also demonstrates the importance of ensuring that there is a coordinated global effort with respect to such interventions. Whatever the scope of authority that a systemic risk regulator has, its implementation of that authority will be critical to the effectiveness of any regulatory regime. We believe that the systemic risk regulator should implement its authority by focusing on all relevant parts of the financial system, including structure, classes of institutions and products. Because systemic risk concerns may arise from a combination of factors, rather than from the presence of any particular factor, a holistic approach is more likely to successfully identify and assess potential systemic risks. Recent coordinated efforts between the Federal Reserve Bank of New York (the ``New York Fed'') and industry participants provide a good example of how a systemic risk regulator could address systemic risk concerns posed by structural issues in our markets. In recent years, the New York Fed, working with MFA and other industry participants through the Operations Management Group (``OMG'') and other industry-led initiatives has made notable progress in addressing concerns related to the over-the-counter (``OTC'') derivatives market. Some of the more recent market improvements and systemic risk mitigants have included: (1) the reduction by 80 percent of backlogs of outstanding credit default swap (``CDS'') confirmations since 2005; (2) the establishment of electronic processes to approve and confirm CDS novations; (3) the establishment of a trade information repository to document and record confirmed CDS trades; (4) the establishment of a successful auction-based mechanism actively employed in 14 credit events including Fannie Mae, Freddie Mac and Lehman Brothers, allowing for cash settlement; and (5) the reduction of 74 percent of backlogs of outstanding equity derivative confirmations since 2006 and 53 percent of backlogs in interest rate derivative confirmations since 2006. In addition to these efforts, MFA, its members and other industry participants have been working with the New York Fed to expedite the establishment of central clearing platforms covering a broad range of OTC derivative instruments. We believe a central clearing platform, if properly established, could provide a number of market benefits, including: (1) the mitigation of systemic risk; (2) the mitigation of counterparty risk and protection of customer collateral; (3) market transparency and operational efficiency; (4) greater liquidity; and (5) clear processes for the determination of a credit event (for CDS).II. Prudential Regulation We recognize that, in addition to systemic risk regulation, some policy makers, regulators and authors of various reports (e.g., the Group of 30, Government Accountability Office and Congressional Oversight Panel) have contemplated the notion of a prudential regulatory framework, including mandatory registration for private pools of capital. There are a great many issues that should be considered in determining what, if any, such a framework should look like. As an Association, we are currently engaged in an active dialogue with our members on these critical issues and we are committed to being constructive participants as discussions on these issues progress. While many of the details regarding reform initiatives have yet to be proposed, we would like to share some initial thoughts with you on some of the key principles that we believe should be considered by Congress, the Administration and other policy makers as you consider prudential regulatory reform. Those principles are: The goal of regulatory reform should be to develop intelligent regulation, which makes our system stronger for the benefit of businesses and investors. Prudential regulation should address identified risks or potential risks, and should be appropriately tailored to those risks. Regulators should engage in ongoing dialogue with market participants. Any rulemaking should be transparent and provide for public notice and comment by affected market participants, as well as a reasonable period of time to implement any new or modified regulatory requirements. This public-private dialogue can help lead to more effective regulation and avoid unintended consequences, market uncertainty and increased market volatility. Reporting requirements should provide regulators with the right information to allow them to fulfill their oversight responsibilities as well as to prevent, detect and punish fraud and manipulative conduct. Overly broad reporting requirements can limit the effectiveness of a reporting regime as regulators may be unable to effectively review and analyze data, while duplicative reporting requirements can be costly to market participants without providing additional benefit to regulators. I would add that it is critical that any reporting of sensitive, proprietary information by market participants be kept confidential. As discussed in the section above on reporting to a systemic risk regulator, public disclosure of such information can be harmful to members of the public that may act on incomplete data, increase risk to the financial system, and harm the ability of market participants to establish and exit from investment positions in an economically viable manner. We believe that any prudential regulatory construct should distinguish, as appropriate, between different types of market participants and different types of investors or customers to whom services or products are marketed. While we recognize that investor protection should not be limited only to retail investors, we believe that a ``one-size fits all'' approach will likely not be as effective as a more tailored approach. Lastly, we believe that industry best practices and robust investor diligence should be encouraged and viewed as an important complement to prudential regulation. Strong business practices and robust diligence are critical to addressing investor protection concerns.III. Short Selling One issue in particular which has been the focus of a great deal of discussion recently is short selling, specifically the role of short selling in capital markets. Short selling, as recognized by the Securities and Exchange Commission (the ``SEC''), ``plays an important role in the market for a variety of reasons, including providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities and, importantly, limiting upward market manipulations.'' \1\ Similarly, the FSA has noted that short selling is, ``a legitimate investment technique in normal market conditions,'' and ``can enhance the efficiency of the price formation process by allowing investors with negative information, who do not hold stock, to trade on their information.'' In addition, short selling can ``enhance liquidity by increasing the number of potential sellers,'' and increase market efficiency. \2\ We strongly agree with the SEC and the FSA that short selling, along with derivatives trading, provides capital markets with necessary liquidity and plays an important role in the price discovery process. Markets are more efficient, and securities prices are more accurate, because investors with capital at risk engage in short selling.--------------------------------------------------------------------------- \1\ Statement of Securities and Exchange Commission Concerning Short Selling and Issuer Stock Repurchases, SEC Release 2008-235 (Oct. 1, 2008). \2\ Temporary Short Selling Measures, FSA Consultation Paper 09/1 (Jan. 2009), at page 4.--------------------------------------------------------------------------- Short selling and other techniques, including listed and over-the-counter derivatives trading, are important risk management tools for institutional investors, including MFA members, and essential components of a wide range of bona fide cash and derivatives hedging strategies that enable investors to provide liquidity to the financial markets. We are concerned that requirements that investors publicly disclose short position information, or that create the potential for public disclosure, would negatively reduce overall market efficiency by undermining the important role that short selling plays in providing liquidity and price discovery to markets. The risk of public disclosure could cause investors, including pension plans and endowments, with billions of dollars of assets to withdraw capital and further disrupt already stressed capital markets. In the long-term, pension, endowment and foundation investors would forego diversification and risk management benefits provided by alternative investment vehicles. We believe that concerns which have led some to propose public disclosure of short positions could be substantially mitigated through effective, comprehensive reporting of short sale information by prime brokers and clearing brokers. Regulators could require short sales and short position information to be provided by brokers on an aggregate basis. A regulator could request specific information as to short sales and short positions of individual investors if it suspected or became concerned about manipulation of a particular security. Such reporting also would provide regulators with a more effective means by which to identify manipulative activity.Conclusion Hedge funds have important market functions, in that they provide liquidity and price discovery to capital markets, capital to companies to allow them to grow or turn around their businesses, and sophisticated risk management to investors such as pension funds, to allow those pensions to meet their future obligations to plan beneficiaries. MFA and its members acknowledge that smart regulation helps to ensure stable and orderly markets, which are necessary for hedge funds to conduct their businesses. We also acknowledge that active, constructive dialogue between policy makers and market participants is an important part of the process to develop smart regulation. We are committed to being constructive participants in the regulatory reform discussions and working with policy makers to reestablish a sound financial system and restore stable and orderly markets. MFA appreciates the opportunity to testify before the Committee. I would be happy to answer any questions that you may have. ______ CHRG-111shrg57709--125 Mr. Volcker," Well, that is a reasonable question. I am sorry I apparently cannot get through with the answer, but I do not want to restrict commercial banks from doing commercial banking, traditional business. I do not want to. I want to encourage their lending. I do not want to encourage their speculative activities. Senator Johanns. Let me just wrap up. I am out of time, and I thank the Chairman. I really appreciate both of your being here. I really do. And we are wrestling with some very tough issues here, trying to figure them out, understand them, without damaging the economy. " CHRG-111hhrg56776--222 Mr. Marchant," Right. " Mr. Bernanke," --so that the taxpayer is not losing any money. And it has the advantage that it reduces the amount of reserves in the banking system for the given amount of mortgage-backed securities that we hold. And that gives us more flexibility as we manage policy, going forward. " FOMC20050630meeting--132 130,MR. LACKER.," My understanding is that we’ve used it fairly often in the postwar period, in the ’60s, ’70s, and ’80s—in early 1980, for example. My understanding is that it hasn’t worked very well. There have been times when we’ve tried to jawbone the banking system’s allocation of credit." CHRG-111hhrg52400--165 Mr. McCarthy," I think it's a good question. And, again, we look at it from our sort of narrow perspective in the industry. The first word you used ``optional,'' is where the trouble is, I think, in that an optional charter would leave itself open to arbitrage, meaning that people would--companies would have the ability to gravitate towards wherever they think the most liberal or the most friendly for their particular pursuits would be. A mandatory Federal, that would encompass all companies, whether it's just the monolines or whether it's a broader class of companies, would address that. The second issue is that if there was Federal regulation, whether it was--and it was focused on products, one of the ways to look at perhaps the AIG issue, is their participation in credit default swaps. But inside those credit default swaps there are requirements for them to post collateral, which really was the reason why they ended up collapsing. It's the product itself, and the nature of the terms that are inside that product. So, I would say that, you know, Federal mandatory sort of applies to everybody, no possibility for arbitrage is important. But second, had it been in place, and had they focused on what were the terms in the product, that would be the case. And that's why we think, in a financially driven company such as ourselves, that really looks more like something that the Fed would do for banks, in terms of permissible kinds of business that they're in. " CHRG-111hhrg54873--97 Mr. Donnelly," And I know I don't have to tell you folks, but the critical nature of what you do--in my State, the damage caused to our economy was breathtaking, with company after company unable to obtain credit because of the collapse of credit markets. And there is a deep anger in our area toward Wall Street, toward the work done there, that what you did there caused our families to lose jobs. And that is the perspective that we have in middle America, is that--was this done by rating agencies alone? No. But the work that was done caused so much damage that we had moms and dads going home at the end of a day--I represent the recreational vehicle area, the auto area--that they went home and lost their jobs because the credit markets had been destroyed. And so we had a lot of skin in the game. I guess the question I will ask you is, short of the liability discussions that we have had, what skin in the game do you have or should you have or what can we put in there to make sure that your work isn't done for one of the investment banks but is done for accuracy and the American people so that they have some sense of confidence in what you are doing? I mean, what consequence is there to you? The consequence to us is our companies are destroyed and our jobs are lost. Mr. Sharma, would you be willing to help out here? " FOMC20080130meeting--180 178,MR. HOENIG.," Thank you, Mr. Chairman. Let me talk a bit about the region. The Tenth District is generally moving forward at a fairly steady pace, but there are some mixed data. The obvious wide variances are in real estate. Housing is weak--not as weak as some parts of the country but still weak. Also, it is interesting that commercial real estate in each of our major cities right now continues to do well. I recently talked with several developers. They are all doing well but are very concerned, and they are beginning to cut back on their plans and move away from them. So you can see the worry carrying forward in terms of what actions they are taking. In the agricultural area and in the energy area, real estate is a different story. It is booming. Land values have gone up in the ag part--non-irrigated land, something like 20 percent over the past year. If you are near an ethanol plant, it has gone up 25 to 30 percent. It is also interesting that the ag credit system is helping to fund that. Their increase in lending was about 12 percent this past year. That is up from about 9 percent the year before, so they are providing that. They are also now involved in lending to these ethanol plants in a very significant way, helping to carry that boom forward. That gives me some pause in terms of what is going on in some of the rural areas. Related to that, the energy and lease values are also accelerating at a fairly high rate. I found it reminiscent and somewhat disturbing in talking to a couple of individuals when they noted that the land values have about doubled over the past two or three years in some areas, and they said that I should relax because on current ag prices they should have tripled. [Laughter] Where have I seen that before? On the other side, actually, manufacturing in our region has held steady. We have a lot of aircraft manufacturing, which is really strong, and some other smaller manufacturers providing support in both ag and energy, and they seem to be doing well. Technology is also doing well in the region, especially in the mountain areas--the Colorado and Denver areas. Engineering firms are still very strong--the strong demand for engineers and the unfilled positions continue. They are supplying that service across the globe and see continued demand there. So it is mixed, but overall probably our region is doing better than average relative to the rest of the nation. On the national level, my projections suggest that we are going to grow below our potential growth rate. I am not as pessimistic as the Greenbook. I also have inflation coming down, but that is on the assumption that we are able to reverse our monetary policy at a fairly quick pace as we move through this year and into 2009. I will leave it there. Thank you. " CHRG-111shrg57322--913 Mr. Blankfein," I think it was a number of factors. I don't know whether that was the initial factor, but that certainly was a major, major episode in the collapse. Senator McCain. And your involvement in the housing market is not in the direct mortgage business? " CHRG-111shrg55278--73 Mr. Reinhart," Sure, a couple points. One is when you give an entity that has macropowers a supervisory responsibility, they have the ability to clean up their mistakes after the fact. Would a Fed that can lend to an institution be more willing to lend to it when it hadn't identified it as a systemic threat? Would it be willing to use its monetary policy tool to make markets function better in an environment where it had failed to identify some market areas as posing systemic risk? Now, for 6 years, I signed off on the minutes and transcripts of the Federal Open Market Committee, a wonderful resource actually giving the details of deliberations of monetary policy. And the next time you hear someone say there is important cross-pollination between monetary policy decisions and bank supervision, you should ask them to go back to the FOMC transcripts and give you the examples where there was a significant discussion about bank supervisory matters that informed the monetary policy decision. The fact is, as has already been noted, an agency is filled with hardened silos and the economists don't talk to the lawyers who don't talk to the bank supervisors. What is important is to enforce an information sharing, and in some ways, it is easier to do that across agencies than within an agency. " CHRG-111shrg53822--74 Mr. Wallison," I will take that first, I think. My view is--first of all, I do not--in my prepared testimony and in my oral testimony, I said that I thought that banks were the only organizations that really required serious regulation for a variety of reasons. They can create systemic risk, but I do not think others can. On the question of this capital, what we do about banks that are growing and yet they still have the same amount of capital, which increases their leverage, I am one who does believe that we ought to increase capital requirements as growth occurs. As profitability and growth occurs, capital should go up so that it can perform the function that it was supposed to perform, which is as a buffer for the bad times. I think we are seeing today that the 10 percent risk-based capital requirement that was imposed in the United States under Basel I and Basel II, for well capitalized, was insufficient. Banks should have had more capital. But in addition, they should have added to their capital positions as a percentage, as they have grown larger and larger, and as they have more and more profits. That is something that we could very profitably do. And as a matter of fact, it would also go some distance to addressing this question of institutions getting too large and complex, because if additional capital requirements are imposed on them as they get larger and more complex, they will not get larger and more complex. They will make a judgment about what they have to do to be profitable rather than just getting larger. Senator Akaka. Mr. Baily? " CHRG-110shrg50416--29 THE FEDERAL RESERVE SYSTEM Ms. Duke. Thank you. Chairman Dodd, Senator Shelby, and other members of the Committee, I appreciate this opportunity to discuss recent actions taken to stabilize financial markets and foreclosure prevention efforts. My oral remarks today all focus primarily on actions taken by the Federal Reserve. My colleagues are all focusing on other important initiatives at their agencies. Financial markets have been strained for more than a year, as house prices declined, economic activity slowed and investors pulled back from risk taking. These strains intensified in recent weeks. Lending to banks and other financial institutions beyond a few days virtually shut down. Withdrawals from money market mutual funds and prospects that net asset values would fall further severely disrupted commercial paper and other short-term funding markets. Longer term credit became much more costly as credit spreads for bonds jumped and interest rates rose. These problems and increasing concerns about the economy caused equity prices to swing sharply and decline notably. Policymakers here and in other countries have taken a series of extraordinary actions in recent weeks to restore market functioning and improve investor confidence. The Federal Reserve has continued to address ongoing problems in interbank funding markets by expanding its existing lending facilities and recently increased the quantity of term funds at auctions to banks and accommodated greater demand for funds from banks and primary dealers. We also increased our currency swap lines with foreign central banks. To alleviate pressure on money market mutual funds and commercial paper issuers we implemented several important temporary facilities, including one to provide financing to banks to purchase high quality asset-backed commercial paper for money funds, and another to provide a backstop to commercial paper markets by purchasing highly rated commercial paper directly from businesses at a term of 3 months. On Tuesday of this week we announced another program in which we will provide senior secured financing to conduits that purchase certain highly rated commercial paper and certificates of deposit from money market mutual funds. The financial rescue package recently enacted by Congress, the Emergency Economic Stabilization Act (EESA), provides critically important new tools to address financial market problems. EESA authorized the Troubled Asset Relief Program (TARP), which allows Treasury to buy troubled assets, to provide guarantees, and to inject capital to strengthen the balance sheets of financial institutions. As provided in the Act, the Federal Reserve Board and its staff are consulting with Treasury regarding the TARP and Chairman Bernanke serves as Chairman of the Oversight Board for TARP. Last week the first use of TARP funds was announced. The Treasury announced a voluntary capital purchase program and nine of the Nation's largest financial institutions agreed to participate. A second complementary use of TARP funds will be used to purchase mortgage assets in order to remove uncertainty from lenders' balance sheets and to restore confidence in their viability. Another objective is to improve the modification efforts of services on these loans to prevent more avoidable foreclosures. The Federal Reserve System is also working to develop solutions to rising foreclosures. For example, the Federal Reserve has worked with other agencies to put in place the standards and procedures for the new Hope for Homeowners program, and I serve on that Oversight Board. These loans can help borrowers who might otherwise face foreclosure because the new loan payments are affordable and the homeowner gets some equity in their homes. Lenders and servicers are analyzing their borrowers for good candidates for the H4H program. The FHA and its authorized lenders are poised to process applications. We do appreciate the additional flexibility provided in the program by Congress in EESA, in particular allowing up front payments to junior lien holders that agree to release their claims. In addition, the Federal Reserve System is strategically utilizing its presence around the country through its regional Federal Reserve Banks and their branches to address foreclosures. We have employed economic research and analysis to target scarce resources to the communities most in need of assistance. The Federal Reserve System has sponsored or cosponsored more than 80 events related to foreclosures since last summer, reaching more than 6,000 lenders, counselors, community development specialists, and policymakers. For example, we sponsored five ``Recovery, Renewal, Rebuilding'' forums this year in which key experts discuss the challenges related to REO inventories and vacant properties and explored solutions. We also cosponsored an event at Gillette Stadium in August that brought together more than 2,100 borrowers seeking help with servicers and housing counselors. In conclusion, the Federal Reserve has taken a range of actions to stabilize financial markets and to help borrowers and communities. Taken together, these measures should help rebuild confidence in the financial system, increase the liquidity of financial markets, and improve the ability of financial institutions to raise capital from private sources. Efforts to stem avoidable foreclosures, I believe, will also help homeowners and communities. These steps are important to help stabilize our financial institutions and the housing market and will facilitate a return to more normal functioning and extension of credit. Thank you. " CHRG-111shrg54589--39 Mr. Gensler," Senator, I appreciate your concern. What we are recommending is that clear rules of the road would be put out by the regulators that are best at setting capital. For these dealers, it is most likely going to be either their bank or other prudential. In some cases it would be the Securities and Exchange Commission or possibly the systemic regulator. Those capital standards set by rule would be set out for customized and standardized products as well. So I would not envision a trade-by-trade circumstance or a contract-by-contract, as you asked. Senator Johanns. No, but the nature of this system and the reason why it got some legs underneath it is because it was so darn adaptable. Now, in the end, that had its downside, too, and then you add stupidity to it, and greed, and it really went south. But as Senator Crapo points out, many companies and, therefore, many shareholders got great benefit from this process. And it seems to me that if you run into anything that is not standardized, you run into the bureaucracy. " CHRG-111hhrg54867--11 Secretary Geithner," Thank you, Mr. Chairman, Ranking Member Bachus, members of the committee. It is a pleasure to be back before you today and to talk about how best to reform the system. I am pleased to hear the enthusiasm for reform across both sides of the aisle. And, of course, we all recognize the task we face is how to do it right and how to get it right. Our objective, of course, is to provide stronger protection for consumers and investors, to create a more stable financial system, and to reduce the risk that taxpayers have to pay for the consequences of future financial crises. We have outlined a broad set of proposals for achieving these. We provided detailed and extensive legislative language. We welcome the time and effort you have already put into considering these proposals and the suggestions you have made, many of you individually and collectively, have made to improve them. As the President likes to say, we don't have a monopoly of wisdom on these things. Our test is, what is going to work? That is our test. What will work? What will create a more stable system, better protections, with less risk to the taxpayer? I want to focus my remarks briefly on what I think are the two key challenges before us at the center of any debate on reform. The first is about how you achieve the right balance between consumer protection and choice and competition. And the other is how to deal with the moral-hazard risk people refer to as ``too-big-to-fail.'' So, first, on the consumer challenge, our system of rules and enforcement failed to protect consumers and investors. The failures were extensive and costly. They caused enormous damage not just to those who were the direct victims of predatory practice, fraud, and deception, but to millions of others who lost their jobs and their homes or their savings in the wake of the crisis. And to fix this--and I will just say it simply--we need to have strong minimum national standards for protection. They need to apply not just to banks but to institutions that compete with banks in the business of providing credit. They need to be enforced effectively, consistently, and fairly. And there need to be consequences for firms that engage in unfair, ineffective practices, consequences that are strong enough to deter that behavior. We believe we cannot achieve that within our current framework of diffused authority with the responsibility divided among a complex mix of different supervisors and authorities who have different missions and many other priorities. We think it requires fundamental overhaul so that consumers can understand the risks of the products they are sold and have reasonable choices, and institutions have to live with some commonsense rules about financial credit. Of course, the challenge is to do this without limiting consumer choice, without stifling competition that is necessary for innovation, and without creating undue burden and cost on the system. Our proposal tries to achieve this balance by consolidating the fragmented, scattered authorities that are now spread across the Federal Government and State government. And it is designed to save institutions that are so important to our communities--credit unions, community banks, other institutions that provide credit--from making that untenable choice between losing revenue, losing market share, or stooping to match the competitive practices that less responsible competitors engage in, competitors that had no oversight, that were allowed to engage in systematic predatory practices without restraint. Now, some have suggested that, to ensure no increase in regulatory burden, we should separate rule-writing authority from enforcement. But our judgment is this is a recipe for bad rules that are weakly enforced--a weaker agency. So we think we need one entity with a clear mission, the authority to write rules and enforce them. Now, just briefly on this deeply important, consequential question of moral hazard and ``too-big-to-fail,'' no financial system can function effectively if institutions are allowed to operate with the expectation they are going to be protected from losses. And we can't have a system in which taxpayers are called on to absorb the costs of failure. We can't achieve this with simple declarations of intent to let future financial crises burn themselves out. We need to build a system that is strong enough to allow firms to fail without the risk of substantial collateral damage to the economy or to the taxpayer. And this requires that we have the tools and authority to unwind, dismantle, restructure, or close large institutions that are at the risk of failure without the taxpayers assuming the burden. It requires that banks pay for the costs incurred by the government in acting to contain the damage caused by bank failures. And this requires higher capital standards, tougher constraints on leverage across-the-board, with more rigorous standards applied to those who are the largest, most complicated, posing the biggest risks to the system. Now, this package of measures is central to reform. You can't do each of these and expect it to work. You have to take a broad, comprehensive approach. And the central objective, again, is to make the system strong enough so we can allow failure to happen in a way that doesn't cause enormous collateral damage to the economy and to the taxpayer. As the President said last week, taxpayers shouldered the burden of the bailout, and they are still bearing the burden of the fallout in lost jobs, lost homes, and lost opportunities. We look forward to working with this committee to help create a more stable system. We can't let the momentum for reform fade as the memory of the crisis recedes. Thank you, Mr. Chairman. [The prepared statement of Secretary Geithner can be found on page 54 of the appendix.] " FinancialCrisisReport--235 General, OTS typically relied on the “cooperation of IndyMac management to obtain needed improvements” – which was usually not forthcoming – to remedy identified problems. 909 In February 2011, the SEC charged three former senior IndyMac executives with securities fraud for misleading investors about the company’s deteriorating financial condition. 910 The SEC alleged that the former CEO and two former CFOs participated in the filing of false and misleading disclosures about the financial stability of IndyMac and its main subsidiary, IndyMac Bank F.S.B. One of the executives – S. Blair Abernathy, former CFO – has agreed to settle the SEC’s charges without admitting or denying the allegations for approximately $125,000. The SEC’s complaint against former CEO Michael W. Perry and former CFO A. Scott Keys seeks, among other things, disgorgement, financial penalties, and a bar on their acting as an officer or director of a publicly traded corporation. 911 IndyMac was the third-largest bank failure in U.S. history and the largest collapse of a FDIC-insured depository institution since 1984. 912 At the time of its collapse, IndyMac had $32 billion in assets and $19 billion in deposits, of which approximately $18 billion were insured by the FDIC. 913 IndyMac’s failure cost the FDIC $10.7 billion, 914 a figure which, at the time, represented over 10% of the federal Deposit Insurance Fund. 915 (c) New Century New Century Financial Corporation is an example of a failed mortgage lender that operated largely without federal or state oversight, other than as a publicly traded corporation overseen by the SEC. New Century originated, purchased, sold, and serviced billions of dollars in subprime residential mortgages, operating not as a bank or thrift, but first as a private corporation, then as a publicly traded corporation, and finally, beginning in 2004, as a publicly traded Real Estate Investment Trust (REIT). 916 By 2007, New Century had approximately 7,200 employees, offices across the country, and a loan production volume of $51.6 billion, making it 909 Id. at 38. 910 2/11/2011 SEC press release, “SEC Charges Former Mortgage Lending Executives With Securities Fraud,” http://www.sec.gov/news/press/2011/2011-43.htm. 911 Id. 912 “The Fall of IndyMac,” CNNMoney.com (7/13/2008). 913 Id. 914 3/31/2010 Office of Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” http://www.treasury.gov/about/organizational- structure/ig/Documents/March%202010%20SAR%20Final%20%20(04-30-10).pdf. 915 “Crisis Deepens as Big Bank Fails; IndyMac Seized in Largest Bust in Two Decades,” Wall Street Journal (7/12/2008). 916 See SEC v. Morrice , Case No. SACV09-01426 (USDC CD Calif.), Complaint (Dec. 7, 2009), ¶¶ 12-13 (hereinafter “SEC Complaint against New Century Executives”). See also In re New Century , Case No. 2:07-cv- 00931-DDP (USDC CD Calif.), Amended Consolidated Class Action Complaint (March 24, 2008), at ¶¶ 55-58 (hereinafter “New Century Class Action Complaint”). the second largest subprime lender in the country. 917 Because it did not accept deposits or have insured accounts, it was not overseen by any federal or state bank regulator. CHRG-111shrg51395--117 PREPARED STATEMENT OF JOHN C. COFFEE, JR. Adolf A. Berle Professor of Law, Columbia University Law School March 10, 2009 Enhancing Investor Protection and the Regulation of Securities Markets ``When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.'' ----Charles Prince, CEO of Citigroup Financial Times, July 2007 Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am pleased and honored to be invited to testify here today. We are rapidly approaching the first anniversary of the March 17, 2008, insolvency of Bear Stearns, the first of a series of epic financial collapses that have ushered in, at the least, a major recession. Let me take you back just one year ago when, on this date in 2008, the U.S. had five major investment banks that were independent of commercial banks and were thus primarily subject to the regulation of the Securities and Exchange Commission: Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns. Today, one (Lehman) is insolvent; two (Merrill Lynch and Bear Stearns) were acquired on the brink of insolvency by commercial banks, with the Federal Reserve pushing the acquiring banks into hastily arranged ``shotgun'' marriages; and the remaining two (Goldman and Morgan Stanley) have converted into bank holding companies that are primarily regulated by the Federal Reserve. The only surviving investment banks not owned by larger commercial banks are relatively small boutiques (e.g., Lazard Freres). Given the total collapse of an entire class of institutions that were once envied globally for their entrepreneurial skill and creativity, the questions virtually ask themselves: Who failed? What went wrong? Although there are a host of candidates--the investment banks, themselves, mortgage loan originators, credit-rating agencies, the technology of asset-backed securitizations, unregulated trading in exotic new instruments (such as credit default swaps), etc.--this question is most pertinently asked of the SEC. Where did it err? In overview, 2008 witnessed two closely connected debacles: (1) the failure of a new financial technology (asset-backed securitizations), which grew exponentially until, after 2002, annual asset-backed securitizations exceeded the annual total volume of corporate bonds issued in the United States, \1\ and (2) the collapse of the major investment banks. In overview, it is clear that the collapse of the investment banks was precipitated by laxity in the asset-backed securitization market (for which the SEC arguably may bear some responsibility), but that this laxity began with the reckless behavior of many investment banks. Collectively, they raced like lemmings over the cliff by abandoning the usual principles of sound risk management both by (i) increasing their leverage dramatically after 2004, and (ii) abandoning diversification in pursuit of obsessive focus on high-profit securitizations. Although these firms were driven by intense competition and short-term oriented systems of executive compensation, their ability to race over the cliff depended on their ability to obtain regulatory exemptions from the SEC. Thus, as will be discussed, the SEC raced to deregulate. In 2005, it adopted Regulation AB (an acronym for ``Asset-Backed''), which simplified the registration of asset-backed securitizations without requiring significant due diligence or responsible verification of the essential facts. Even more importantly, in 2004, it introduced its Consolidated Supervised Entity Program (``CSE''), which allowed the major investment banks to determine their own capital adequacy and permissible leverage by designing their own credit risk models (to which the SEC deferred). Effectively, the SEC abandoned its long-standing ``net capital rule'' \2\ and deferred to a system of self-regulation for these firms, which largely permitted them to develop their own standards for capital adequacy.--------------------------------------------------------------------------- \1\ See John C. Coffee, Jr., Joel Seligman & Hillary Sale, SECURITIES REGULATION: Cases and Materials (10th ed. 2007) at 10. \2\ See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''), 17 CFR 240.15c3-1.--------------------------------------------------------------------------- For the future, it is less important to allocate culpability and blame than to determine what responsibilities the SEC can perform adequately. The recent evidence suggests that the SEC cannot easily or effectively handle the role of systemic risk regulator or even the more modest role of a prudential financial supervisor, and it may be more subject to capture on these issues than other agencies. This leads me to conclude (along with others) that the U.S. needs one systemic risk regulator who, among other tasks, would have responsibility for the capital adequacy and safety and soundness of all institutions that are too ``big to fail.'' \3\ The key advantage of a unified systemic risk regulator with jurisdiction over all large financial institutions is that it solves the critical problem of regulatory arbitrage. AIG, which has already cost U.S. taxpayers over $150 billion, presents the paradigm of this problem because it managed to issue billions in credit default swaps without becoming subject to regulation by any regulator at either the federal or state level.--------------------------------------------------------------------------- \3\ I have made this argument in greater detail in an article with Professor Hillary Sale, which will appear in the 75th Anniversary of the SEC volume of the Virginia Law Review. See Coffee and Sale, ``Redesigning the SEC: Does the Treasury Have a Better Idea?'' (available on the Social Science Research Network at http://ssrn.com/abstract=1309776).--------------------------------------------------------------------------- But one cannot stop with this simple prescription. The next question becomes what should be the relationship between such a systemic risk regulator and the SEC? Should the SEC simply be merged into it or subordinated to it? I will argue that it should not. Rather, the U.S. should instead follow a ``twin peaks'' structure (as the Treasury Department actually proposed in early 2008 before the current crisis crested) that assigns prudential supervision to one agency and consumer protection and transparency regulation to another. Around the globe, countries are today electing between a unified financial regulator (as typified by the Financial Services Authority (``FSA'') in the U.K.) and a ``twin peaks'' model (which both Australia and The Netherlands have followed). I will argue that the latter model is preferable because it deals better with serious conflict of interest problems and the differing cultures of securities and banking regulators. By culture, training, and professional orientation, banking regulators are focused on protecting bank solvency, and they historically have often regarded increased transparency as inimical to their interests, because full disclosure of a bank's problems might induce investors to withdraw deposits and credit. The result can sometimes be a conspiracy of silence between the regulator and the regulated to hide problems. In contrast, this is one area where the SEC's record is unblemished; it has always defended the principle that ``sunlight is the best disinfectant.'' Over the long-run, that is the sounder rule. If I am correct that a ``twin peaks'' model is superior, then Congress has to make clear the responsibilities of both agencies in any reform legislation in order to avoid predictable jurisdictional conflicts and to identify a procedure by which to mediate those disputes that are unavoidable.What Went Wrong? This section will begin with the problems in the mortgage loan market, then turn to the failure of credit-rating agencies, and finally examine the SEC's responsibility for the collapse of the major investment banks.The Great American Real Estate Bubble The earliest origins of the 2008 financial meltdown probably lie in deregulatory measures, taken by the U.S. Congress at the end of the 1990s, that placed some categories of derivatives and the parent companies of investment banks beyond effective regulation. \4\ Still, most accounts of the crisis start by describing the rapid inflation of a bubble in the U.S. housing market. Here, one must be careful. The term ``bubble'' can be a substitute for closer analysis and may carry a misleading connotation of inevitability. In truth, bubbles fall into two basic categories: those that are demand-driven and those that are supply-driven. The majority of bubbles fall into the former category, \5\ but the 2008 financial market meltdown was clearly a supply-driven bubble, \6\ fueled by the fact that mortgage loan originators came to realize that underwriters were willing to buy portfolios of mortgage loans for asset-backed securitizations without any serious investigation of the underlying collateral. With that recognition, loan originators' incentive to screen borrowers for creditworthiness dissipated, and a full blown ``moral hazard'' crisis was underway. \7\--------------------------------------------------------------------------- \4\ Interestingly, this same diagnosis was recently given by SEC Chairman Christopher Cox to this Committee. See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing and Urban Affairs, United States Senate, September 23, 2008. Perhaps defensively, Chairman Cox located the origins of the crisis in the failure of Congress to give the SEC jurisdiction over investment bank holding companies or over-the-counter derivatives (including credit default swaps), thereby creating a regulatory void. \5\ For example, the high-tech Internet bubble that burst in early 2000 was a demand-driven bubble. Investors simply overestimated the value of the Internet, and for a time initial public offerings of ``dot.com'' companies would trade at ridiculous and unsustainable multiples. But full disclosure was provided to investors and the SEC cannot be faulted in this bubble--unless one assigns it the very paternalistic responsibility of protecting investors from themselves. \6\ This is best evidenced by the work of two University of Chicago Business School professors discussed below. See Atif Mian and Amir Sufi, ``The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis'', (http://ssrn.com/abstract=1072304) (May 2008). \7\ Interestingly, ``moral hazard'' problems also appear to have underlain the ``savings and loan'' crisis in the United States in the 1980s, which was the last great crisis involving financial institutions in the United States. For a survey of recent banking crises making this point, see Note, Anticipatory Regulation for the Management of Banking Crises, 38 Colum. J. L. & Soc. Probs. 251 (2005).--------------------------------------------------------------------------- The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications. \8\ With an increased supply of mortgage credit, housing prices rose rapidly, as new buyers entered the market. But at the same time, a corresponding increase in mortgage debt relative to income levels in these same communities made these loans precarious. A study by University of Chicago Business School professors has found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults--in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials. \9\ This study determined that a one standard deviation in the supply of mortgages from 2001 to 2004 produced a one standard deviation increase thereafter in mortgage default rates. \10\--------------------------------------------------------------------------- \8\ See Mian and Sufi, supra note 6, at 11 to 13. \9\ Id. at 18-19. \10\ Id. at 19.--------------------------------------------------------------------------- Even more striking, however, was its finding that the rate of mortgage defaults was highest in those neighborhoods that had the highest rates of securitization. \11\ Not only did securitization correlate with a higher rate of default, but that rate of default was highest when the mortgages were sold by the loan originator to financial firms unaffiliated with the loan originator. \12\ Other researchers have reached a similar conclusion: conditional on its being actually securitized, a loan portfolio that was more likely to be securitized was found to default at a 20 percent higher rate than a similar risk profile loan portfolio that was less likely to be securitized. \13\ Why? The most plausible interpretation is that securitization adversely affected the incentives of lenders to screen their borrowers.--------------------------------------------------------------------------- \11\ Id. at 20-21. \12\ Id. \13\ See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, ``Did Securitization Lead to Lax Screening? Evidence from Subprime Loans,'' (http://ssrn.com/abstract=1093137) (April, 2008). These authors conclude that securitization did result in ``lax screening.''--------------------------------------------------------------------------- Such a conclusion should not surprise. It simply reflects the classic ``moral hazard'' problem that arises once loan originators did not bear the cost of default by their borrowers. As early as March, 2008, The President's Working Group on Financial Markets issued a ``Policy Statement on Financial Market Developments'' that explained the financial crisis as the product of five ``principal underlying causes of the turmoil in financial markets'': a breakdown in underwriting standards for subprime mortgages; a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors, related in part to failures to provide or obtain adequate risk disclosures; flaws in credit rating agencies' assessment of subprime residential mortgages . . . and other complex structured credit products, . . . risk management weaknesses at some large U.S. and European financial institutions; and regulatory policies, including capital and disclosure requirements, that failed to mitigate risk management weaknesses. \14\--------------------------------------------------------------------------- \14\ The President's Working Group on Financial Markets, ``Policy Statement on Financial Market Developments,'' at 1 (March 2008). Correct as the President's Working Group was in noting the connection between the decline of discipline in the mortgage loan origination market and a similar laxity among underwriters in the capital markets, it did not focus on the direction of the causality. Did mortgage loan originators fool or defraud investment bankers? Or did investment bankers signal to loan originators that they would buy whatever the loan originators had to sell? The available evidence tends to support the latter hypothesis: namely, that irresponsible lending in the mortgage market was a direct response to the capital markets' increasingly insatiable demand for financial assets to securitize. If underwriters were willing to rush deeply flawed asset-backed securitizations to the market, mortgage loan originators had no rational reason to resist them. The rapid deterioration in underwriting standards for subprime mortgage loans is revealed at a glance in the following table: \15\--------------------------------------------------------------------------- \15\ See Allen Ferrell, Jennifer Bethel and Gang Hu, Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis (Harvard Law & Economics Discussion Paper No. 612, Harvard Law School Program in Risk Regulation Research Paper No. 08-5) at Table 4. Underwriting Standards in Subprime Home-Purchase Loans, 2001-2006---------------------------------------------------------------------------------------------------------------- Debt Year Low/No-Doc Payments/ Loan/Value ARM Share Interest- Share Income Only Share----------------------------------------------------------------------------------------------------------------2001...................................... 28.5% 39.7% 84.0% 73.8% 0.0%2002...................................... 38.6% 40.1% 84.4% 80.0% 2.3%2003...................................... 42.8% 40.5% 86.1% 80.1% 8.6%2004...................................... 45.2% 41.2% 84.9% 89.4% 27.3%2005...................................... 50.7% 41.8% 83.2% 93.3% 37.8%2006...................................... 50.8% 42.4% 83.4% 91.3% 22.8%----------------------------------------------------------------------------------------------------------------Source: Freddie Mac, obtained from the International Monetary Fund. The investment banks could not have missed that low document loans (also called ``liar loans'') rose from 28.5 percent to 50.8 percent over the 5 year interval between 2001 and 2006 or that ``interest only'' loans (on which there was no amortization of principal) similarly grew from 6 percent to 22.8 percent over this same interval. Thus, the real mystery is not why loan originators made unsound loans, but why underwriters bought them. Here, it seems clear that both investment and commercial banks saw high profits in securitizations and believed they could quickly sell on a global basis any securitized portfolio of loans that carried an investment grade rating. In addition, investment banks may have had a special reason to focus on securitizations: structured finance offered a level playing field where they could compete with commercial banks, whereas, as discussed later, commercial banks had inherent advantages at underwriting corporate debt and were gradually squeezing the independent investment banks out of this field. \16\ Consistent with this interpretation, anecdotal evidence suggests that due diligence efforts within the underwriting community slackened in asset-backed securitizations after 2000. \17\ Others have suggested that the SEC contributed to this decline by softening its disclosure and due diligence standards for asset-backed securitizations, \18\ in particular by adopting in 2005 Regulation AB, which covers the issuance of asset backed securities. \19\ From this perspective, relaxed discipline in both the private and public sectors overlapped to produce a disaster.--------------------------------------------------------------------------- \16\ See text and notes infra at notes 56 to 61. \17\ Investment banks formerly had relied on ``due diligence'' firms that they employed to determine whether the loans within a loan portfolio were within standard parameters. These firms would investigate and inform the underwriter as to the percentage of the loans that were ``exception'' loans (i.e., loans outside the investment bank's normal guidelines). Subsequent to 2000, the percentage of ``exception loans'' in portfolios securitized by these banks often rose from the former level of 25 percent to as high as 80 percent. Also, the underwriters scaled back the intensity of the investigations that they would authorize the ``due diligence'' firm to conduct, reducing from 30 percent to as few as 5 percent the number of loans in a portfolio that it was to check. See Vikas Bajaj & Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' N.Y. Times, January 12, 2008, at p. A-1. \18\ See Richard Mendales, ``Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown And How To Fix It'' (Working Paper 2008) at 36 (forthcoming in 2009, U. Ill. L. Rev.). \19\ See Securities Act Release No. 8518 (``Asset-Backed Securities'') (January 7, 2005, 79 FR 1506). Regulation AB codified a series of ``no action'' letters and established disclosures standards for all asset-backed securitizations. See 17 C.F.R. 229.1100-1123 (2005). Although it did not represent a sharp deregulatory break with the past, Regulation AB did reduce the due diligence obligation of underwriters by eliminating any need to assure that assets included in a securitized pool were adequately documented. See Mendales, supra note 18.---------------------------------------------------------------------------Credit Rating Agencies as Gatekeepers It has escaped almost no one's attention that the credit rating agencies bear much responsibility for the 2008 financial crisis, with the consensus view being that they inflated their ratings in the case of structured finance offerings. Many reasons have been given for their poor performance: (1) rating agencies faced no competition (because there are really only three major rating agencies); (2) they were not disciplined by the threat of liability (because credit rating agencies in the U.S. appear never to have been held liable and almost never to have settled a case with any financial payment); (3) they were granted a ``regulatory license'' by the SEC, which has made an investment grade rating from a rating agency that was recognized by the SEC a virtual precondition to the purchase of debt securities by many institutional investors; (4) they are not required to verify information (as auditors and securities analysts are), but rather simply express views as to the creditworthiness of the debt securities based on the assumed facts provided to them by the issuer. \20\ These factors all imply that credit rating agencies had less incentive than other gatekeepers to protect their reputational capital from injury. After all, if they face little risk that new entrants could enter their market to compete with them or that they could be successfully sued, they had less need to invest in developing their reputational capital or taking other precautions. All that was necessary was that they avoid the type of major scandal, such as that which destroyed Arthur Andersen & Co., the accounting firm, that had made it impossible for a reputable company to associate with them.--------------------------------------------------------------------------- \20\ For these and other explanations, see Coffee, GATEKEEPERS: The Professions and Corporate Governance (Oxford University Press, 2006), and Frank Partnoy, ``How and Why Credit Rating Agencies Are Not Like Other Gatekeepers'' (http://ssrn.com/abstract=900257) (May 2006).--------------------------------------------------------------------------- Much commentary has suggested that the credit rating agencies were compromised by their own business model, which was an ``issuer pays'' model under which nearly 90 percent of their revenues came from the companies they rated. \21\ Obviously, an ``issuer pays'' model creates a conflict of interest and considerable pressure to satisfy the issuer who paid them. Still, neither such a conflicted business model nor the other factors listed above can explain the dramatic deterioration in the performance of the rating agencies over the last decade. Both Moody's and Standard & Poor were in business before World War I and performed at least acceptably until the later 1990s. To account for their more recent decline in performance, one must point to more recent developments and not factors that long were present. Two such factors, each recent and complementary with the other, do provide a persuasive explanation for this deterioration: (1) the rise of structured finance and the change in relationships that it produced between the rating agencies and their clients; and (2) the appearance of serious competition within the ratings industry that challenged the long stable duopoly of Moody's and Standard & Poor's and that appears to have resulted in ratings inflation.--------------------------------------------------------------------------- \21\ See Partnoy, supra note 20.--------------------------------------------------------------------------- First, the last decade witnessed a meteoric growth in the volume and scale of structured finance offerings. One impact of this growth was that it turned the rating agencies from marginal, basically break-even enterprises into immensely profitable enterprises that rode the crest of the breaking wave of a new financial technology. Securitizations simply could not be sold without ``investment grade'' credit ratings from one or more of the Big Three rating agencies. Structured finance became the rating agencies' leading source of revenue. Indeed by 2006, structured finance accounted for 54.2 percent of Moody's revenues from its ratings business and 43.5 percent of its overall revenues. \22\ In addition, rating structured finance products generated much higher fees than rating similar amounts of corporate bonds. \23\ For example, rating a $350 million mortgage pool could justify a fee of $200,000 to $250,000, while rating a municipal bond of similar size justified only a fee of $50,000. \24\--------------------------------------------------------------------------- \22\ See In re Moody's Corporation Securities Litigation, 2009 U.S. Dist. LEXIS 13894 (S.D.N.Y. February 23, 2009) at *6 (also noting that Moody's grossed $1.635 billion from its ratings business in 2006). \23\ See Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught Napping?'' New York Times, December 7, 2008, at p. 1, 40. \24\ Id.--------------------------------------------------------------------------- Beyond simply the higher profitability of rating securitized transactions, there was one additional difference about structured finance that particularly compromised the rating agencies as gatekeepers. In the case of corporate bonds, the rating agencies rated thousands of companies, no one of which controlled any significant volume of business. No corporate issuer, however large, accounted for any significant share of Moody's or S&P's revenues. But with the rise of structured finance, the market became more concentrated. As a result, the major investment banks acquired considerable power over the rating agencies, because each of them had ``clout,'' bringing highly lucrative deals to the agencies on a virtually monthly basis. As the following chart shows, the top six underwriters controlled over 50 percent of the mortgage-backed securities underwriting market in 2007, and the top eleven underwriters each had more than 5 percent of the market and in total controlled roughly 80 percent of this very lucrative market on whom the rating agencies relied for a majority of their ratings revenue: \25\--------------------------------------------------------------------------- \25\ See Ferrell, Bethel, and Hu, supra note 15, at Table 2. For anecdotal evidence that ratings were changed at the demand of the investment banks, see Morgenson, supra note 23. MBS Underwriters in 2007-------------------------------------------------------------------------------------------------------------------------------------------------------- Proceed Amount + Rank Book Runner Number of Market Overallotment Sold in U.S. Offerings Share ($mill)--------------------------------------------------------------------------------------------------------------------------------------------------------1....................................................... Lehman Brothers 120 10.80% $100,1092....................................................... Bear Stearns & Co., Inc. 128 9.90% 91,6963....................................................... Morgan Stanley 92 8.20% 75,6274....................................................... JPMorgan 95 7.90% 73,2145....................................................... Credit Suis109 7.50% 69,5036....................................................... Bank of America Securities LLC 101 6.80% 62,7767....................................................... Deutsche Bank AG 85 6.20% 57,3378....................................................... Royal Bank of Scotland Group 74 5.80% 53,3529....................................................... Merrill Lynch 81 5.20% 48,40710...................................................... Goldman Sachs & Co. 60 5.10% 47,69611...................................................... Citigroup 95 5.00% 46,75412...................................................... UBS 74 4.30% 39,832-------------------------------------------------------------------------------------------------------------------------------------------------------- If the rise of structured finance was the first factor that compromised the credit rating agencies, the second factor was at least as important and had an even clearer empirical impact. Until the late 1990s, Moody's and Standard & Poor's shared a duopoly over the rating of U.S. corporate debt. But, over the last decade, a third agency, Fitch Ratings, grew as the result of a series of mergers and increased its U.S. market share from 10 percent to approximately a third of the market. \26\ The rise of Fitch challenged the established duopoly. What was the result? A Harvard Business School study has found three significant impacts: (1) the ratings issued by the two dominant rating agencies shifted significantly in the direction of higher ratings; (2) the correlation between bond yields and ratings fell, suggesting that under competitive pressure ratings less reflected the market's own judgment; and (3) the negative stock market reaction to bond rating downgrades increased, suggesting that a downgrade now conveyed worse news because the rated offering was falling to an even lower quality threshold than before. \27\ Their conclusions are vividly illustrated by one graph they provide that shows the correlation between grade inflation and higher competition:--------------------------------------------------------------------------- \26\ Bo Becker and Todd Milburn, ``Reputation and Competition: Evidence from the Credit Rating Industry,'' Harvard Business School, Working Paper No. 09-051 (2008) (http://ssrn.com/abstract =1278150) at p. 4. \27\ Id. at 17. FinancialCrisisReport--234 In July 2007, after the credit rating agencies downgraded the ratings on most subprime mortgage backed securities and the subprime secondary market collapsed, IndyMac – like WaMu – was left holding a large inventory of poor quality mortgage loans it could not sell. As delinquencies increased and the value of the mortgages fell, IndyMac incurred substantial losses, and its depositors began withdrawing funds. The withdrawals continued throughout 2007 and into 2008, eventually reaching $1.55 billion and triggering a liquidity crisis at the bank. 900 In July 2008, IndyMac collapsed and was seized by the FDIC, which had to pay more than $10 billion from the Deposit Insurance Fund to protect insured deposits and pay related expenses. 901 As it did with WaMu, OTS gave IndyMac high CAMELS ratings until shortly before the thrift’s failure, despite the fact that OTS had identified numerous problems with IndyMac’s subprime mortgage business practices. 902 Those problems included adopting an overly narrow definition of “subprime,” so that IndyMac could maintain a lower level of capital reserves; 903 poor underwriting and sloppy property appraisal practices; 904 and improper risk mitigation. 905 Neither OTS nor the FDIC ever took a public enforcement action against the bank. After IndyMac’s failure, the Treasury Inspector General conducted a review and issued a report evaluating OTS’ oversight efforts. 906 The report attributed IndyMac’s collapse to its strategy of rapid growth; originating and securitizing nontraditional, high risk loans; lack of verification of borrowers’ income or assets; lax underwriting; and reliance on high interest loans for its own operations. 907 The Treasury IG found that OTS was aware of IndyMac’s problems, but did not take sufficient enforcement action to correct them. 908 According to the Inspector 899 Id. at 7. 900 Id. at 3. 901 Id. at 1. 902 Id. at 8. 903 Id. at 18. 904 Id. at 21-31. 905 Id. 906 Id. In addition to the Material Loss Review, the Treasury Inspector General investigated OTS’ conduct in permitting thrifts, including IndyMac to backdate certain capital infusions. See 12/22/2008 Office of the Inspector General, Dept. of the Treasury, Letter to Ranking Member Charles Grassley, Senate Committee on Finance, http://media.washingtonpost.com/wp- srv/business/documents/Indymac_Thorson_122308pdf.pdf?sid=ST2008122202386. Darrel Dochow was removed from his position as Director of the OTS West Division for having allowed IndyMac to backdate a capital contribution of $18 million, which made it appear stronger than it really was in the relevant financial statement. Then Acting OTS Director Scott Polakoff was also placed on leave during the backdating investigation, but he disputed that he directed anyone to allow backdated capital injections and asserted that the real impetus for his being placed on leave was his Congressional testimony critical of the agency’s conduct related to AIG. Subcommittee interview of Scott Polakoff (3/16/10). 907 3/31/2009 Office of the Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” at 15, http://www.treasury.gov/about/organizational-structure/ig/Documents/sar042009.pdf. 908 Id. at 31. fcic_final_report_full--127 Even as the Fed was doing little to protect consumers and our financial system from the effects of predatory lending, the OCC and OTS were actively engaged in a campaign to thwart state efforts to avert the com- ing crisis. . . . In the wake of the federal regulators’ push to curtail state authority, many of the largest mortgage-lenders shed their state licenses and sought shelter behind the shield of a national charter. And I think that it is no coincidence that the era of expanded federal preemption gave rise to the worst lending abuses in our nation’s history.  Comptroller Hawke offered the FCIC a different interpretation: “While some crit- ics have suggested that the OCC’s actions on preemption have been a grab for power, the fact is that the agency has simply responded to increasingly aggressive initiatives at the state level to control the banking activities of federally chartered institutions.”  MORTGAGE SECURITIES PLAYERS: “WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT ” Subprime and Alt-A mortgage–backed securities depended on a complex supply chain, largely funded through short-term lending in the commercial paper and repo market—which would become critical as the financial crisis began to unfold in . These loans were increasingly collateralized not by Treasuries and GSE securities but by highly rated mortgage securities backed by increasingly risky loans. Independent mortgage originators such as Ameriquest and New Century—without access to de- posits—typically relied on financing to originate mortgages from warehouse lines of credit extended by banks, from their own commercial paper programs, or from money borrowed in the repo market. For commercial banks such as Citigroup, warehouse lending was a multibillion- dollar business. From  to , Citigroup made available at any one time as much as  billion in warehouse lines of credit to mortgage originators, including  mil- lion to New Century and more than . billion to Ameriquest.  Citigroup CEO Chuck Prince told the FCIC he would not have approved, had he known. “I found out at the end of my tenure, I did not know it before, that we had some warehouse lines out to some originators. And I think getting that close to the origination function— being that involved in the origination of some of these products—is something that I wasn’t comfortable with and that I did not view as consistent with the prescription I had laid down for the company not to be involved in originating these products.”  As early as , Moody’s called the new asset-backed commercial paper (ABCP) programs “a whole new ball game.”  As asset-backed commercial paper became a popular method to fund the mortgage business, it grew from about one-quarter to about one-half of commercial paper sold between  and . CHRG-111shrg61651--27 Mr. Zubrow," Thank you very much, Chairman Dodd, Ranking Member Shelby, Members of the Committee. Thank you for giving us the opportunity to appear this morning. While the history of the financial crisis has yet to be written conclusively, we know enough about the causes to recognize that we need substantial regulatory reform. Our current framework was patched together over many decades. When it was tested, we saw its flaws all too clearly. Mr. Chairman, I want to assure you and the other Members of the Committee that we strongly support your efforts to craft and pass meaningful regulatory legislation. In our view, the markets and the economy reflect continued uncertainty about the regulatory environment. However, the details matter a great deal, and a bill that creates further uncertainty or undermines the competitiveness of the U.S. financial sector will not serve our goal of a strong, stable economy. At a minimum, we need a systemic regulator to monitor risk across our financial system. In addition, as we at JPMorgan Chase have stated repeatedly, no firm, including our own, should be too big to fail. Regulators need enhanced resolution authority to wind down failing firms, in a controlled way that does not put taxpayers' dollars at risk or the broader economy at risk. Other aspects of the regulatory system also need to be strengthened, including consumer protection, capital standards and the oversight of OTC derivatives. But I emphasize systemic risk regulation and resolution authority because they provide a useful framework for consideration of the most recent proposals from the Administration. Two weeks ago, the Administration proposed new restrictions on certain activities related to proprietary trading, hedge funds and private equity. The new proposals are a divergence from the hard work being done by legislators, central banks and regulators around the world to address the root causes of the financial crisis and to establish robust mechanisms to properly regulate systemically important financial institutions. While there may be valid reasons to examine these activities, there should be no misunderstanding. The activities the Administration proposes to restrict did not cause the financial crisis. Further, regulators currently have the authority to ensure that these risks are adequately managed in the areas that the Administration proposes to restrict. We need to take the next logical step of extending these authorities to all systemically important firms regardless of their legal structure. If the last 2 years have taught us anything, it is that threats to our financial system can and do originate in nondepository institutions. Thus, any new regulatory framework should reach all systemically important entities, including investment banks whether or not they have insured deposits. All systemically important institutions should be regulated to the same rigorous standards. If we leave some firms outside the scope of this regulation framework, we will be right back where we were before the crisis started. We cannot have two tiers of regulation for these systemically important, interconnected firms. As I noted at the outset, it is also very important that we get the details right. Thus far, the Administration has offered few details on what is meant about proprietary trading. Any individual trade taken in isolation might appear to be proprietary trading, but in fact is part of a mosaic of serving clients and properly managing the firm's risks. If defined improperly, this proposal could reduce the safety and soundness of our banking institutions, raise the cost of capital formation and restrict the availability of credit for businesses, large and small, all with no commensurate benefit to reducing systemic risk. Similarly, the Administration has yet to define what ownership or sponsorship of hedge funds and private equity activities means. Asset managers, including JPMorgan, serve a broad range of clients including individuals, universities and pensions, and need to offer these investors a broad range of investment opportunities across all types of asset classes. In each case, investments are designed to meet the needs of our clients. While we agree that the United States must show leadership in regulating financial firms, if we take an approach that is out of sync with other major countries, without any demonstrable risk reduction benefit, we will dramatically weaken our firms' ability to serve our clients in this Country. The Administration also proposed certain limits on the size of financial firms. If you consider the institutions that failed during the crisis, some of the largest and most consequential failures were standalone investment banks, mortgage companies, thrifts and insurance companies, not the diversified financial firms that appear to be the target of the Administration's proposals. It is not AIG's or Bear Stearns's size that led to their problems, but rather the interconnection of those firms that required the Government to step in. In fact, our capabilities, size and diversity were essential to both withstanding the impacts of the crisis and emerging as a stronger firm, but equally importantly putting us in a position to acquire Bear Stearns and Washington Mutual when the Government asked us to help. An artificial cap on liabilities will likely have significant negative consequences. Banks' liabilities and capital support the asset growth of their lending activities. By artificially capping liabilities, banks may be incented to reduce the growth of assets or the size of their existing balance sheets, which in turn would restrict our ability to make loans to consumers, to businesses, as well as to invest in Government securities. While numerical limits and strict rules may sound simple. There is great potential that they would undermine the goals of economic stability, growth and job creation. The better solution is modernization of our financial regulatory regime that gives regulators the authority and the resources needed to do the rigorous oversight involved in examining firms' balance sheets and lending practices. Let me conclude by just noting that it is vital that you as policymakers and those like us, with a stake in our financial system, work together to overhaul regulation thoughtfully and well. While the specific changes may seem arcane and technical, they are critical to the future of our economy. We look forward to working with the Committee to enact reforms that will position our financial industry and economy for sustained growth for decades to come. Thank you and I look forward to your questions. " CHRG-111shrg53822--85 PREPARED STATEMENT OF GARY H. STERN * President and Chief Executive Officer, Federal Reserve Bank of Minneapolis May 6, 2009 Chairman Dodd, Ranking Member Shelby, and members of the Committee, thank you for the opportunity to review the ``too-big-to-fail'' (TBTF) problem with you today. I will develop a simple conclusion in this testimony: The key to addressing TBTF is to reduce substantially the negative spillover effects stemming from the failure of a systemically important financial institution. Let me explain how I have come to that conclusion.--------------------------------------------------------------------------- * These remarks reflect my views and not necessarily those of others in the Federal Reserve.--------------------------------------------------------------------------- The TBTF problem is one of undesirable incentives which we need to address if we hope to fix the problem. TBTF arises, by definition, when the uninsured creditors of systemically important financial institutions expect government protection from loss when these financial institutions get into financial or operational trouble. The key to addressing this problem and changing incentives, therefore, is to convince these creditors that they are at risk of loss. If creditors continue to expect special protection, the moral hazard of government protection will continue. That is, the creditors will continue to underprice the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline Facing prices that are too low, systemically important firms will take on too much risk. Excessive risk-taking squanders valuable economic resources and, in the extreme, leads to financial crises that impose substantial losses on taxpayers. Put another way, if policymakers do not address TBTF, the United States likely will endure an inefficient financial system, slower economic growth, and lower living standards than otherwise would be the case. To address TBTF, policymakers must change these incentives, and I recommend the following steps to achieve that goal. And let me emphasize that these are my personal views. First, identify why policymakers provide protection to uninsured creditors. If we do not address the underlying rationale for providing protection, we will not credibly put creditors of systemically important firms at risk of loss. The threat of financial spillovers leads policymakers to provide such protection.\1\ Indeed, I would define systemically important financial institutions by the potential that their financial and operational weaknesses can spill over to other financial institutions, capital markets, and the rest of the economy. As a result, my recommendations to address the TBTF problem focus on mitigating the perceived and real fallout from financial spillovers.--------------------------------------------------------------------------- \1\ We discuss other potential motivations that could lead to TBTF support and why we think spillovers are the most important motivation in Gary H. Stern and Ron J. Feldman, 2009, Too Big To Fail: The Hazards of Bank Bailouts, chapter 5.--------------------------------------------------------------------------- Second, enact reforms to reduce the perceived or real threat of the spillovers that motivate after-the-fact protection of uninsured creditors. These reforms include, but are not limited to, increased supervisory focus on preparation for the potential failure of a large financial institution, enhanced prompt corrective action, and better communication of efforts to put creditors of systemically important firms at risk of loss. I call this combination of reforms systemic focused supervision (SFS). Other reforms outside of SFS will help address TBTF as well. I also recommend, for example, capital regimes that automatically provide increased protection against loss during bad times and insurance premiums that raise the cost for financial institution activities that create spillovers. I recognize the substantial benefits of highlighting a single reform that would fix TBTF, but I believe a variety of steps are required to credibly take on TBTF.\2\--------------------------------------------------------------------------- \2\ More generally, see the testimony of Daniel K. Tarullo on March 19, 2009, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs for options for modernizing bank supervision and regulation, including many that seek to foster financial stability.--------------------------------------------------------------------------- Third, be careful about relying heavily on reforms that do not materially reduce spillovers. In particular, I do not think that intensification of traditional supervision and regulation of large financial firms will effectively address the TBTF problem. In a similar vein, while I support the creation of a new resolution regime for systemically important nonbank financial institutions, I would augment the new resolution regime with the types of reforms I just noted. I will now discuss these points quite briefly. I will provide additional detail in the appendix to this testimony.\3\--------------------------------------------------------------------------- \3\ The appendix includes summaries of the key arguments in our book on TBTF, more recent analysis applying the recommendations in the book to the current crisis, and an initial analysis of proposals to address TBTF by making large financial institutions smaller. Our writings on TBTF can be found at http://www.minneapolisfed.org/publications_papers/studies/tbtf/index.cfm.---------------------------------------------------------------------------Spillovers Produce the TBTF Problem Uninsured creditors of systemically important firms come to expect protection because they understand the motivation of policymakers. Policymakers provide protection, in my experience, believing that such protection will contain costly financial spillovers. Policymakers understand that protecting creditors reduces market discipline, but they judge the costs of such a reduction to be smaller than the fallout from the collapse of a major institution. Policymakers worry about spillovers--for example, the failure of other large financial firms due to their direct exposure to a weak firm or because of a more general panic--and the potential impact they may have on the rest of the economy. I see three general approaches to addressing concerns over spillovers and thus increasing market discipline (and reducing moral hazard). First, enact reforms that make policymakers more confident that they can impose losses on creditors without creating spillovers that would justify government protection. Second, reduce the losses that failing firms can impose on other firms or markets, which helps reduce spillovers. Third, alter payments systems to reduce their transmission of losses suffered by one firm to others. Policymakers cannot eliminate spillovers entirely, nor can they credibly commit to never providing protection to creditors of systemically important firms. But they can make significant progress in reducing the probability of providing protection, reducing the number of creditors who might receive protection, and reducing the amount of coverage that creditors receive. These are all valuable results. I will now provide several specific examples of approaches to deal with spillovers.Examples of Reforms That Credibly Address TBTF by Taking on Spillovers To take on spillovers, I recommend starting with SFS, a combination of reforms that would identify and better manage spillovers, reduce losses from the failure of systemically important financial institutions, and alter uninsured creditor expectations so that they better price risk-taking. To provide a sense for additional reforms I have endorsed, I will provide two other examples of reforms you might consider beyond SFS. Others have begun endorsing reforms of this type, which indicates that attacking spillovers is not considered impossible.Systemic Focused Supervision. This approach to addressing spillovers has three components. Engage in Early Identification. I would focus financial institution oversight, defined broadly, on identifying potential spillovers both in general and for specific firms, and offering recommendations to mitigate them. To my mind, this is conceptually similar to the macroprudential or systemic-risk supervision others have supported. I would concentrate such efforts, which would require significant input from bank supervisors and others, on carefully mapping out the exposures that systemically important firms have with each other and other basic sources of spillovers. Once the responsible supervisory entity documents where and how spillovers might arise, it would take the lead in offering recommendations to address them. This effort either would assure policymakers that a perceived spillover did not in fact pose a significant threat or would direct resources to fix the vulnerability and generate such comfort. Lest such an exercise sound like it would be unproductive, I believe that fairly simple failure simulation exercises over the years confirmed the potential spillovers, created by the overseas and derivative operations of some large financial firms, that now bedevil us. I would also note that macroprudential supervision can and should put some of the burden of early identification on the systemically important firms themselves by, for example, requiring them to prepare for and explain the challenges of entering what would amount to a prepackaged bankruptcy.\4\--------------------------------------------------------------------------- \4\ Raghuram Rajan made a similar recommendation in ``The Credit Crisis and Cycle Proof Regulation,'' the Homer Jones Lecture at the Federal Reserve Bank of St. Louis, April 15, 2009.--------------------------------------------------------------------------- Enhanced Prompt Corrective Action (PCA). To focus supervisors on closing weak institutions early, which reduces the losses they can impose on others, I recommend incorporating market signals of firm risk into the current PCA regime. The incorporation would require care. Market signals contain noise, but such signals also offer forward-looking measures of firm specific-risk with valuable information for bank and other supervisors. Improve Communication. The goals here are to establish the credibility of efforts to put creditors at risk of loss and to give creditors the opportunity to alter their behavior. As a result, I recommend that supervisory and other stability-focused agencies clearly communicate the steps in process to avoid full protection. Simply put, creditors cannot read minds and will not alter their expectations and behavior unless they understand the policy changes under way. SFS is not the only approach to addressing spillovers. Let me highlight two other reforms by way of example. Develop Capital Instruments to Absorb Losses When Problems Arise. Requiring firms to hold substantially more capital offers a path to absorb losses before they spill over and directly affect other firms. But having to raise expensive capital can either encourage firms to avoid socially beneficial lending or to take on more risk to generate targeted returns. I urge policymakers to examine capital tools that effectively create capital when firms need it most, which reduces their cost and avoids fueling downcycles.\5\--------------------------------------------------------------------------- \5\ We discuss such a recommendation, based on work by Mark Flannery, briefly on page 128 of the TBTF book. For a more current discussion of this idea, along with other proposals to address TBTF, see the analysis carried out by the Squam Lake Working Group on Financial Regulation at http://www.cfr.org/thinktank/greenberg/squamlakepapers.html.--------------------------------------------------------------------------- Price for Spillover Creation. A direct way to discourage the types of activities that generate spillovers is to put a price on them because, after all, spillovers impose costs on all of us. Using the early-identification approach noted above to identify the major causes of spillovers would offer a first step. The actual pricing of such activities could occur via something like an insurance premium. The FDIC already has made important progress in creating such an approach for large banks, although the price it charges is capped at a low level at this time. I now turn to reforms to address TBTF where I am concerned policymakers may be asking too much.Do Not Rely Too Heavily on Traditional Supervision and Regulation (S&R), Resolution Regimes, or Downsizing Based on direct observation, I am not convinced that supervisors can consistently and effectively prevent excessive risk-taking by the large firms they oversee in a timely fashion, absent draconian measures that tend to throw out the good with the bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.\6\ While policymakers should improve S&R by incorporating the lessons learned over the last two years, it cannot be the bulwark in addressing TBTF.--------------------------------------------------------------------------- \6\ For a fuller discussion, see Appendix C of the TBTF book.--------------------------------------------------------------------------- I do see clear benefits in increasing the scope of bank-like resolution systems to entities such as bank holding companies. Such regimes would facilitate imposition of losses on equity holders, allow for the abrogation of certain contracts, and provide a framework for operating an insolvent firm. These steps address some spillovers and increase market discipline. But I have long argued that the resolution regime created by FDICIA would not, by itself, effectively limit after-the-fact protection for creditors of systemically important banks.\7\ Events over the last two years have largely reinforced those concerns. A bank-like resolution regime for nonbanks, which creates a systemic-risk exception, leaves some potential spillovers remaining, and so it is a necessary but not sufficient reform to address TBTF.--------------------------------------------------------------------------- \7\ For a fuller discussion of limitations of the FDICIA resolution process, see Appendix A of the TBTF book.--------------------------------------------------------------------------- Finally, there has been increased discussion of efforts to address TBTF by making the largest financial firms smaller. My concerns here are practical and do not reflect any particular empathy for managers or equity holders of large firms. In short, I think efforts to break up the firms would result in a focus on a very small number of institutions, thereby leaving many systemically important firms as is. Moreover, I am skeptical, for the reasons noted above, that policymakers will effectively prevent the newly constituted (smaller) firms from taking on risks that can bring down others.Conclusion Maintaining the status quo with regard to TBTF could well impose large costs on the U.S. economy. We cannot afford such costs. I encourage you to focus on proposals that address the underlying reason for protection of creditors of TBTF financial institutions, which is concern for financial spillovers. I have offered examples of such reforms. Absent these or similar reforms, I am skeptical that we will make significant progress against TBTF. Addressing TBTF by Shrinking Financial Institutions: An Initial Assessment The Region, June 2009By Gary H. Stern President Federal Reserve Bank of Minneapolis and Ron Feldman Senior Vice President Supervision, Regulation and Credit Federal Reserve Bank of Minneapolis ``If financial institutions raise systemic concerns because of their size, fix the TBTF problem by making the firms smaller.'' A number of prominent observers have adopted this general logic and policy recommendation.\1\ While we're sympathetic to the intent of this proposal, we have serious reservations about its likely effectiveness and associated costs. Our preferred approach to addressing the ``too-big-to-fail'' problem continues to be better management of financial spillovers.\2\--------------------------------------------------------------------------- \1\ Examples include Robert Reich in an Oct. 21, 2008, blog post (``If they're too big to fail, they're too big period''), George Shultz in the Aug. 14, 2008, Wall Street Journal (``If they are too big to fail, make them smaller''), Gerald O'Driscoll in the Feb. 23, 2009, Wall Street Journal (``If a bank is too big to fail, then it is simply too big''), Meredith Whitney in a Feb. 19, 2009, CNBC interview (reported to advocate ``disaggregating'' market share of largest banks) and Simon Johnson in a Feb. 19, 2009, blog post (``Above all, we need to encourage or, most likely, force the large insolvent banks to break up''). \2\ The Minneapolis Fed Web site (minneapolisfed.org/publications_papers/studies/tbtf/index.cfm) provides access to our fairly extensive prior writing on TBTF.--------------------------------------------------------------------------- In this essay, we review our concerns about this ``make-them-smaller'' reform. We also recommend several interim steps to address TBTF that share some similarities with the make-them-smaller approach but do not have the same failings. Specifically, we support (1) imposing special deposit insurance assessments for TBTF banks to allow for spillover-related costs, (2) retaining the national deposit cap on bank mergers and (3) modifying the merger review process for large banks to provide better focus on reduction of systemic risk. If our suggested reforms prove less effective than we believe, policymakers will have to take the make-them-smaller approach seriously.The reform While its proponents have not provided details, this reform-if taken literally-seems straightforward. Policymakers would demark some firms as TBTF through the use of a specific measure, such as share of a given market(s), asset size or revenue. Policymakers would then force those firms to (1) shrink their balance sheets organically (that is, not replacing loans or securities after repayment), (2) divest certain operations or assets and/or (3) split them into smaller constituent parts such that the resulting firms fall below a specified threshold. (We distinguish such measures from short-term efforts to wind down the operations of a targeted, insolvent financial institution to position it for resolution, a reform we support.)Rationale for reform On its surface, the proposal has two attractive features, both related to simplicity. First, size seems to offer an easily measured and verifiable means of identifying financial institutions whose financial or operational failure would raise systemic concern. After all, firms that are frequently identified as posing TBTF concerns are large in some important, obvious way. Second, implementing this reform appears to be fairly straightforward. The government could simply order across-the-board shrinkage of balance sheets for certain firms. Since many larger financial institutions came about through mergers of smaller institutions, and because the popularity among corporate leaders of creating and then destroying conglomerates tends to wax and wane, a simple ``unbundling'' would merely return the financial world to a period when the TBTF problem did not loom as large. A third rationale for the reform appears rooted in desperation. Recent events suggest profound failure in the supervision and regulation of large and complex financial institutions. Likewise, a number of observers have long seen the TBTF problem as intractable because policymakers will always face compelling incentives to support creditors at the time systemically important firms get into trouble. Society therefore appears to have no way to impose meaningful restraint on large or complex financial institutions. An option that makes firms neither large nor complex may appear to offer the only real means of imposing either market or supervisory discipline.The reform's weaknesses Shrinking firms so they don't pose systemic concern faces static and dynamic challenges that seem to seriously limit its effectiveness as a potential reform. The static challenge involves the initial metric used to identify firms that need to be made smaller. Given the severity of the punishment (that is, breakup), policymakers will have to use a simple standard they can make public and defend from legal challenge. They might consider using, for example, the current limit on bank size that can be achieved via merger: 10 percent of nationwide deposits. Importantly, we assume (and again, because of the high-stakes nature of the reform) that policymakers would make only a few firms subject to forced contraction. This ``high bar'' raises the stakes in getting the ``right'' firms cut down to size. But such a metric will not likely capture some or perhaps many firms that pose systemic risk. Some firms that pose systemic risk are very large as measured by asset size, but others--Northern Rock and Bear Stearns, for example--are not. Other small firms that perform critical payment processing pose significant systemic risk, but would not be identified with a simple size metric. We believe that a government or public agent with substantial private information could identify firms likely to impose systemic risk, but only by looking across many metrics and making judgment calls. Policymakers cannot easily capture such underlying analytics in a simple metric used to break up the firms. The dynamic challenge concerns both the ability of government to keep firms below the size threshold over time and the future decisions of firms that could increase the systemic risk they pose. On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms' stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Academic research has typically found economies of scale exhausted before banks reach the size of the largest banking organizations, although some recent analysis suggests such economies may exist at these large sizes as well.\3\ (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.)--------------------------------------------------------------------------- \3\ For literature that did not find economies of scale for large banks, see Allen N. Berger, Rebecca Demsetz, and Philip E. Strahan, 1999, ``The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future,'' Journal of Banking and Finance 23 (2-4), pp. 35-94; and Group of Ten, 2001, ``Report of Consolidation in the Financial Sector,'' p. 253. For summaries of more current research finding economies of scale for larger institutions, see Joseph P. Hughes and Loretta J. Mester, 2008, ``Efficiency in Banking: Theory, Practice and Evidence,'' Chap. 18 in Oxford Handbook of Banking, Oxford University Press. See also Loretta J. Mester, 2008, ``Optimal Industrial Structure in Banking,'' in Section 3 of Handbook of Financial Intermediation and Banking, Elsevier.--------------------------------------------------------------------------- Prominent examples suggest our concern about reconsolidation is not theoretical. Consider the breakup of the original AT&T and the subsequent mergers among telecommunication firms. Scholars have also highlighted the historical difficulty in limiting the long-run market share of powerful financial firms, including those found in the ``zaibatsus'' of Japan.\4\--------------------------------------------------------------------------- \4\ See Raghuram G. Rajan and Luigi Zingales, 2003, ``The Great Reversals: The Politics of Financial Development in the Twentieth Century,'' Journal of Financial Economics 69, July, pp. 5-50.--------------------------------------------------------------------------- Even if policymakers could get the initial list of firms right and were able to keep the post-breakup firms small, this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk. Newly shrunken firms could, for example, shift their portfolios to assets that suffer catastrophic losses when economic conditions fall off dramatically. As a result, creditors (including other financial firms) of the ``small'' firms could suffer significant enough losses to raise questions about their own solvency precisely when policymakers are worried about the state of the economy. Moreover, funding markets might question the solvency of other financial firms as a result of such an implosion. Such spillovers prompted after-the-fact protection of financial institution creditors in the current crisis, and we believe they would do so again, all else equal. One might call on supervision and regulation to address such high-risk bets. But the rationale for the make-them-smaller reform seems dubious in the first place if such oversight were thought to work. These dynamics of firm risk-taking mean that the make-them-smaller reform offers protection with a Maginot line flavor. That is, it appears sensible and effective-even impregnable-but in fact it provides only a false sense of security that may lull policymakers into inaction on other fronts. In our experience, policymakers would likely view this reform as a substitute for other desirable actions, including some of the key reforms we think necessary to address spillovers. In the past, policymakers have thought-mistakenly-that the strong condition of banks, the FDICIA resolution regime or initiatives around new capital rules all provided rationales for not addressing the underlying sources of spillovers and the TBTF problem. If we exclusively embrace a reform that misleadingly promises victory over TBTF by constraining the size of large financial firms, we may squander the time and resources needed to address the problem at its roots.Interim steps While we would not move forward with a plan to make large financial firms smaller, we take seriously its intent to put uninsured creditors at risk of loss and to address concerns over size, spillovers and government support. In that vein, we recommend three interim steps that address concerns that might lead to support for the make-them-smaller option. They are (1) modify the FDIC insurance premium to better allow for spillover-related charges, (2) maintain the current national deposit cap on bank mergers and (3) modify the merger review process for bank holding companies to focus on systemic risk. We conclude this section with a brief discussion on when the make-them-smaller option might make sense. Expand FDIC insurance premiums First, we recommend expanding the ability of the FDIC to charge banks (through the deposit insurance premium it levies) for activities that increase potential for spillovers.\5\ The presence of spillovers makes it more likely that policymakers will resolve bank failures in a manner outside of the FDIC's mandated ``least-cost'' resolution, because those spillovers impose broader costs on society. Premiums offer an established mechanism by which society can force banks to internalize potential costs.\6\--------------------------------------------------------------------------- \5\ More generally, George Pennacchi argues that premiums for banks should incorporate a ``systematic risk'' factor to account for links between a bank's specific condition and overall economic conditions. See George G. Pennacchi, 2009, ``Deposit Insurance,'' paper for AEI Conference on Private Markets and Public Insurance Programs, January. \6\ Some observers have outlined a broader reform along the same lines that would charge all systemically important financial firms an assessment. We focus on banks in the short term because the infrastructure for such charges already exists; charging other systemically important financial firms should have similar benefits. For a discussion of the broader change, see Viral Acharya, Lasse Pedersen, Thomas Philippon and Matthew Richardson, 2008, ``Regulating Systemic Risk,'' Chap. 13 in Restoring Financial Stability: How to Repair a Failed System, Wiley.--------------------------------------------------------------------------- We use the term ``expand'' in referring to the FDIC's ability to charge banks, because the FDIC has already created an infrastructure to facilitate spillover-related charges. In particular, the current premium structure allows under certain conditions for a ``large bank [premium] adjustment.'' The FDIC offers several rationales for the adjustment, including the need ``to ensure that assessment rates take into account all available information that is relevant to the FDIC's risk-based assessment decision.''\7\--------------------------------------------------------------------------- \7\ See Federal Register, Oct. 16, 2008, p. 61568.--------------------------------------------------------------------------- The FDIC lists the types of information it would consider in setting the adjustment, and several of them provide reasonable proxies for potential spillovers. For example, the FDIC would review (1) potential for ``ring fencing'' of foreign assets (which would limit the FDIC's ability to seize and sell those assets to pay off insured depositors, for example), (2) availability of information on so-called qualified financial contracts (which include a wide range of derivatives) and (3) FDIC ability to take over key operations without paying extraordinary costs.\8\ We might propose that the FDIC include other proxies of systemic risk, including measures of organizational complexity (such as number and type of legal entities) and a supervisory ``score'' of each bank's contingency plan for winding down operations while minimizing spillovers.--------------------------------------------------------------------------- \8\ See Federal Register, May 14, 2007, p. 27125.--------------------------------------------------------------------------- The FDIC apparently believes it can price spillover risk without having to rely on size per se (although it limits this assessment adjustment to large institutions). Not having to rely on size of financial institutions seems desirable, as it more directly targets activities causing spillovers. And imposing a price on these activities would discourage them, which is the point. However, the FDIC has limited its ability to fully incorporate such spillover-related factors into its premium. It can, for example, only adjust large bank premiums by 100 basis points or less (recently increased from 50 basis points).\9\ We recommend that the FDIC remove such artificial restrictions so that it can fully price the potential costs of spillovers.--------------------------------------------------------------------------- \9\ See Federal Register, March 4, 2009, p. 9525.--------------------------------------------------------------------------- Keep the cap Second, we recommend retaining the current national deposit cap. In general terms, Congress forbids authorities from approving mergers or acquisitions if it would result in the acquiring bank holding more than 10 percent of U.S. bank deposits. This cap, which applies to M&As across state lines, was put in place by the Riegle-Neal Banking Act of 1994. Note that a bank can exceed the national cap if its deposit growth comes from a non-M&A source (that is, so-called organic growth). Why keep the cap at the current level? We see some serious downsides to lowering the cap as a way of addressing TBTF. A lower cap could cause the bank to increase its funding from nondeposit sources, which, all else equal, could increase its susceptibility to a run. Or a firm could meet the target by jettisoning its retail banking operations and increase its securities, payments or wholesale operations. This outcome, too, would seem to increase systemic risk. Lowering the cap effectively taxes deposits, thereby directing energies at the wrong target. While this argument might suggest abolishing or increasing the cap, we would keep it at its current level at least for the foreseeable future because its costs do not seem large. In particular, the cap has not prevented the creation of extremely large and diversified financial institutions through mergers. Thus, we doubt it has had significant scale or scope costs. Moreover, we think the cap offers some benefits. It provides a binding limit on size growth that may offer a marginal contribution to managing TBTF. The cap may also have the salutary effect of keeping policymakers' attention on the TBTF issue over time. Because the costs of keeping the cap seem quite low, we feel comfortable with our recommendation, even though the benefits seem low as well. Reform the merger review process Third, we recommend implementing a reform to the merger reviews that the Federal Reserve conducts for large bank holding companies. In 2005, we proposed that ``for mergers between two of the nation's 50 largest banks, the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the U.S. Treasury should report publicly on their respective efforts to address and manage potential TBTF concerns.''\10\ Such a requirement, which needn't be restricted to the 50 largest banks if policymakers favor another cutoff, would highlight the key policy issues raised by the merger itself and provide a communication focus for spillover-reduction efforts. We could envision this as an interim approach if spillover reduction does not prove possible to achieve. The Federal Reserve may find it appropriate over time to support changes to the statutes governing merger reviews to allow for explicit consideration of potential spillover costs created or made worse by the merger.\11\--------------------------------------------------------------------------- \10\ See Gary H. Stern and Ron J. Feldman, 2005, ``Addressing TBTF When Banks Merge: A Proposal,'' The Region, September, Federal Reserve Bank of Minneapolis. \11\ For discussions of how policymakers should or should not consider TBTF in the antitrust review process, see statements by Deborah A. Garza and Albert A. Foer before the House Judiciary Committee, Subcommittee on Courts and Competition Policy, March 17, 2009.--------------------------------------------------------------------------- We have confidence in our preferred approach of tackling spillovers directly by putting TBTF creditors at credible risk of loss. But others with equally strong convictions have been proven wrong when it comes to financial instability, and we could be wrong as well. In that case, we must go with an alternative, and the proposed reform to make firms smaller may offer the only promising choice. Moreover, we view addressing spillovers as the primary motivation for providing after-the-fact protection to uninsured creditors. To the degree that other motivations drive provision of such protection in the United States (for example, to reward ``cronies'' of elected officials or other entrenched interests), our reforms may not adequately address the TBTF problem, and other reforms might. That said, we continue to strongly believe that spillovers are the salient motivation that policymakers must address to fix TBTF (and our prior writings comment extensively on why we do not think other motivations have equal weight).Conclusion There is no easy solution to TBTF. Our longstanding proposal to put creditors at risk of loss by managing spillovers will prove challenging to implement effectively. Cutting firms down to size may seem easy by comparison. It is not. The high stakes of making firms smaller will make it difficult to determine which to shrink, and even then, the government will not have an easy time managing risk-taking by newly shrunken firms. We do take the aims of the make-them-smaller reform seriously and in that vein suggest options in this regard that we think would be more effective, including a spillover-related tax built on the FDIC's current deposit insurance premiums. Better Late Than Never: Addressing Too-Big-To-Fail Remarks presented at the Brookings Institution, Washington, DC, March 31, 2009 By Gary H. Stern, President, Federal Reserve Bank of Minneapolis Destiny did not require society to bear the cost of the current financial crisis. To at least some extent, the outcome reflects decisions, implicit or explicit, to ignore warnings of the large and growing ``too-big-to-fail'' problem and a failure to prepare for and address potential spillovers. While I am, as usual, speaking only for myself, there is now I think broad agreement that policymakers vastly underestimated the scale and scope of ``too big to fail'' and that addressing it should be among our highest priorities. From a personal point of view, this recent consensus is both gratifying and disturbing. Gratifying because many initially dismissed our book,\1\ published five years ago by Brookings, as exaggerating the TBTF problem and underestimating the value of FDICIA in strengthening bank supervision and regulation. In turn, I would point out that we identified:--------------------------------------------------------------------------- \1\ See Gary H. Stern and Ron J. Feldman, 2004, Too Big to Fail: The Hazards of Bank Bailouts, Washington, D.C.: Brookings Institution. virtually all key facets of the growing TBTF problem, including the role that increased concentration and increased organizational and product complexity, as well as increased reliance on short-term funding, played in creating the current --------------------------------------------------------------------------- TBTF mess; and important reforms which, if taken seriously, could have reduced the risk-taking that produced the crisis. But belated recognition of the severity of ``too big to fail'' is also disturbing because it implies that inaction raised the costs of the current financial crisis, as our analyses and prescriptions went unheeded. Despite our warnings, important institutions, public and private alike, were unprepared. And I am quite concerned that policymakers may double-down on previous decisions; some ideas presented in the current environment to address TBTF are unlikely to be effective and, if pursued, will waste valuable time and resources. In the balance of these remarks, I will principally cover three subjects: (1) the nature of the current TBTF problem; (2) policies essential to addressing the problem effectively; (3) policies that, although well intentioned, are unlikely to make a material difference to TBTF at the end of the day.The current TBTF problem As matters stand today, the risk-taking of large, complex financial institutions is not constrained effectively by supervision and regulation nor by the marketplace. If this situation goes uncorrected, the result will almost surely be inefficient marshaling and allocation of financial resources, serious episodes of financial instability and lower standards of living than otherwise. Certainly, we should seek to improve and strengthen supervision and regulation where we can, but supervision and regulation is not a credible check on the risk-taking of these firms. I will go into this issue in more detail later and will simply note at this point that the recent track record in this area fails to inspire confidence. Similarly, market discipline is not now a credible check on the risk-taking of these firms; indeed, a critical plank of current policy is to assure creditors of TBTF institutions that they will not bear losses. Given the magnitude of the crisis, I have supported the steps taken to stabilize the financial system by extending the safety net, but I am also acutely sensitive to the moral-hazard costs of these steps and have no illusion that losses experienced by equity holders and management will somehow resurrect market discipline. How did we arrive at such a bleak point in terms of TBTF? Let me make just two observations. First, the crisis was made worse, in my view significantly worse, by the lack of preparation I mentioned above. To provide some examples, policymakers did not create and/or execute (1) an effective communication strategy regarding government intentions for uninsured creditors of firms perceived as TBTF; (2) a program to systematically identify the interconnections between these large firms; and (3) systems aimed at reducing the losses that these large firms could impose on other firms. I raise these examples, not surprisingly, because we identified these steps as critical to addressing TBTF in the book and related analysis.\2\--------------------------------------------------------------------------- \2\ See Gary H. Stern, 2008, ``Too Big to Fail: The Way Forward,'' Nov.13, 2008.--------------------------------------------------------------------------- Second, addressing the TBTF problem earlier could have avoided some of the risk-taking underlying the current crisis. To be sure, many small institutions have failed as a result of the crisis in housing finance but, nevertheless, the bulk of the losses seem concentrated in the largest financial institutions. And creditors of these large firms likely expected material support, thereby facilitating excessive risk-taking by such institutions. Policymakers should correct problems at credit-rating agencies with off-balance-sheet financing, mortgage disclosures and the like. But if, fundamentally, TBTF induces too much risk-taking, then these firms will continue to find routes to engage in it, other things equal.Addressing sources of spillovers I have spoken and written about TBTF concerns and policy proposals with sufficient frequency that some observers characterize my views on the topic as ``boilerplate,'' a backhanded compliment I presume. Nonetheless, it suggests I only judiciously review the key points of the reforms we have long endorsed. The logic for our approach is clear. In order to reduce expectations of bailouts and reestablish market discipline, policymakers must convince uninsured creditors that they will bear losses when their financial institution gets into trouble. A credible commitment to impose losses must be built on reforms directly reducing the incentives that lead policymakers to bail out, that is provide significant protection for uninsured creditors. The dominant motivation for bailouts is to prevent the problems in a bank or market from threatening other banks, the financial sector and overall economic performance. That is, policymakers intervene because of concerns about the magnitude and consequences of spillovers. Thus, the key to addressing TBTF is to reduce the potential size and scope of the spillovers, so that policymakers can be confident that intervention is unnecessary.What specifically should policymakers do to achieve this outcome? To answer this question we have taken reforms proposed in the book and combined them in a program we call systemic focused supervision (SFS), which we have discussed in detail elsewhere. In general, SFS, unlike conventional bank supervision and regulation, focuses on reduction of spillovers; it consists of three pillars: early identification, enhanced prompt corrective action (PCA) and stability-related communication. Early identification. As we have described in detail elsewhere, early identification is a process to identify and to respond, where appropriate, to the material direct and indirect exposures among large financial institutions and between those institutions and capital markets.We anticipate valuable progress simply by having central banks and other relevant supervisory agencies focus resources on, and take seriously, the results of failure simulation exercises, for example. Indeed, such exercises appear to have identified the precise type of issues-around derivative contracts, resolution regimes and overseas operations-that have plagued policymakers' ability to adequately address specific TBTF cases.\3\--------------------------------------------------------------------------- \3\ For a discussion of preparing for large bank failure, see Shelia Bair, 2007, ``Remarks,'' March 21, and Shelia Bair, 2008, ``Remarks,'' June 18.--------------------------------------------------------------------------- In fact, it appears that the policy failure was not primarily in identification of potential spillovers, but rather in making corrective action a sufficiently high priority. One constructive option related to early identification would require the relevant TBTF firms to prepare documentation of their ability to enter the functional equivalent of ``prepackaged bankruptcy.''\4\ The appropriate regulatory agencies should require TBTF firms to identify current limitations of the resolution regime they face and the spillovers that might occur if their major counterparties entered such proceedings.--------------------------------------------------------------------------- \4\ For a similar suggestion, see page 62 of Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash D. Persaud, and Hyun Shin, 2009, ``The Fundamental Principles of Financial Regulation.''--------------------------------------------------------------------------- Without doubt, implementing early identification will prove challenging. That said, recommendations from other knowledgeable observers suggest that the task is possible and worthwhile. The G-30 recommendations, for example, would have firms continuously monitor and report on the full range of their counterparty exposures, in addition to reviewing their vulnerability to a host of potential risks, many related to spillovers.\5\ These reports are precisely the key supervisory inputs to early identification.--------------------------------------------------------------------------- \5\ See Group of Thirty, 2009, ``Financial Reform: A Framework for Financial Stability,'' p. 41.--------------------------------------------------------------------------- One might reasonably wonder about a plan that seems to give center stage to supervisors, when I earlier noted reservations about supervision and regulation? I would point out, however, that here we are emphasizing a role for supervision where it in fact has a comparative advantage. In particular, we would focus supervision on collection of private information on financial institutions, looking across institutions, and worrying about fallout that potentially affects the public, rather than asking supervisors to try to tune risk-taking to its optimal level. Other entities have neither the incentive nor the access to carry out the role we envision for supervision. Enhanced prompt corrective action. PCA works by requiring supervisors to take specified actions against a bank as its capital falls below specified triggers. One of its principal virtues is that it relies upon rules rather than supervisory discretion. Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way. If a bank's failure does not impose large losses, by definition it cannot directly threaten the viability of other depository institutions that have exposure to it. Thus, a PCA regime offers an important tool to manage systemic risk. However, the regime currently uses triggers that do not adequately account for future losses and give too much discretion to bank management.We would augment the triggers with more forward-looking data, outside the control of bank management, to address these concerns. Communication. The first two pillars of SFS seek to increase market discipline by reducing the motivation policymakers have for protecting creditors. But creditors will not know about efforts to limit spillovers, and therefore will not change their expectations of support and in turn, their pricing and exposures, absent explicit communication by policymakers about these efforts. This recommendation highlights a key distinction between our approach and that advocated by others: Our approach does not simply seek to limit systemic risk, but takes the next step of directly trying to address TBTF by putting creditors at risk of loss. If we do not do this, we will not limit TBTF. Now let me turn to some alternative reforms that have received significant attention recently.Reducing the size of (TBTF) financial institutions This proposal is straightforward: If financial institutions raise systemic concerns because of their size, make them smaller.We intend to discuss this suggestion at some length in a separate document, but suffice it to say that we have serious reservations about the ultimate effectiveness of such an approach. And I would note, in passing, that it is an idea born of desperation since it seems to admit that large, complex organizations cannot be supervised effectively. To provide a flavor for our concerns about this proposal, consider the government's ability to keep the firms ``small'' after dismantling has occurred. There might, for example, be tremendous pressure in the direction of expansion if, in the future, the smooth resolution of the failure of a major institution required the sale of assets to other significant institutions. Even if this situation can be avoided, these firms could still engage in behavior that increases the risk of significant spillovers. They could do so, for example, by shifting their portfolios to assets that suffer catastrophic losses only when economic conditions deteriorate dramatically, thus making themselves and the financial system vulnerable to cyclical outcomes.Reliance on supervision and regulation and/or FDICIA The two broad approaches discussed to this point seek both increased market and supervisory discipline to better constrain the risk-taking of large financial institutions. But some observers do not believe that policymakers can credibly put creditors of these firms at risk of loss. And some analysts do not believe that creditors can effectively discipline these oft-sprawling firms even if they had an incentive to do so. As a result, some proposals to better limit the risk-taking of firms perceived TBTF focus primarily on strengthening conventional supervisory and regulatory discipline. Policymakers could pursue this approach in many ways. After identifying TBTF firms, a more rigorous supervisory and regulatory regime would be applied to them. The tougher approach might include, for example, (a) higher capital requirements, (b) requirements that the firms maintain higher levels of liquid assets, (c) additional restrictions on the activities in which the firms engage, and (d) a much larger presence of on-site supervisors monitoring compliance with these dictates. My concerns about this approach, and they are considerable, center on the heavy reliance on supervision and regulation but are not a wholesale rejection of S/R per se. Given the distortion to incentives caused by the explicit safety net underpinning banking, society cannot rely exclusively on market forces to provide the appropriate level of discipline to banks.We must have a system of supervision and regulation to compensate. And naturally we should learn from recent events to improve that system, a process under way.\6\--------------------------------------------------------------------------- \6\ For a discussion of improvement efforts under way for both the banking industry and bank supervisors, see Roger T. Cole, 2009, Risk Management in the Banking Industry, before the Subcommittee on Securities, Insurance, and Investment, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C., March 18, 2009.--------------------------------------------------------------------------- But we must recognize the important limitations of supervision and regulation and establish objectives that it can achieve. The owners of systemically important financial institutions provide incentives for firm management to take on risk, which is the source of the returns to equity holders (risk and return go hand in hand). Under a tougher S/R regime, these firms have no less incentive than formerly to find ways of assuming risk that generates the returns required by markets and that does not violate the letter of the restrictions they face. By way of example, research on bank capital regimes finds ambiguous results regarding their ultimate effect, as firms can offset increased capital by taking on more risk. And, as I noted earlier, the track record of S/R does not suggest it prevents risk-taking that seems excessive ex post. True, long shots occasionally come in, and perhaps a regime dependent on conventional S/R would succeed, but it is NCAA Tournament time, and we know that a 15 seed rarely beats a number two. To pick just one example from the current episode, supervisors have been unable once again to prevent excessive lending to commercial real estate ventures, a well-known, high-risk, high-return business which contributed importantly to the serious banking problems of the late 1980s and early 1990s. I recognize that creating a new regulatory framework for a small number of very large institutions differs from supervising thousands of small banks. But I forecast the same disappointing outcome for two reasons. First, we have already applied a version of the suggested approach; right now, we have higher standards and more intensive supervision for the largest banking firms. Second, the failure of supervision and regulation reflects inherent limitations. Supervisors operate in a democracy and must follow due process before taking action against firms. This means that there is an inevitable lag between identification of a problem and its ultimate correction. As previously noted, management has ample incentive to find ways around supervisory restrictions. Further, the time inconsistency problem frequently makes supervisory forbearance look attractive. A truly draconian regulatory regime could conceivably succeed in diminishing risk-taking but only at excessive cost to credit availability and economic performance. As Ken Rogoff, a distinguished economist at Harvard who has considerable public policy experience as well put it: ``If we rebuild a very statist and inefficient financial sector--as I fear we will--it's hard to imagine that growth won't suffer for years.'' Just as we should not rely exclusively, or excessively, on S/R, I do not think that imposing an FDICIA-type resolution regime on systemically important nonbank financial institutions will correct as much of the TBTF problem as some observers anticipate. To be sure, society will be better off if policymakers create a resolution framework more tailored to large financial institutions, in particular one that allows operating the firms outside of a commercial bankruptcy regime once they have been deemed insolvent. This regime would take the central bank out of rescuing and, as far as the public is concerned, ``running'' firms like AIG. That is a substantial benefit. And this regime does make it easier to impose losses on uninsured creditors if policymakers desire that outcome. But I am skeptical that this regime will actually lead to greater imposition of losses on these creditors in practice. Indeed, we wrote our book precisely because we did not think that FDICIA put creditors at banks viewed as TBTF at sufficient risk of loss.We thought that when push came to shove, policymakers would invoke the systemic risk exception and support creditors well beyond what a least-cost test would dictate.We thought this outcome would occur because policymakers view such support as an effective way to limit spillovers. I don't think a new resolution regime will eliminate those spillovers (or at least not the preponderance of them), and so I expect that a new regime will not, by itself, put an end to the support we have seen over the last 20 months.Conclusion I recognize the limits of any proposal to address the TBTF problem.We will never avoid entirely the financial crises that lead to extraordinary government support. But that is a weak excuse for not taking the steps to prepare to make that outcome as remote as we can. It is with deep regret for damage done to residents of the Red River Valley that I note the return of flood season to the Upper Midwest. Many residents have noted that the ``100-year flood'' has come many more times to this part of the country than its designation implies. And these residents have rightly focused on preparing to limit the literal spillovers when this extraordinary event becomes routine. In contrast, policymakers did not prepare for the TBTF flood; indeed, they situated themselves in the flood plain, ignored the flood warning, and hoped for the best.We must now finally give highest priority to preparation and take the actions required before the next deluge. ______ CHRG-111shrg53085--101 Mr. Patterson," Senator, I think that is an excellent point to raise about the fact that we are not isolated from foreign competitors and we are in a global economy. The fact is, whether we like it or not, we have arrived at a situation where too big to fail is a reality, whether it is a desirable circumstance or not or whether there is an available short-term solution to that or not. Be that as it may, that is where we are. And I think what it does is it speaks eloquently to the need for a systemic regulator, whether it be the Fed or whether it be a committee approach or a new entity that the Fed has some involvement with or not. The problem here is not bank regulation. The problem is gaps in regulation, and excessive leverage by institutions, both banks and others in that large category, and lack of understanding of the types of risks that were being taken by management and by regulators. But I do think this: I think that we have got to realize that it takes large, complex organizations to operate in a global economy, and I think there is a role for the community banks, there is a role for the regional banks like mine, and I think there is a role for these very large, complex money center organizations that perform multiple functions. Indeed, they are hard to manage. Some people say they cannot be well managed. Some people say the Fed should focus on its management of monetary policy and its independence and not be the prudential regulator of overall responsibility. Whether it is or should not does not obviate the need for it, that there be some control that these gaps be filled. And I would suggest at least the hypothesis that if these institutions were broken up, others would evolve to develop to fill their place over time. Senator Warner. Mr. Chairman, I have got a couple more questions. Can I go ahead and---- " CHRG-111hhrg49968--189 Mr. Bernanke," I will have to go back and check on that. Ms. Kaptur. We would appreciate that very much. [Questions for the record submitted by Ms. Kaptur follow:] Questions for the Record Submitted by Congresswoman Kaptur How much TARP money AIG has disbursed since January 1 of this year and who were recipients? How much more of our rising debt is being provided by foreign creditors now as our debt rises? copies of the contracts between the fed and blackrock What is the value of assets being managed by BlackRock and any of these contracts in total? What is Blackrock being paid for each contract? Do you know which foreign countries and companies are part of Black Rock's transactions? additional questions for the record What actions are taken by the Fed to examine and prevent conflicts of interest of any kind when awarding no bid contracts? What processes are in place? Please include copies of the documents of the evaluation of conflict of interest in regard to all BlackRock contracts, both those that BlackRock might have bid on and those that were no-bid contracts. Can you explain to me why the Federal Reserve Bank of New York is expected to regulate Wall Street, and yet on its board are Wall Street Executives? Isn't this a conflict on interest from perspective? Please elaborate here. Do we really trust Wall Street to regulate itself? Why does the Federal Reserve buy Treasury notes? Isn't this just money shuffling, especially since the Treasury has $200 billion deposited in the Fed right now through the Treasury Supplemental Financing Program? The Federal Reserve Bank of New York is the only bank of the 12 with an established vote on interest rates; the seven governors have a vote, the Federal Reserve Bank of New York has a vote, and the other 11 banks rotate through the other 4 votes. Why is the NY Fed so special? How much was now Secretary Geithner involved in the drafting of the trust agreement between the Federal Reserve Bank of New York and AIG--at the time Mr. Geithner was service as President of the Federal Reserve Bank of New York. Do you think it is appropriate for the President of the Federal Reserve Bank of New York to have close ties with the CEO's and other key management of the very banks one is regulating? Given that the taxpayers are at this time currently losing money through the obligations accrued through the purchases of securities from AIG and Bear Sterns, is there any real hope that the taxpayers will paid back in full? Can you give me your thoughts on why AIG was saved, and Chrysler and GM allowed to enter bankruptcy? Sure you were involved in each discussion to some degree. Why do you think that Chrysler and GM were given far less money than the banks through TARP with restrictions and conditions on what was to happen at each before there was any more infusion of capital from the TARP into the companies, and the banks can keep coming back and are barely asked to do even reporting in return? Were you present in any meeting in which the Bank of America acquisition of Merrill Lynch was discussed? Please state when each meeting took place, where each meeting was held, the other attendees of the meeting, and go into detail on what was discussed. In addition to the aforementioned, how involved were people such as Larry Summers and other Members of the President's Economic Advisory Council or the President's Working Group on Financial Markets? Other bank CEO's? Do you feel it was appropriate for the federal government to play a role in the activities of private banks, and in particular, the matter of Bank of America and Merrill Lynch? Would you welcome a full audit of the PIPP program now and regularly? Why or why not? Do you resolution authority and a financial product safety commission? Why or why not on each item? You have been quoted as stating that in looking back, it was probably a mistake to let Lehman fail. Please elaborate on this matter. [Mr. Bernanke's responses to Ms. Kaptur's questions follow:] [Prepared statement of Mr. Bernanke before the House Committee on Oversight and Government Reform follows:] Before the Committee on Oversight and Government Reform, U.S. House of Representatives, Washington, DC, June 25, 2009. Statement of Hon. Ben S. Bernanke, Chairman, Board of Governors, Federal Reserve System Chairman Towns, Ranking Member Issa, and other members of the Committee, I appreciate the opportunity to discuss the Federal Reserve's role in the acquisition by the Bank of America Corporation of Merrill Lynch & Co., Inc. I believe that the Federal Reserve acted with the highest integrity throughout its discussions with Bank of America regarding that company's acquisition of Merrill Lynch. I will attempt in this testimony to respond to some of the questions that have been raised. background On September 15, 2008, Bank of America announced an agreement to acquire Merrill Lynch. I did not play a role in arranging this transaction and no Federal Reserve assistance was promised or provided in connection with that agreement. As with similar transactions, the transaction was reviewed and approved by the Federal Reserve under the Bank Holding Company Act in November 2008. It was subsequently approved by the shareholders of Bank of America and Merrill Lynch on December 5, 2008. The acquisition was scheduled to be closed on January 1, 2009. As you know, the period encompassing Bank of America's decision to acquire Merrill Lynch through the consummation of the merger was one of extreme stress in financial markets. The government-sponsored enterprises, Fannie Mae and Freddie Mac, were taken into conservatorship a week before the Bank of America deal was announced. That same week, Lehman Brothers failed, and American International Group was prevented from failing only by extraordinary government action. Later that month, Wachovia faced intense liquidity pressures which threatened its viability and resulted in its acquisition by Wells Fargo. In mid-October, an aggressive international response was required to avert a global banking meltdown. In November, the possible destabilization of Citigroup was prevented by government action. In short, the period was one of extraordinary risk for the financial system and the global economy, as well as for Bank of America and Merrill Lynch.discussions regarding the possible termination of agreement to acquire merrill lynch On December 17, 2008, senior management of Bank of America informed the Federal Reserve for the first time that, because of significant losses at Merrill Lynch for the fourth quarter of 2008, Bank of America was considering not closing the Merrill Lynch acquisition. This information led to a series of meetings and discussions among Bank of America, the regulatory agencies, and Treasury. During these discussions, Bank of America's CEO, Ken Lewis, told us that the company was considering invoking the Material Adverse Event clause in the acquisition contract, known as the MAC, in an attempt to rescind its agreement to acquire Merrill Lynch. In responding to Bank of America in these discussions, I expressed concern that invoking the MAC would entail significant risks, not only for the financial system as a whole but also for Bank of America itself, for three reasons. First, in light of the extreme fragility of the financial system at the time, the uncertainties created by an invocation of the MAC might have triggered a broader systemic crisis that could well have destabilized Bank of America as well as Merrill Lynch. Second, an attempt to invoke the MAC after three months of review, preparation, and public remarks by the management of Bank of America about the benefits of the acquisition would cast doubt in the minds of financial market participants--including the investors, creditors, and customers of Bank of America--about the due diligence and analysis done by the company, its capability to consummate significant acquisitions, its overall risk-management processes, and the judgment of its management. Third, based on our staff analysis of the legal issues, we believed that it was highly unlikely that Bank of America would be successful in terminating the contract by invoking the MAC. Rather, an attempt to invoke the MAC would likely involve extended and costly litigation with Merrill Lynch that, with significant probability, would result in Bank of America being required either to pay substantial damages or to acquire a firm whose value would have been greatly reduced or destroyed by a strong negative market reaction to the announcement. For these reasons, I believed that, rather than invoking the MAC, Bank of America's best option, and the best option for the system, was to work with the Federal Reserve and the Treasury to develop a contingency plan to ensure that the company would remain stable should the completion of the acquisition and the announcement of losses lead to financial stress, particularly a sudden pullback of funding of the type that had been experienced by Wachovia, Lehman, and other firms. Ultimately, on December 30, the Bank of America board determined to go forward with the acquisition. The staff of the Federal Reserve worked diligently with Treasury, other regulators, and Bank of America to put in place a package that would help to shore up the combined company's financial position and reduce the risk of market disruption. The plan was completed in time to be announced simultaneously with Bank of America's public earnings announcement, which had been moved forward to January 16, 2009, from January 20, 2009. The package included an additional $20 billion equity investment from the Troubled Asset Relief Program and a loss-protection arrangement, or ring fence, for a pool of assets valued at about $118 billion. The ring-fence arrangement has not been consummated, and Bank of America now believes that, in light of the general improvement in the markets, this protection is no longer needed. Importantly, the decision to go forward with the merger rightly remained in the hands of Bank of America's board and management, and they were obligated to make the choice they believed was in the best interest of their shareholders and company. I did not tell Bank of America's management that the Federal Reserve would take action against the board or management if they decided to proceed with the MAC. Moreover, I did not instruct anyone to indicate to Bank of America that the Federal Reserve would take any particular action under those circumstances. I agreed with the view of others that the invocation of the MAC clause in this case involved significant risk for Bank of America, as well as for Merrill Lynch and the financial system as a whole, and it was this concern that I communicated to Mr. Lewis and his colleagues. disclosures The Federal Reserve also acted appropriately regarding issues of public disclosure. As I wrote in a letter to this Committee, neither I nor any member of the Federal Reserve ever directed, instructed, or advised Bank of America to withhold from public disclosure any information relating to Merrill Lynch, including its losses, compensation packages or bonuses, or any other related matter. These disclosure obligations belong squarely with the company, and the Federal Reserve did not interfere in the company's disclosure decisions. The Federal Reserve had a legitimate interest in knowing when Bank of America or Merrill Lynch intended to disclose the losses at Merrill Lynch. Given the fragility of the financial markets at that time, we were concerned about the potential for a strong, adverse market reaction to the reports of significant losses at Merrill Lynch. If federal assistance to stabilize these companies were to be effective, the necessary facilities would have to be in place as of the disclosure date. Thus, our planning was importantly influenced by the companies' planned disclosure schedule. But the decisions and responsibilities regarding public disclosure always remained, as it should, with the companies themselves. A related question is whether there should have been earlier disclosure of the aid provided by the U.S. government to Bank of America. Importantly, there was no commitment on the part of the government regarding the size or structure of the transaction until very late in the process. Although we had indicated to Bank of America in December that the government would provide assistance if necessary to keep the company from being destabilized, as it had done in other cases during this time of extraordinary stress in the financial markets, those December discussions were followed in January by significant and intense negotiations involving Bank of America, the Federal Reserve, the Treasury, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency regarding many key aspects of the assistance transaction, including the type of assistance to be provided, the size of the protection, the assets to be covered, the terms for payments, the fees, and the length of the facility. The agreement in principle on these items was reflected in a term sheet that was not finalized until just before its public release on January 16, 2009. The Federal Reserve Board and the Treasury completely and appropriately disclosed the information as required by the Congress in the Emergency Economic Stabilization Act of 2008. In retrospect, I believe that our actions in this episode, including the development of an assistance package that facilitated the consummation of Bank of America's acquisition of Merrill Lynch, were not only done with the highest integrity, but have strengthened both companies while enhancing the stability of the financial markets and protecting the taxpayers. These actions were taken under highly unusual circumstances in the face of grave threats to our financial system and our economy. To avoid such situations in the future, it is critical that the Administration, the Congress, and the regulatory agencies work together to develop a new framework that strengthens and expands supervisory oversight and includes a broader range of tools to promote financial stability. I would be pleased to take your questions. " CHRG-109shrg21981--206 RESPONSE TO A WRITTEN QUESTION OF SENATOR SANTORUM FROM ALAN GREENSPANQ.1. The final version of Basel II was, as I understand, agreed to last summer. How final is the Accord? Are there issues that still need to be addressed? How will U.S. regulators work to mitigate possible negative competitive impacts of the Accord on U.S. banks? Particularly regarding the operational risk sector: (1) Could Pillar 1 treatment actually increase risk as more money goes to meet regulatory capital demands and less is therefore potentially available to apply to risk avoidance, and (2) Could there be increasing competitive concerns for U.S. banks, particularly in business lines for which we are world leaders, such as credit cards and asset management? What is being done to ensure that we continue to maintain our leadership and are not competitively disadvantaged?A.1. The participating countries in the Basel Committee on Banking Supervision reached an ``Agreement in Principle'' in mid-2004 and each country is now following its national procedures for review. As you know, in the United States, that procedure requires, among other things, a Notice of Proposed Rulemaking (NPR), followed by a comment period, the adoption of a final rule, and a delayed effective date. The U.S. banking agencies have made it clear to the Basel Committee that there is no final agreement until we once again have reviewed and evaluated public comments on our NPR. We published in 2003 an Advance Notice of Proposed Rulemaking (ANPR), reviewed comments on the ANPR, and we are now in the process of preparing an NPR that reflects those comments. The mid-2004 Basel II text issued by the Basel Committee followed several years of industry consultation in the late 1990's and early in the current decade, resulting in modifications to the proposal. The U.S. ban! king agencies expect to issue a final rule implementing Basel II in the United States in mid-2006 but every provision is still subject to public comment and review by the agencies. The Basel Committee is still working on some important issues, at the request of the U.S. agencies, and under their leadership. These are (1) the capital rules for certain guaranteed obligations, where both the borrower and the guarantor would have to default (double default) before the lender faces losses, (2) issues involving capital charges for certain trading account assets, and (3) the development of measures of Loss Given Default under conditions of stress. In the ANPR, the U.S. banking agencies proposed a bifurcated application of Basel II in the United States; that is, we proposed that certain large banks would be required to be under Basel II, any bank that meets the infrastructure requirements and wished to do so could opt in to Basel II, and all other banks would remain under the current Basel I-based capital rules. Federal Reserve staff has conducted and published several studies on the competitive implications of the proposed bifurcated application of Basel II in the United States. These studies were of mergers and acquisitions, loans to small- and medium-sized businesses, and operational risk. Early in April, Federal Reserve staff plans to release a residential mortgage study and before mid-year a consumer credit card study. The studies published so far suggest that the proposed U.S. implementation of Basel II would have at most modest competitive impacts, although the studies do indicate that there may be some po! tential effects on regional banks in the market for loans to small- and medium-sized firms. The U.S. banking agencies also have recently conducted their fourth Basel II quantitative impact study (QIS 4), and the results of this study (which should be available in the coming months) should shed additional light on the potential competitive impact of Basel II on the U.S. banking system. The U.S. banking agencies have announced their intention to propose changes in either the application of Basel II in this country or in the current U.S. capital rules that would continue to apply to non-Basel II banks in order to address potential competitive distortions, as well as to make the current capital regime more risk-sensitive. Proposed changes to the current capital rules would be included in an ANPR to be published shortly after the Basel II NPR. Many banks that have been preparing for Pillar 1 treatment of operational risk, using the Advanced Measurement Approach (AMA), which allows banks great flexibility, continue to tell us that they perceive that the process has spawned risk management benefits for their organization that go beyond regulatory compliance. In addition, we as supervisors--and increasingly rating agencies and counterparties--believe that such mechanisms are necessary in well-managed organizations that seek to play a role in global financial markets, in extending credit, trading in large volume, and managing and processing financial assets for a significant share of the global financial system. In effect, the market--independently of Basel II--is requiring that banks establish and maintain an operational risk management infrastructure that is similar in nature and cost to the infrastructure that would be required under Basel II. Moreover, we do not expect that Basel II will impede banks' efforts to m! itigate their operational risk; in fact, Basel II allows banks to reduce substantially their capital requirements for operational risk to the extent the bank has taken action to control or hedge its operational risk. U.S. banks would be stronger, safer, and less vulnerable to shock--and thus the preferred entities for global counterparties--because of having the strong risk measurement and management systems that Basel II requires. This proposition holds true in credit cards, asset management, and across the full range of bank activities. A bank is not competitively disadvantaged if it has strong risk and capital management systems vis-a-vis its rivals here and abroad. In any event, foreign rivals will be subject to the Basel II rules, and securities firms in this country will be subject to similar rules." CHRG-110hhrg46593--321 Mr. Royce," Thank you. Let me ask a question of our two economists here. Because one of the occurrences that we listen to over and over again in this committee is the Federal Reserve coming up here and also Treasury Secretaries saying that there was a systemic risk to the economy because of the leveraging that was occurring in the system. And, specifically, they were identifying the leveraging, which I guess got up to about 100 to 1 at a point, with the GSEs, with Fannie Mae and Freddie Mac doing what somebody described as arbitraging, but borrowing at one rate and then--I guess they borrowed about $1 billion and then went out into the market and had $1.5 billion in these mortgage-backed securities in the portfolios. And, as they described it, one of the consequences of this was that the financial system worldwide was relying heavily on the mortgage-backed securities and, I guess, also, the debt a lot of the banks were holding as part of their collateral, these instruments from Fannie and Freddie. So maybe one of the things we weren't thinking about at the time was that there was also all of this leveraging going on not just in the institutions themselves--maybe that got up to 100 to 1--but also, because it was collateral for loans, there was this additional leveraging that was leveraged into the system. And then, along the way, there was a little bit of nudging from Congress to Fannie and Freddie, in terms of the type of loans that they should be purchasing, the goals that they should have. And so, as a consequence, Alt-A loans, you know, and subprime loans, I mean, this was a place then that those who were writing those loans could get Fannie and Freddie to purchase them, as they got near the end of the year especially and needed to make that target. And so, as they ended up buying those back into their portfolio, and that being 10 percent of the portfolio, the argument that I have seen is that 50 percent of their losses at one point were these Alt-A loans and subprime loans that they had repurchased. And so one of the questions was: We have tried creating a charter, we have tried giving direction to a quasi-governmental entity or a private entity, however we want to define Fannie and Freddie, but might it be wiser, going forward, for us to just let market principles play out, rather than take a scheme like securitization through Fannie and Freddie and then disallow or prevent the regulator--in this case, OFHEO, because OFHEO testified here maybe a month ago or so, the Director of OFHEO. He said, if they had gotten the legislation that they wanted, which would have allowed them to regulate for systemic risk, they could have deleveraged the situation, forced more capital. And they felt that even as, you know, 16 months from today, if they could have gotten that authority, they could have deleveraged this problem and made it a lot less of a crisis for at least the GSEs. And that might have staved off--they said it would have staved off the GSE problem. Be that as it may--that is their opinion--I had carried legislation in 2005 that the Federal Reserve had asked for to try to give them the ability to regulate for systemic risk in this way. But that is the question I wanted to ask you gentlemen. Do you think, going forward, that perhaps we should back off of the portfolio arrangement there that we have, or the leveraging arrangement, and look at simply market principles maybe, in terms of the way that Fannie and Freddie would conduct itself in the future? Because I can see, going out 4 years, 5 years from now as we get this thing resolved, that same dynamic occurring again as long as we have that-- " FinancialCrisisInquiry--217 VICE CHAIRMAN THOMAS: Additional two minutes? HOLTZ-EAKIN: Thank you. ZANDI: Oh, I’m sorry. HOLTZ-EAKIN: That’s fine. ZANDI: OK. HOLTZ-EAKIN: High-quality answers. Keep going. ZANDI: OK. Two trillion dollars in private bond issuance at the height of the issuance is clearly overdone. It’s— it’s unhealthy. That’s how we got all these bad loans being made. But in 2009, we had $150 billion in issuance, all of it TALF-supported. That is clearly unhealthy, and the banking system won’t work with that, either. We need something in between so that the system can work properly and credit will start to flow. Until that happens, the system is going to remain quite troubled. CHRG-111hhrg48874--18 Mr. Long," Chairman Frank, Ranking Member Bachus and members of the committee, my name is Tim Long. I am the Senior Deputy Comptroller for Bank Supervision Policy at the OCC. I appreciate this opportunity to discuss the OCC's role in ensuring banks remain safe and sound, while at the same time meet the credit needs of their communities and customers. The last few months have underscored the importance of credit availability and prudent lending to our Nation's economy. Recent actions to provide facilities and programs to help banks strengthen their balance sheets and restore liquidity to various credit segments are important steps in restoring our banking system and we support these initiatives. Nonetheless, the current economic environment poses significant challenges to banks and their loan customers that we and bankers must address. As a bank examiner for nearly 30 years, I have experienced firsthand the importance of the dynamics between bankers and examiners during periods of market and credit stress. One of the most important lessons I have learned is the need to effectively communicate with bankers about the problems facing their institutions and how we expect them to confront those problems without exacerbating the situation. Delay or denial about conditions by bankers or regulators is not an effective strategy. It only makes things worse. Against that backdrop, here are some facts that bankers and regulators are facing today: First, asset quality in many bank loan portfolios is deteriorating. Non-performing loan levels are increasing. Borrowers who could afford a loan when the economy is expanding are now having problems repaying their loans. Increased levels of non-performing loans will likely persist for some time before they work through the banking system. Second, bankers have appropriately become more selective in their underwriting criteria for some types of loans. Where markets are over-lent or borrowers overleveraged, this is both prudent and appropriate. Third, loan demand and loan growth have slowed. This is normal in a recession. Consumers cut back on spending; businesses cut back on capital expenditures. What is profoundly different in this cycle has been the complete shut-down of the securitization markets. Restoring these markets is a critical part of stabilizing and revitalizing our financial system. Despite these obstacles, bankers are making loans to creditworthy borrowers. The bankers I talk with are committed to meeting the credit needs of their communities, and they recognize the critical role they play in the wellbeing of our economy. Simply put, banks have to lend money to make money. The OCC's mission is to ensure that national banks meet these needs in a safe and sound manner. This requires a balance: supervise too lightly, and some banks will make unsafe loans that can ultimately cause them to fail; supervise too strictly, and some banks will become too conservative and not make loans to creditworthy borrowers. We strive to get this balance right through strong and consistent supervision. In the 1980's, we waited too long to warn the industry about excesses building up in the system which resulted in bankers and regulators slamming on the brakes once the economy turned down. Because of this lesson, we have taken a series of actions starting as early as 2003 to alert bankers to the risks we were seeing and to direct them when needed to take corrective actions. Today, our message to bankers is straightforward. Make loans that you believe will be repaid, don't make loans that are unlikely to be repaid, and work constructively with borrowers who may be facing difficulties with their obligations, but recognize repayment problems and loans when you see them. Contrary to some press reports, our examiners are not telling bankers which loans to approve and which to deny. Rather, our message to examiners is this: Take a balanced approach in your supervision. Communicate concerns and expectations clearly and consistently. Provide bankers a reasonable time to document and correct credit risk management weaknesses, but don't hesitate to require corrective action when needed. It is important to keep in mind that it is normal for our banks to experience an increase in problem loan levels during economic downturns. This should not preclude bankers from working with borrowers to restructure or modify loans so foreclosure is avoidable wherever possible. When a workout is not feasible, and the bank is unlikely to be repaid, examiners will direct bankers to have adequate reserves and capital to absorb their loan losses. Finally, the reality is that some community banks are so overextended in relation to capital and reserves, the management needs to reduce the bank's exposures and concentrations to ensure the long-term viability of the bank. In all of these cases, our goal is to work constructively with bankers so that they can have the financial strength to meet the credit needs of their communities and borrowers. Thank you, and I will be happy to answer any questions. [The prepared statement of Mr. Long can be found on page 132 of the appendix.] " CHRG-111hhrg56776--19 Mr. Volcker," If you are going to have more than one regulatory agency, and I have some sympathy for that, you have to have some division of responsibility. Just where you place that, I do not know. I do not know the implications of the $50 billion. I do not know how many banks are below $50 billion offhand, and if the Federal Reserve maintained a small number of member bank supervision, what the FDIC would have and what the OCC would have. I think that is a practical and maybe pretty arbitrary matter in the last judgment. I do think we do not want to signal out some institutions as ``too-big-to-fail.'' I think we want a system in which particularly non-banking institutions can fail. That brings up many other issues in financial reform that do not rest significantly on precise quantitative amounts. " FinancialCrisisReport--46 Asset Relief Program (TARP) and authorized the expenditure of up to $700 billion to stop financial institutions from collapsing and further damaging the U.S. economy. Administered by the Department of the Treasury, with support from the Federal Reserve, TARP funds have been used to inject capital into or purchase or insure assets at hundreds of large and small banks. The largest recipients of TARP funds were AIG, Ally Financial (formerly GMAC Financial Services), Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, PNC Financial Services, U.S. Bancorp, and Wells Fargo, as well as Chrysler, and General Motors. Most have repaid all or a substantial portion of the TARP funds they received. Although initially expected to cost U.S. taxpayers more than $350 billion, the Congressional Budget Office estimated in November 2010, that the final cost of the TARP program will be approximately $25 billion. 101 Federal Reserve Emergency Support Programs. In addition, as the financial crisis began to unfold, the Federal Reserve aggressively expanded its balance sheet from about $900 billion at the beginning of 2008, to more than $2.4 trillion in December 2010, to provide support to the U.S. financial system and economy. Using more than a dozen programs, through more than 21,000 individual transactions, the Federal Reserve provided trillions of dollars in assistance to U.S. and foreign financial institutions in an effort to promote liquidity and prevent a financial collapse. 102 In some instances, the Federal Reserve created new programs, such as its Agency Mortgage Backed Securities Purchase Program which purchased more than $1.25 trillion in mortgage backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae. 103 In other instances, it modified and significantly expanded existing programs, such as by lowering the quality of collateral it accepted and increasing lending by the discount window. Dodd-Frank Act. On July 21, 2010, Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203. This law, which passed both Houses with bipartisan majorities, expanded the authority of regulatory agencies to try to prevent future financial crises. Among other provisions, the law: – established a Financial Stability Oversight Council, made up of federal financial regulators and others, to identify and respond to emerging financial risks; – established a Consumer Financial Protection Bureau to strengthen protection of American consumers from abusive financial products and practices; – restricted proprietary trading and investments in hedge funds by banks and other large financial institutions; 101 11/2010 “Report on the Troubled Asset Relief Program,” prepared by the Congressional Budget Office, http://www.cbo.gov/ftpdocs/119xx/doc11980/11-29-TARP.pdf. 102 “Usage of Federal Reserve Credit and Liquidity Facilities,” Federal Reserve Board, available at http://www.federalreserve.gov/newsevents/reform_transaction.htm. 103 “Agency Mortgage-Backed Securities Purchase Program,” Federal Reserve Board, available at http://www.federalreserve.gov/newsevents/reform_mbs.htm. – prohibited sponsors of asset backed securities from engaging in transactions that would involve or result in a material conflict of interest with investors in those securities; – established procedures to require nonbank firms whose failure would threaten U.S. financial stability to divest some holdings or undergo an orderly liquidation; – strengthened regulation of credit rating agencies; – strengthened mortgage regulation, including by clamping down on high cost mortgages, requiring securitizers to retain limited liability for securities reliant on high risk mortgages, banning stated income loans, and restricting negative amortization loans; – required better federal regulation of mortgage brokers; – directed regulators to require greater capital and liquidity reserves; – required regulation of derivatives and derivative dealers; – required registration of certain hedge funds and private equity funds; – authorized regulators to impose standards of conduct that are the same as those applicable to investment advisers on broker-dealers who provide personalized investment advice to retail customers; and – abolished the Office of Thrift Supervision. CHRG-111hhrg61852--61 Mr. Hinojosa," Madam Chairwoman, I am going to pass. I yield back. Mrs. McCarthy of New York. I recognize the gentleman from North Carolina. Mr. Miller of North Carolina. Thank you, Madam Chairwoman. This morning, Mr. Bernanke said that the housing market remains weak with the overhang of vacant and foreclosed homes weighing on home prices and construction. That seemed to be the kind of understatement that you would have expected from his predecessor. In 2005, housing starts were 2,068,000; last year, there were 554,000. Some have said that 2 million was way too many, that was part of the bubble. But from 1996 through 2002 or so, new housing starts were at 1.5 million to 1.6 million, and the estimate this year is that it is going to come in less than last year. That seems to be an enormous burden on the economy. That is a huge employer. Home building has been 16 percent of our GDP, and if it is a quarter of what it has been, it is hard to imagine how we are going to come out of the recession in a very strong way. And usually it is housing that has led us out of downturns in the past. There is some debate about what the problem is. Some have said we just have too many houses for our population. Others have said that it is really tied to the recession; that demand is down because of recessionary forces, the liquidity trap; that people aren't buying houses because nobody is buying the stuff that their employer is making, so their wages are down, or they are unemployed. And there is also the foreclosure crisis that continues to push down home values, which continues to be a huge disincentive to building new houses. There is a large number of houses that are foreclosed or destined for foreclosure that are either in the inventory or part of the shadow inventory. Mr. Mishel, what is your sense of what the demand is for housing now? If we got the economy functioning halfway normally, how many new housing starts could we expect in a year? And how much of this is because of foreclosure? How much of this is because of recessionary factors? " CHRG-111hhrg55814--386 Mr. Yingling," Chairman Frank, Congressman Bachus, and members of the committee, thank you for inviting me to testify. It has been over a year since I first testified before this committee in favor of broad financial reform. This week, the committee is considering legislation that addresses the critical issues that we identified in that testimony, and the ABA continues to support such reform. The key issues addressed include the creation of a systemic oversight council, addressing key gaps in the regulation of non-banks, addressing ``too-big-to-fail,'' and establishing a regulatory approach to the payment system. My written testimony addresses these issues more fully, and I want to emphasize we appreciate the progress that has been made in these areas, the areas that are most critical to reform. One very important change in the draft from the original Administration proposal is that the draft maintains the thrift charter. The ABA wishes to thank Chairman Frank for his leadership on this important issue. In my remaining time, I want to talk about a few areas that need further work, in our opinion. First, there is one glaring omission in the Administration's original proposal and in the draft, the failure to address accounting policy. A systemic risk oversight council cannot possibly do its job if does not have oversight authority over accounting rule-making. Accounting policies are increasingly influencing financial policy and the very structure of our financial system. Thus, accounting standards must now be part of a systemic risk calculation. We believe the Federal Accounting Standards Board should continue to function as it does today, but it should no longer report only to the SEC. The SEC's view is simply too narrow. Accounting policies contribution to this crisis has now been well-documented, and yet the SEC is not charged with considering systemic or structural effects. ABA has strongly supported H.R. 1349, introduced by Representatives Perlmutter and Lucas, in this area. Second, I want to reiterate the ABA's strong opposition to using the FDIC directly for non-bank resolutions. Several weeks ago, the ABA provided a comprehensive approach to resolutions and to ending ``too-big-to-fail.'' The draft, in many ways, mirrors that proposal. However, using the FDIC directly as opposed to indirectly is fraught with problems and is unnecessary. Putting the FDIC directly in charge of such resolutions would greatly undermine public confidence in the FDIC's insurance for the public's deposits. This confidence is critical and it's the reason we have had no runs on banks for over 70 years, even during this very difficult period. The importance of this public confidence should not be taken for granted. Witness the lines that formed in front of the British bank, Northern Rock, at the beginning of this crisis, where they did have classic runs. Yet our own research and polling shows that while consumers trust FDIC insurance, their understanding of how it works is not all that deep. Headlines saying, ``FDIC in charge of failed XYZ non-bank'' would greatly undermine that trust. Just imagine if the FDIC were trying to address the AIG situation this year, dealing with AIG bonuses and that type of thing. We urge the Congress not to do anything that would confuse consumers or undermine confidence in the FDIC. We also believe it's a mistake to use existing bank resolution policies in the case of non-bank creditors. Basic bankruptcy principles should be applied in those cases. Finally, we want to work with the committee to achieve the right balance on securitization reform. We want to work with you to provide for skin in the game on securitization. We understand why there is interest in that, but we need to address the very thorny accounting and business issues involved in having skin in the game. ABA has been a strong advocate for reform. A good deal of progress has been made through the constructive debate in this committee, and we really appreciate the consideration members have given to our views. Thank you. [The prepared statement of Mr. Yingling can be found on page 321 of the appendix.] " CHRG-110hhrg46591--425 Mr. Wilson," And then to Mr. Bartlett or Mr. Yingling, both of you were talking about under TARP, I think there are three things that we could do. And I would ask that you talk to your members about it. One is, you know, buy the junk portfolios, whatever you want to call them, the troubled assets. Two, recapitalize the banks. And the third one is--and this I got in a colloquy with the chairman--is that we can use this $700 billion to go directly through the SBA, go through the Federal Home Loan Bank system or get to the community banks directly and the Farm Credit Administration, because there is fury out in, you know, Wheat Ridge, Colorado, about money getting down to small businesses and to people. I mean, there really is a huge amount of anger about all of this. And so one of the things that I would ask all of you to take back to your members and also continue to promote is that there is a way through this whole thing we have done to get it directly down to the people on the street, the small businesses on the street, the homeowners on the street, the bankers and the farmers. But I didn't get that in there. It is not as crisply written as I would like, but it is in the record. Thank you. " FinancialCrisisInquiry--177 And so, Mr. Zandi, if you would commence your testimony. Thank you very much. ZANDI: Well, thank you, Mr. Chairman and other distinguished members of the commission. I—I want to thank you for the opportunity to testify today. The views I express are my own and not those of the Moody’s Corporation. The purpose of my testimony is to assess the economic impact of the financial crisis that began nearly three years ago. While the financial crisis has abated and the financial system has stabilized, the system remains troubled. Failures at depository institutions continue at an alarming rate and likely will continue for several years more to come. The securitization markets also remain dysfunctional as investors anticipate more loan losses and are uncertain about various legal and accounting rule changes and regulatory reform. Without support from the Federal Reserve’s TALF program, private bond issuance and securities backing of consumer and business loans would be completely dormant. Households and businesses are struggling with the resulting severe credit crunch. The extraordinary tightening of underwriting standards by nearly all creditors is clear in the lending statistics. Here’s a very astounding statistic. The number of bank credit cards outstanding has fallen by nearly 100 million cards in just over the past year and-a-half, a 20 percent decline. Total household debt, including credit cards, auto loans and mortgage debt has declined a stunning $600 billion, or 5 percent. And outstanding C&I loans, commercial investor loans, have declined by some 20 percent since peaking in late 2008. Some of this reflects the desire of households and businesses to reduce their debt loads. But it also stems from lenders’ inability and unwillingness to lend. Small banks are vital to consumer and small- business lending. And without the ability to sell the loans they originate to investors in the securities market, banks and other lenders don’t have the capital sufficient to significantly expand their lending. The economic recovery will struggle to gain traction until credit flows more freely, which won’t occur until bank failures abate and there’s a well functioning securities market. FOMC20080310confcall--100 98,MR. ALVAREZ.," ""The Federal Open Market Committee directs the Federal Reserve Bank of New York to increase the amount available from the System Open Market Account under the existing reciprocal currency arrangement with the Swiss National Bank to an amount not to exceed $6 billion. Draws are authorized up to the full amount of the swap. The current swap arrangement shall be extended until September 30, 2008, unless further extended by the Federal Open Market Committee."" " CHRG-110hhrg46596--372 Mr. Kashkari," I think we can continue to encourage banks to increase credit. And that is what we are working on with the regulators, to measure that now, so we have the data to know what is really happening. But I will say I am very cautious about getting into the business where the Treasury Department is telling an individual bank, ``You should make this individual loan.'' I think that is a bridge too far. I don't think the Treasury Department or Washington is the best place to make those individual decisions. But we think the system as a whole should get the credit out to the people who need it. " FOMC20070131meeting--22 20,CHAIRMAN BERNANKE.," Are there other questions about the memo? I need a vote. In favor? Opposed? Thank you. Third, we need to select a Federal Reserve Bank to execute transactions for the System Open Market Account. Governor Kohn, would you like to make a proposal? [Laughter]" CHRG-111shrg53085--188 Chairman Dodd," Let me ask you--I am jumping around here, but trying to wrap up. Forgive me for not remembering exactly which one of you embraced this view, but I mentioned Gramm-Leach-Bliley going back a number of years ago and the issue of whether or not you could create firewalls between traditional commercial activities and banking activities. One of you has advocated that actually the distinction between commerce and banking doesn't have much validity. Is that your opinion. " CHRG-110hhrg46591--319 Mr. LaTourette," Thank you so much. Gentlemen, at the beginning of the hearing, I referenced two articles, one appearing over the weekend in the New York Times that dealt with a development down in Texas. In this morning's paper, in the Cleveland Plain Dealer, it talks a little bit about the same thing. The author of the Plain Dealer article is a guy named Phillip Morris. You, Mr. Bartlett, and you, Mr. Yingling, at least have talked about the unregulated side dragging down the regulated side. I just want to sort of focus on that for a second. There was a fellow just indicted in Ohio for turning a place called Slavic Village, a beautiful place, into a wasteland. The fellow who has been indicted was a mortgage broker from Cleveland Heights. Basically, the article indicates--and I am paraphrasing--that he could turn you into a real estate mogul on somebody else's dime. No credit, no problem. The guy would invent you some. No work history, no problem. He could create that, too. The example is a guy named Irvin Johnson, not the basketball player but another Irvin Johnson. He indicated that the FBI was sort of sniffing around because, between 2005 and 2006, he and his wife amassed nearly $2 million in residential property. By profession, he was a grass cutter who made no more than $10,000 a year, and his wife was a nurse's aide. So it clearly goes through that probably this guy should not have been qualified for the six mortgages that he had. I think we would all agree that the unregulated side and the unscrupulous, in some cases, had willing victims, but his walk-off line is: The bankers who financed and who once greatly profited from the foreclosure epidemic remain in the shadows. I think what he is talking about is that the unregulated side may have originated the mortgages, but that the regulated side purchased the mortgages, and then they were securitized, as Mr. Ryan talks about. Either Mr. Bartlett or Mr. Yingling, if you could respond to sort of that walk-off line. We all know of these fly-by-night groups that came in and that wrote mortgages they were not supposed to write on the basis of a commission, but then somebody bought them. Somebody bought the paper. " Mr. Bartlett," " CHRG-111shrg57322--917 Mr. Blankfein," De minimis. Senator McCain. But since it was the housing market that collapsed, you needed $10 billion, and you recovered rather nicely, I guess. I guess you declared earnings for 2009 of some $13 billion, is that correct? Roughly? " FOMC20080430meeting--216 214,MR. HILTON.," Thank you, Jim. We have identified four critical objectives for a new operating framework, which are listed on page 34 of your handout. These are (1) to reduce burdens and deadweight loss associated with the current regime, (2) to enhance monetary policy implementation, (3) to promote efficient and resilient money markets, and (4) to promote an efficient payment system. For each of the five options that Jim has just presented, I am going to describe what we see as the major advantages and disadvantages of each vis � vis these objectives. I will also highlight some important sources of uncertainty that we have about how some of these options might function in practice. Then I will close with a broad assessment of how the five options measure up against each of these four objectives. The key advantages and disadvantages of option 1--remunerate required and excess reserve balances--are listed on page 35. This option would have the advantage of being relatively easy to implement given that it would build largely on elements of the current operating framework and would simply pay interest on reserve requirements and, at a lower rate, on excess reserves. The basic framework, which consists of an interest rate corridor with reserve requirements and maintenance periods, is widely used by other central banks, and we're pretty certain how it would function in practice. For central banks that have adopted this basic framework, it has proven to be reasonably effective for controlling short-term interbank rates under a variety of circumstances. However, this option would do little to reduce the administrative burdens associated with our current regime. This framework is also somewhat rigid, particularly in the flexibility it would provide to us and to banks themselves to adjust the level of requirements in ways that would facilitate monetary policy implementation. A particular shortcoming is that many depositories active in the interbank market have a very small base of deposits against which requirements of any level could be assessed. An important source of uncertainty with this option is whether it would lead to a significant increase in total required operating balances, which would be helpful for damping interest rate fluctuations that can arise when requirements are very low. However, the Fed would have some power to influence the aggregate level of requirements by raising requirement ratios. Option 2--voluntary balance targets--(shown on page 36) would lead to some reduction of administrative costs and burdens compared with the current framework (option 1), as relative simplicity would be one of the principal design objectives for a new system of voluntary reserve targets. The basic framework is similar to that of option 1. It consists of an interest rate corridor with maintenance periods but substitutes voluntary targets for reserve requirements. As already noted, this basic framework has proven to be reasonably effective for controlling overnight interbank rates where it has been adopted. Furthermore, a new system of voluntary targets could provide all DIs with considerable flexibility for setting their own level of targets and for adjusting the size of these targets, a feature that banks might find useful during periods of heightened uncertainty or stress. With this option, there would also be the opportunity to review and totally revamp the length and mechanics of the maintenance period to make them more supportive of monetary policy implementation. However, almost any system of voluntary targets for reserves is bound to impose some administrative costs on both depositories and the Fed, and there may be some tradeoff between administrative simplicity and design flexibility. An important source of uncertainty with this option is that we have yet to identify with precision a system of voluntary reserve targets that would be workable, in the sense of being easy to administer across a large number of DIs with disparate structures, and that would be effective in yielding a total level and distribution of voluntary targets across DIs that would enhance our ability to achieve our operating objectives. Unfortunately, experiences of other central banks offer little guidance in how to design voluntary targets. A particular risk that concerned the Bank of England when it designed its voluntary target scheme was the potential for market manipulation that a new system might offer individual banks if they were entirely free to choose their level. Option 3--simple corridor--(on page 37) would go about as far as possible toward eliminating administrative burdens by doing away with all requirements and maintenance period accounting rules. This option should also keep the overnight interbank rate within a narrower range than the other options, assuming that we adopt a narrower spread between the discount rate and the interest rate paid on excess reserves. Experiences of other central banks that have adopted this kind of operating system support that belief. However, there is also reason to believe that, with removal of the ability of banks to average reserve holdings over a maintenance period, interest rate volatility within the interest rate corridor could be high. We could respond to high volatility within a corridor by further narrowing that corridor. But there is the risk that, at some point as you go in that direction, market participants could use our discount window or interest on excess reserves as a first recourse rather than as a last resort and thus affect the Fed's role as intermediary and impair normal market functioning. There are some important questions about how effectively a simple corridor system would function in our particular environment. All the options we are considering propose to use the primary credit facility to limit upward movements in market rates. To the extent that this facility might not serve as an effective brake on upward rate movements, the consequences would be greatest for this option because there are no other mechanisms for smoothing interest rates. Some central banks that have a simple corridor framework have also developed arrangements to adjust reserve levels late in the day to prevent exogenous reserve shocks from pushing market rates to either the upper or the lower end of the corridor. Option 4--floor with high balances--is shown on page 38. It would also do away with all requirements and maintenance period accounting rules and, like option 3, would go a long way toward eliminating administrative burdens. Moreover, because the rate effects of even a large aggregate reserve shock or a payment shock at an individual DI are likely to be relatively small, the need for depositories or for the Desk to manage daily reserve positions intensively is likely to be reduced, which should translate to further resource savings. Better insulation of market rates from exogeneous reserve shocks is a design objective, and it is a particularly distinctive feature of this framework. However, completely severing the link between daily reserve levels and interest rate movements can be a double-edged sword. While we may wish to better insulate market rates from reserve shocks, we may also wish to preserve some ability to influence market rates by manipulating reserve supply when other factors are distorting rates. One risk associated with this option is that it would represent a radical departure from the basic elements of our own current framework and from those of almost every other central bank, preventing us from learning from the experiences of other central banks. A particular unknown with this option is the possible implication for the functioning of the interbank market. Offering to compensate DIs for all the reserves they might choose to hold at a rate that is in line with market rates could have profound effects on their willingness to lend in the market, under both normal circumstances and during periods of market stress. The Reserve Bank of New Zealand, one central bank that has experimented with a system similar to option 4, did run into some difficulties with the hoarding of reserves by individual banks to the detriment of the interbank market. As a result, they adjusted their framework to cap holdings of excess reserves by individual banks. Option 5--voluntary daily target with clearing band--is on page 39. It has many of the same advantages and disadvantages as option 2, stemming from the fact that both feature voluntary reserve targets. Because simplicity would be one of the design principles, it should reduce current administrative burdens. It would also provide DIs with the same kind of flexibility that option 2 does for setting and adjusting their own reserve targets. On the other hand, a system of voluntary targets for reserves would still leave some administrative costs, and we have yet to specify a system of voluntary reserve targets that would be workable and effective. An additional advantage of this option is that it could allow the Fed to adjust the width of the daily clearing band around the reserve target. The final choice of clearing band width could be made after some experimentation based on what works best. Moreover, being able to make temporary adjustments to the width of this daily clearing band could be a powerful tool for dealing with exigent circumstances. Experiences of other central banks provide little guidance about how this flexibility might be best employed. But the Bank of England did widen its maintenance period clearing band during the recent financial market turmoil, and they have been happy with the results. Interestingly, the ECB, quite independently, has been examining the possibility of a new system centered on a one-day clearing band rather than a multi-day maintenance period. Let me sum up by outlining how these five options stack up against the four objectives that we have established for a new operating framework, which are summarized on pages 40 and 41. First, all the options would eliminate most of the current ""reserve tax"" associated with the nonpayment of interest on reserves, and perhaps with the exception of option 1, they would reduce the administrative burdens associated with our current framework. Option 3 (simple corridor) and option 4 (floor with high balances) would do the most to eliminate these administrative costs. Second, all the options would improve monetary policy implementation by helping set a floor on the fed funds rate. Most have additional features that could help control rate volatility, although these differ from one another in terms of their mechanics. But some of the options offer greater potential to adjust parameters in ways that could be helpful amid changing circumstances--say, during periods of market stress or heightened uncertainty about developments that could affect our balance sheet. An adjustable clearing band in option 5 could offer considerable flexibility. Adjustable reserve targets, a feature of both options 2 and 5, are another possibility. Third, all the options would rely on efficient money markets for distributing reserves between DIs. There is more uncertainty, however, about how some of the options might influence the incentive structure for trading and the allocation of liquidity in short-term financing markets and the role of the central bank in that process. This is the case with option 3 (simple corridor), should that corridor be too narrow, and with option 4 (floor with high balances), where the choices of lending excess liquidity in the market versus holding excess reserves would be nearly equivalent. Fourth, all the options are compatible with the proposed changes in payment system policies. However, there are differences among the options in the levels of reserves that would likely be in place and that could serve as a substitute for the provision of central bank daylight credit. Option 4 (floor with high balances) would provide the most reserves in the system, and option 3 (simple corridor) would provide the fewest, perhaps even lower than current levels. A system of voluntary reserve targets, a feature of both options 2 and 5, could be deliberately designed to encourage a relatively high level of reserves. " FOMC20071206confcall--75 73,MR. LACKER.," I have strong reservations about this term auction facility. I oppose proceeding at this time. I expressed many of my concerns in a letter that I circulated yesterday. The gist of it is that I questioned the need for this. I don’t think our willingness to keep the overnight fed funds rate low and near the target, especially over year-end, is in question. If it were in question, I think something more like what we did about the millennium change would be appropriate. It’s not obvious that there’s an apparent inefficiency in markets. Banks are paying a lot for insurance against term funding costs to them going up, and a lot of banks are forgoing large spreads in order to marshal their resources. It seems as though they have potentially very legitimate reasons to do so. Now LIBOR is 50 basis points over the discount rate, so it’s not obvious that the rate we charge for discount window lending is a significant factor and is germane here. The Europeans and the British markets have the same problem, and they have very different ways of injecting reserves that suggest that maybe this isn’t something that our discount window really needs to address. I pointed out in my letter that the Federal Home Loan Banks are a very significant source of liquidity to banks, and some of the largest banks are some of the largest borrowers at the Federal Home Loan Banks. They’ve increased their lending tremendously. The lending is on virtually the same terms as the lending we propose here. So it’s not obvious to me that banks have any inability to obtain term funding from a government-subsidized entity. I don’t think this lending is going to alleviate balance sheet pressure, and I think balance sheet pressure is at the heart of what’s going on here. More broadly, this sets an unfortunate precedent, I think. It is targeting credit to a narrow segment of the market—it will be subsidized credit to the riskiest borrowers, who are obviously going to be willing to pay the most for this. It harkens back to Operation Twist in the early 1960s, which I don’t think was a well-thought-out policy initiative. I understand that the urge to act is strong at times like this, but I think we might need to recognize that the financial system is coping with genuinely serious and difficult issues, and this might be the normal way a financial system copes with very serious difficulties such as they are coping with now. So while we’d like to see financial systems exhibit the behavior they exhibit in normal times, I’m not sure the fundamentals are normal right now, and I’m not sure this isn’t the way financial markets normally ought to be expected to behave at a time like this. So I oppose this facility at this time." CHRG-111shrg55278--11 EXCHANGE COMMISSION Ms. Schapiro. Thank you. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am very pleased to be here today with my colleagues from the Fed and FDIC. There are many lessons to be learned from the recent financial crisis, and a key one is that we as regulators need to identify, monitor, and reduce systemic risk before they threaten the stability of the financial system. However, in our efforts to minimize the potential for institutional failures to threaten the system, we must take care not to unintentionally facilitate the growth of large, interconnected institutions whose failure might later pose even greater systemic risk. To best address these risks, I believe we must rely on two lines of defense. First, there is traditional oversight and regulation. This includes enhancing existing regulations, filling gaps, increasing transparency, and strengthening enforcement to prevent systemic risks from developing. And, second, we should establish a workable macroprudential regulatory framework and resolution regime that can identify, reduce, and unwind systemic risks if they do develop. Closing regulatory gaps is an important part of reducing systemic risk. If financial participants realize they can achieve the same economic ends with fewer costs by flocking to a regulatory gap, they will do so quickly, often with size and leverage. We have seen this time and again, most recently with over-the-counter derivatives, instruments through which major institutions engage in enormous, virtually unregulated trading in synthetic versions of other, often highly regulated financial products. We can do much to reduce systemic risk if we close these gaps and ensure that similar products are regulated similarly. In addition to filling gaps, we need to ensure greater transparency of risk. Transparency helps reduce systemic risk by enabling market participants to better allocate capital and giving regulators more information about risks that are building in the financial system. Transparency has been utterly lacking in the world of unregulated over-the-counter derivatives, hedge funds, and dark pools. Additionally, we need to recognize the importance that vigorous enforcement plays in sending a strong message to market participants. As a second line of defense, I believe there is a need to establish a framework for macroprudential oversight, a key element of the Administration's financial regulatory plan. Within that framework, I believe the most appropriate approach consists of a single systemic risk regulator and a very strong council. In terms of a systemic risk regulator, I agree there needs to be a governmental entity responsible for monitoring our financial markets for systemwide risks. This role could be performed by the Federal Reserve or by a new entity specifically designed for this task. The systemic risk regulator should have access to information across the financial markets about institutions that pose significant risk. And it should be able to monitor whether institutions are maintaining appropriate capital levels, and it should have clear delegated authority from the council to respond quickly in extraordinary circumstances. Most importantly, the systemic risk regulator should serve as a second set of eyes upon those institutions whose failure might put the system at risk. At the same time, I agree with the Administration that the systemic risk regulator must be combined with a newly created council, but I believe that any council must be strengthened well beyond the framework set forth in the Administration's white paper. The council should have authority to identify institutions, practices, and markets that create potential systemic risks and to set standards for liquidity, capital, and other risk management practices at systemically important institutions. This hybrid approach can help minimize systemic risk in a number of ways. First, a council would bring different perspectives to the identification of risks that individual regulators might miss or consider too small to warrant attention. Second, the members on the council would have experience regulating different types and sizes of institutions so that the council would be more likely to ensure that risk-based capital and leverage requirements do not unintentionally foster greater systemic risk. And, third, the council would include multiple agencies, thereby significantly reducing potential conflicts of interest and regulatory capture. Finally, the council would monitor the growth and development of financial institutions to prevent the creation of institutions that are either too-big-to-fail or too-big-to-succeed. At most times, I would expect the council and systemic risk regulator to work with and through primary regulators who are experts on the products and activities of their regulated entities. The systemic risk regulator, however, can provide a second layer of review over the activities, capital, and risk management procedures of systemically important institutions as a backstop to ensure that no red flags are missed. To ensure that authority is checked and decisions are not arbitrary, the council would remain the place where general policy is set, and if differences remain between the council and the primary regulator, the more stringent standards should apply. For example, on questions of capital, the new systemic risk framework should only be in a position to raise standards for regulatory capital for these institutions, not lower them. This will reduce the ability of any single regulator to compete with other regulators by lowering standards, driving a race to the bottom. And, finally, the Government needs a credible resolution mechanism for unwinding systemically important institutions. Currently, banks and broker-dealers are subject to resolution processes, but no corresponding resolution process exists for the holding companies of systemically significant financial institutions. I believe we have an opportunity to create a regulatory framework that will help prevent the type of systemic risk that created havoc in our financial system, and I believe we can create a credible regulatory regime that will help restore investor confidence. I look forward to working with you to address these issues and doing all we can to foster a safer, dynamic, and more nimble financial system. Thank you. " fcic_final_report_full--397 In addition to those TARP investments, at the end of  Bank of America and Merrill Lynch had borrowed  billion under the Fed’s collateralized programs ( billion through the Term Auction Facility and  billion through the PDCF and TSLF) and  billion under the Fed’s Commercial Paper Funding Facility. (During the previous fall, Bank of America’s legacy securities arm had borrowed as much as  billion under TSLF and as much as  billion under PDCF.) Also at the end of , the bank had issued . billion in senior debt guaranteed by the FDIC under the debt guarantee program.  And it had borrowed  billion from the Federal Home Loan Banks. Yet despite Bank of America’s recourse to these many supports, the regulators worried that it would experience liquidity problems if the fourth-quarter earnings were weak.  The regulators wanted to be ready to announce the details of government sup- port in conjunction with Bank of America’s disclosure of its fourth-quarter per- formance. They had been working on the details of that assistance since late December,  and had reason to be cautious: for example,  of Bank of America’s repo and securities-lending funding, a total of  billion, was rolled over every night, and Merrill “legacy” businesses also funded  billion overnight. A one- notch downgrade in the new Bank of America’s credit rating would contractually obligate the posting of  billion in additional collateral; a two-notch downgrade would require another  billion. Although the company remained adequately capi- talized from a regulatory standpoint, its tangible common equity was low and, given the stressed market conditions, was likely to fall under .  Low levels of tangible common equity—the most basic measure of capital—worried the market, which seemed to think that in the midst of the crisis, regulatory measures of capital were not informative. On January , the Federal Reserve and the FDIC, after “intense” discussions, agreed on the terms:  Treasury would use TARP funds to purchase  billion of Bank of America preferred stock with an  dividend. The bank and the three perti- nent government agencies—Treasury, the Fed, and the FDIC—designated an asset pool of  billion, primarily from the former Merrill Lynch portfolio, whose losses the four entities would share. The pool was analogous to Citigroup’s ring fence. In this case, Bank of America would be responsible for the first  billion in losses on the pool, and the government would cover  of any additional losses. Should the government losses materialize, Treasury would cover , up to a limit of . bil- lion, and the FDIC , up to a limit of . billion. Ninety percent of any additional losses would be covered by the Fed.  The FDIC Board had a conference call at  P . M . on Thursday, January , and voted for the fourth time, unanimously, to approve a systemic risk exception under FDICIA.  The next morning, January , Bank of America disclosed that Merrill Lynch had recorded a . billion net loss on real estate-related write-downs and charges. It also announced the  billion TARP capital investment and  billion ring fence that the government had provided. Despite the government’s support, Bank of Amer- ica’s stock closed down almost  from the day before. CHRG-111hhrg53241--3 Mr. Royce," Thank you, Mr. Chairman. We really do need regulation. And what happens when a regulator fails in his task to make certain that you don't have overleveraging in the financial institutions is something like what happened with AIG. You end up with overleveraging of 170 to 1. Banks typically are regulated to make certain they don't overleverage more than 10 to 1. The consequences are catastrophic when a regulator misses something like that. The consequences also are catastrophic when, for example, GSEs were leveraged 100 to 1. In this case, the regulators did catch it, but in this case we in Congress did not take the decisive action necessary to allow those regulators the power to deleverage Fannie Mae and Freddie Mac. And, likewise, you have a consequence there of an impact to the system, a shock to the system. And with that kind of overleveraging in a society, you end up also, of course, with a consequence of helping to create a boom or an expansion, an overexpansion in housing. Now we're here today again talking about the regulatory reform proposal issued by the Administration, and, logically, the consumer financial products agency is going to be discussed here today, as it was yesterday. We know what happens when you separate solvent protection from consumer protection. We saw it with the regulatory structure over Fannie and Freddie. OFHEO focused on safety and soundness and for years competed against HUD, who was enforcing the affordable housing goals, akin to mission oversight in that case so you had that competition. Those affordable housing goals pushed by one agency led to the build-up of junk loans in Fannie and Freddie, which ultimately led to their demise. Going forward, it will be very difficult to create a separate regulatory entity, charge it with consumer protection oversight, and not expect similar politically driven mandates to come further down the road. There is a reason why virtually every Federal safety and soundness regulator has expressed concern over this proposal that we are talking about today. And it isn't because they are trying to protect their regulatory turf. It is because it is a flawed idea. Consumers benefit from a competitive market with adequately capitalized institutions that consumers know will be there down the road. In many ways, solvency protection is the most effective form of consumer protection. Instead of bifurcating the mission of the various regulators, we should ensure consumers throughout the financial system have the tools necessary to make sound, educated financial institutions. What we are doing with the plan that is being put forward today, I am concerned, is you are going to eliminate choice by requiring government bureaucrats to define what are suitable financial products. And then it gives each State the ability to change those standards. To avoid litigation, institutions will have no choice but to sell only one-size-fits-all products. Also, the plan put forward here that we are discussing would add an additional layer of bureaucracy on top of the current regulatory patchwork, with broad, undefined, and arbitrary powers which would impose requirements that would likely conflict with those of other regulatory agencies. So the plan invites the kind of turf battles that will undermine rather than promote effective consumer protection. And lastly, in terms of lawsuits, we know what the consequence is going to be of outlawing mandatory arbitration clauses. Creating subjective standards for what constitutes acceptable products and reasonable disclosures, that is inevitably going to lead to more lawsuits. So the plan put forward here in this committee today I am afraid will impose new taxes and fees on consumer financial transactions, increase the cost of borrowing and create a government bureaucracy. And, frankly, what we should be doing is providing regulators with more investigative and enforcement tools, increasing civil penalties, and maximizing restitution of victims of fraud. That should be our focus here and we should streamline and consolidate regulations of financial institutions, including consumer protection, so that no institution can game the system. Thank you, Mr. Chairman. " CHRG-111shrg54533--28 Secretary Geithner," We are very worried about the same basic problem, designed as carefully as we could to mitigate that risk, but we haven't eliminated it completely. So let me just say a few things in response to that concern. Right now in the United States of America, we have a set of institutions that are of a--play a role in markets, it is probably because of size, but it is not principally because of size--you know, Bear Stearns and Lehmans were not that large--but play a role where their health and safety is critical to the stability of financial markets. Those institutions need to be subjected to stronger, more conservative constraints and leverage and we need to have the capacity through resolution authority, like we have for banks and thrifts now, to deal with their prospective failure in the future. Our judgment is the combination of those two things, the explicit change in policy now to recognize that those institutions need to be subjected to more conservative constraints on risk taking, combined with resolution authority to give the government better tools to manage their failure when that happens, will help mitigate the inherent moral hazard risk in any system that comes from the emergence of large institutions. Now, just one final thing, because this is an important kind of thing--an important issue. If you look at our system today, we are substantially less concentrated than the banking system of almost--I think of any major economy in the world. Less so than Canada. Less so than most of the countries in Western Europe. We have thousands of small institutions that play a critical role in creating a more resilient, more stable system. We want to preserve that balance. And by establishing this important change in principle of higher standards, higher capital requirements on the largest, we will help mitigate the risk in the future that we see future consolidation to a point that would leave us with a more vulnerable system. Senator Vitter. Mr. Chairman, if I could just ask one more question quickly, a lot of my concerns also go to the role of the Fed and the independence of the Fed and I would note two huge concerns. One is that under this plan, to use certain expanded powers and emergency steps, the Fed needs approval from Treasury. I think that is a big change in terms of the independence of the Fed. I think that is really crossing a line and a sort of fundamental change in terms of the nature of the Fed and I just point that out as a big concern, because all of a sudden, the Fed is acting more like a department of the government than an independent bank. It is asking Treasury for permission in that circumstance. Second, my other big concern is that we would be very much diluting the focus of the Fed from stable monetary policy. To me, getting monetary policy right is a big job, and to me it is a crucial job. And I don't think it is any coincidence that when we look at the periods of sustained, robust growth, at least in my lifetime, they coincided with sustained, predictable monetary policy and management. So I also have a fundamental fear of diverting the attention of the Fed on what is already a really big job and a really important job. I know my time has expired. Thank you, Mr. Chairman. Senator Johnson. Senator Warner. " CHRG-111shrg49488--50 Mr. Carmichael," In a short answer, yes. But, more importantly, their role is to communicate and coordinate between the agencies and to make sure that there is a regular testing of issues. Sometimes the central bank, if it is concerned about a systemic issue, has the power to send some of its staff with the prudential people going on inspections, for example, to learn more about what some of those issues might be. The involvement of the Treasury is there for exactly the systemic type reason. So while it does not have any direct authority--there is no charter that gives it the power to do anything--through coordination they are able to focus the issues and decide, for example, do we need more information about a particular area? Do we need one of the agencies to collect that on behalf of the systemic regulator? Senator Collins. Mr. Nason, I know you were very involved in the Paulson Blueprint for reform, and I very much appreciated your insights. As I understand it, the Blueprint that Secretary Paulson put out did call for a systemic risk regulator, but it would be vested in, I believe, the Federal Reserve. Is that correct? " CHRG-111shrg52619--200 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON FROM DANIEL K. TARULLOQ.1. Will each of you commit to do everything within your power to prevent performing loans from being called by lenders? Please outline the actions you plan to take.A.1. The Federal Reserve's survey of senior loan officers at banks has indicated that banks have been tightening standards for both new commercial and industrial loans and new consumer loans since the beginning of 2008, although the net percentage of banks that have tightened standards in both categories has diminished a bit in recent months. We also are aware of reports that some banking organizations have declined to renew or extend new credit to borrowers that had performed on previously provided credit, or have exercised their rights to lower the amount of credit available to performing customers under existing lines of credit, such as home equity lines of credit. There is a variety of factors that potentially could influence a banking organization's decision to not renew or extend credit to a currently performing borrower, or reduce the amount of credit available to such a borrower. Many of these factors may be unique to the individual transaction, customer or banking organization involved. However, other more general factors also may be involved. For example, due to the ongoing turmoil in the financial markets, many credit and securitization markets have experienced substantial disruptions in the past year and a half, which have limited the ability of banking organizations to find outlets for their loans and obtain the financing to support new lending activities. In addition, losses on mortgage-related and other assets reduced the capital position of many banking organizations, which also weakened their ability to make or renew loans. The Federal Reserve, working in conjunction with the Treasury Department, has taken a number of important steps to help restore the flow of credit to households and businesses. For example, the Term Asset-Backed Securities Leading Facility (TALF), which began operations in March 2009, is designed to restart the securitization markets for several types of consumer and commercial credit. In addition, the recently completed Supervisory Capital Assessment Program was designed to ensure that the largest banking organizations have the capital necessary to fulfill their critical credit intermediation functions even in seriously adverse economic conditions. Besides these actions, we continue to actively work with banking organizations to encourage them to continue lending prudently to creditworthy borrowers and work constructively with troubled customers in a manner consistent with safety and soundness. I note that, in some instances, it may be appropriate from a safety and soundness perspective for a banking organization to review the creditworthiness of an existing borrower, even if the borrower is current on an existing loan from the institution. For example, the collateral supporting repayment of the loan may have declined in value. However, we are very cognizant of the need to ensure that banking organizations do not make credit decisions that are not supported by a fair and sound analysis of creditworthiness, particularly in the current economic environment. Striking the right balance between credit availability and safety and soundness is difficult, but vitally important. The Federal Reserve has long-standing policies and procedures in place to promote sound risk identification and management practices at regulated institutions that also support bank lending, the credit intermediation process, and working with borrowers. For example, guidance issued as long ago as 1991, during the commercial real estate crisis that began in the late 1980s, specifically instructs examiners to ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers. \1\ The 1991 guidance also states that examiners are to ``ensure that supervisory personnel are reviewing loans in a consistent, prudent, and balanced fashion and to ensure that all interested parties are aware of the guidance.''--------------------------------------------------------------------------- \1\ ``Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans,'' (November 1991).--------------------------------------------------------------------------- This emphasis on achieving an appropriate balance between credit availability and safety and soundness continues today. To the extent that institutions have experienced losses, hold less capital, and are operating in a more risk-sensitive environment, supervisors expect banks to employ appropriate risk-management practices to ensure their viability. At the same time, it is important that supervisors remain balanced and not place unreasonable or artificial constraints on lenders that could hamper credit availability. As part of our effort to help stimulate appropriate bank lending, the Federal Reserve and the other federal banking agencies issued a statement in November 2008 to encourage banks to meet the needs of creditworthy borrowers. \2\ The statement was issued to encourage bank lending in a manner consistent with safety and soundness--specifically, by taking a balanced approach in assessing borrowers' ability to repay and making realistic assessments of collateral valuations. This guidance has been reviewed and discussed with examination staff within the Federal Reserve System.--------------------------------------------------------------------------- \2\ ``Interagency Statement on Meeting the Needs of Credit Worthy Borrowers,'' (November 2008).--------------------------------------------------------------------------- Earlier, in April 2007, the federal financial institutions regulatory agencies issued a statement encouraging financial institutions to work constructively with residential borrowers who are financially unable to make their contractual payment obligations on their home loans. \3\ The statement noted that ``prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term interest of both the financial institution and the borrower.'' The statement also noted that ``the agencies will not penalize financial institutions that pursue reasonable workout arrangements with borrowers who have encountered financial problems.'' It further stated that, ``existing supervisory guidance and applicable accounting standards do not require institutions to immediately foreclose on the collateral underlying a loan when the borrower exhibits repayment difficulties.'' This guidance has also been reviewed by examiners within the Federal Reserve System.--------------------------------------------------------------------------- \3\ ``Federal Regulators Encourage Institutions To Work With Mortgage Borrowers Who Are Unable To Make TheirPayments,'' (April 2007).--------------------------------------------------------------------------- More generally, we have directed our examiners to be mindful of the pro-cyclical effects of excessive credit tightening and to encourage banks to make economically viable loans, provided such lending is based on realistic asset valuations and a balanced assessment of borrowers' repayment capacities. Banks are also expected to work constructively with troubled borrowers and not unnecessarily call loans or foreclose on collateral. Across the Federal Reserve System, we have implemented training and outreach to underscore these objectives. ------ CHRG-110hhrg46591--44 Mr. Seligman," Mr. Chairman, we have reached a moment of discontinuity in our Federal and State systems of financial regulation that will require a comprehensive reorganization. Not since the 1929-1933 period, has there been a period of such crisis and such need for a fundamentally new approach to financial regulation. Now, this need is only based, in part, on the economic emergency. Quite aside from the current emergency, finance has fundamentally changed in recent decades while financial regulation has moved far more slowly. First, in the New Deal period, most finance was atomized into separate investment banking, commercial banking, or insurance firms. Today, finance is dominated by financial holding companies which operate in each of these and cognate areas such as commodities. Second, in the New Deal period, the challenge of regulation was essentially domestic. Increasingly, our fundamental challenge in financial regulation is international. Third, in 1930, approximately 1.5 percent of the American people directly owned stock on the New York Stock Exchange. Today, a substantial majority of Americans own stock directly or indirectly through pension plans or mutual funds. A dramatic deterioration in stock prices affects the retirement plans and sometimes the livelihoods of millions of Americans. Fourth, in the New Deal period, the choice of financial investments was largely limited to stock, debt, and to bank accounts. Today, we live in an age of increasingly complex derivative instruments, some of which, as recent experience has painfully shown, are not well-understood by investors and, on some occasions, by issuers or counterparties. Fifth, and most significantly, we have learned that our system of finance is more fragile than we earlier had believed. The web of interdependency that is the hallmark of sophisticated trading today means when a major firm such as Lehman Brothers is bankrupt, cascading impacts can have powerful effects on an entire economy. Against this backdrop, what lessons does history suggest for the committee to consider as it begins to address the potential restructuring of our system of financial regulation? First, make a fundamental distinction between emergency rescue legislation, which must be adopted under intense time pressure, and the restructuring of our financial regulatory order, which will be best done after systematic hearings and which will operate best when far more evidence is available. The creation of the Securities and Exchange Commission, for example, and the adoption of six Federal securities laws between 1933 and 1940 was preceded by the Stock Exchange Practices hearings of the Senate Banking Committee and counterpart hearings in the House between 1932 and 1934. Second, I would strongly urge each House of Congress to create a select committee similar to that employed after September 11th to provide a focused and less contentious review of what should be done. The most difficult issues in discussing appropriate reform of our regulatory system become far more difficult when multiple congressional committees with conflicting jurisdictions address overlapping concerns. Third, the scope of any systematic review of financial regulation should be comprehensive. This not only means that obvious areas of omission today such as credit default swaps and hedge funds need to be part of the analysis, but it also means, for example, our historic system of State insurance regulation should be reexamined. In a world in which financial holding companies can move resources internally with breathtaking speed a partial system of Federal oversight runs an unacceptable risk of failure. Fourth, a particularly difficult issue to address will be the appropriate balance between the need for a single agency to address systemic risk and the advantages of expert specialized agencies. There is today an obvious and cogent case for the Federal Reserve System and the Department of the Treasury to serve as a crisis manager to address issues of systemic risk, including those related to firm capital and liquidity. But to create a single clear crisis manager only begins analysis of what appropriate structure for Federal regulation should be. Subsequently, there must be considerable thought as to how best to harmonize the risk management powers with the role of specialized financial regulatory agencies that continue to exist. Existing financial regulatory agencies, for example, often have dramatically different purposes and scopes. Bank regulation, for example, has long been focused on safety insolvency, securities regulation on investor protection. Similarly, these differences and purposes in scope in turn are based on different patterns of investors, retail versus institutional for example, different degrees of internationalization and different risk of intermediation in specific financial industries. The political structure of our existing agencies is also strikingly different. The Department of the Treasury, of course, is part of the Executive Branch. The Federal Reserve System and the SEC, in contrast, are independent regulatory agencies. But, the SEC's independence itself as a practical reality is quite different from the Federal Reserve System with a form of self-funding than for the SEC and most independent regulatory agencies whose budgets are presented as part of the Administration's budget. Underlying any potential financial regulatory reorganization are pivotal questions I urge this committee to consider, such as what should be the fundamental purpose of new legislation, should Congress seek a system that effectively addresses systemic risk, safety insolvency, investor consumer protection, or other overarching objectives. How should Congress address such topics as coordination of inspection examination, conduct or trading rules enforcement of private rules of action? Should new financial regulators be part of the Executive Branch or independent regulatory agencies? Should the emphasis in the new financial regulatory order be on command and control to best avoid economic emergency or on politicization to ensure that all relevant views are considered by financial regulators before decisions are made? How do we analyze the potentialities of new regulatory norms in the increasingly global economy? What role should self-regulatory organizations such as FINRA have in a new system of financial regulations? These and similar questions should inform the most consequential debate over financial regulation that we have experienced since the new deal period. [The prepared statement of Mr. Seligman can be found on page 140 of the appendix.] " CHRG-110hhrg46596--371 Mr. Scott," Let me give you an example. Right now, today, a bank, the major bank in Atlanta, Georgia, where the airport is, SunTrust Bank, is coming and asking you for an additional $1.4 billion. Cannot you use that direction to put that marriage together, and cannot we use that as a pattern, that, as we go about getting moneys into these banks, that we systematically have an identification plan of which we can assist these banks, say, ``Okay, you want this money?''--these are taxpayers' dollars. They are not the bank's dollars. These are the taxpayers' dollars. We are the stewards of the taxpayers' dollars. The taxpayers want this money to get out into the system so they can stay in their homes, they can keep their car dealerships, they can keep their jobs, and we can build the expansion for the Maynard Jackson terminal airport. Or, for example, another example, at the same time in my district, in Clayton County, for example, we are on the verge of losing a hospital, because the hospital is $40 billion in debt to their creditors. Well, it seems to me that we ought to be able to--if the bank is down there--that is what I am saying. They are hoarding this. The communities around them are suffering. It is not just the homeowners who are not getting money; the businesses are not either. Can we do this? " CHRG-111hhrg51591--99 Mr. Webel," Well, basically, I mean, it is convenient because the balance of trade accounting has two specific columns in it: One is for essentially insurance services; and one is for non-insurance financial services, i.e., primarily banking and securities. So I believe they release the data quarterly, or it may be annually. You know, when they release the new data, it is very easy to go to the Web site and say, okay, this is the amount that the trade deficit was in these services for the past year or the past quarter. And so you can look at it very clearly that it is fairly striking that in non-insurance financial services, we have consistently run a fairly substantial surplus. In insurance financial services, we have consistently run a fairly substantial deficit. And there isn't necessarily anything wrong with that in the sense that--you know, in the automobile industry, if you looked at imports and exports of SUVs versus small sports cars, the Germans and Italians probably import small sports cars--or we import them from Germany. We would export SUVs. So it is not unheard of to have the same industry with differentiation among product types, but it is still--I mean, it is still interesting to note that our banking system, our security system, seems to be very competitive on the world stage, and the insurance system isn't. " CHRG-110shrg50369--50 Mr. Bernanke," Senator, the Basel Accord is implemented by regulation, and we have determined a joint action by the four bank regulators. We are working together through regulation to try to make improvements. We will certainly take a lot of advice from the Basel Committee and the changes and suggestions that they make. We have a very conservative process in place for introducing the Basel II system, which includes several years of transition floors that will not allow capital to decline very much, and a lookback study that will review the experience both here in the United States and elsewhere to try to understand and make sure that we are confident that the system is going to develop appropriately and provide enough capital for banks. So we will be taking the lessons of the recent experience very much to heart and incorporating them in the system. Basel II has the virtue of being flexible enough that it can adjust when you make changes like this. So I do not think at this point that legislation is necessary. " Chairman Dodd," OK. Well, I am pleased to hear that, and as I said, it is an excellent question that Senator Reed has asked. Senator Bennett. Senator Bennett. Thank you very much, Mr. Chairman, and welcome, Chairman Bernanke. I trust you saw the piece in this morning's Wall Street Journal, the op-ed piece by Allan Meltzer. " CHRG-111shrg55278--118 RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM SHEILA C. BAIRQ.1. I appreciate the FDIC's desire to provide clarity around the process of private investors investing in failed banks that have been taken over by the FDIC. We need to make sure that the final rule doesn't deter private capital from entering the banking system, leaving the FDIC's insurance fund and, ultimately, the taxpayers with the final bill. Are you open to modifying some of the proposed requirements, such as the 15 percent capital requirement?A.1. The Federal Deposit Insurance Corporation is aware of the need for additional capital in the banking system and the potential contribution that private equity capital could make to meet this need. At the same time, the FDIC is sensitive to the need for all investments in insured depository institutions, regardless of the source, to be consistent with protecting the Deposit Insurance Fund and the safety and soundness of insured institutions. In light of the increased number of bank and thrift failures and the consequent increase in interest by potential private capital investors, the FDIC published for comment on July 9, 2009, a Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions (Proposed Policy Statement). The Proposed Policy Statement provided guidance to private capital investors interested in acquiring the deposit liabilities, or the liabilities and assets, of failed insured depository institutions. It included specific questions on the important issues surrounding nontraditional investors in insured financial institutions including the level of capital required for the institution that would be owned by these new entrants into the banking system and whether these owners can be a source of strength. We sought public and industry comment to assist us in evaluating the policies to apply in deciding whether a nontraditional investor may bid on a failed institution. On August 26, 2009, the FDIC's Board of Directors voted to adopt the Final Statement of Policy on Qualifications for Failed Bank Acquisitions (Final Policy Statement), which was published in the Federal Register on September 2, 2009. The Final Policy Statement takes into account the comments presented by the many interested parties who submitted comments. Although the final minimum capital commitment has been adjusted from 15 percent Tier 1 leverage to 10 percent Tier 1 common equity, key elements of the earlier proposed statement remain in place: cross-support, prohibitions on insider lending, limitations on sales of acquired shares in the first 3 years, a prohibition on bidding by excessively opaque and complex business structures, and minimum disclosure requirements. Importantly, the Final Policy Statement specifies that it does not apply to investors who do not hold more than 5 percent of the total voting powers and who are not engaged in concerted actions with other investors. It also includes relief for investors if the insured institution maintains a Uniform Financial Institution composite rating of 1 or 2 for 7 consecutive years. The FDIC Board is given the authority to make exceptions to its application in special circumstances. The Final Policy Statement also clearly excludes partnerships between private capital investors and bank or thrift holding companies that have a strong majority interest in the acquired banks or thrifts. In adopting the Final Policy Statement, the FDIC sought to strike a balance between the interests of private investors and the need to provide adequate safeguards for the insured depository institutions involved. We believe the Final Policy Statement will encourage safe and sound investments and make the bidding more competitive and robust. In turn, this will limit the FDIC's losses, protect taxpayers, and speed the resolution process. As a result, the Final Policy Statement will aid the FDIC in carrying out its mission. ------ CHRG-111shrg52619--133 Mr. Tarullo," Absolutely. Absolutely correct. And so on the systemic risk regulator issue, there is a strong sense that if there is to be a systemic risk regulator, the Federal Reserve needs to be involved because of our function as lender of last resort, because of the mission of protecting financial stability. How that function is structured seems to me something that is open-ended because the powers in question need to be decided by the Congress. Let me give you one example of that. It is very important that there be consolidated supervision of every systemically important institution. So with bank holding companies, that is not a problem, because we have already got that authority. But there are other institutions out there currently unregulated over which no existing agency has prudential, safety and soundness, supervisory authority. Senator Bunning. You realize that your two Chairmen came to us and told us that certain entities---- " CHRG-111shrg51395--83 Mr. Silvers," I do not, in general, share Lynn's complete enthusiasm for mark-to-market accounting. I think that there are a wide range of areas in financial accounting where historical cost accounting is actually more indicative of the life of the business than mark-to-market. However, the financial institutions, particularly those with demand deposits where in theory the funds can walk out the door, are ones that seem uniquely kind of attuned to mark-to-market principles. In the course of the work of the Congressional Oversight Panel, we have done two oversight--two hearings, two field hearings in relation to our mortgage crisis, which I believe and I think most economists believe is at the heart of what has gone wrong here in our economy, that underlies the financial crisis, and it is clear from those field hearings, in P.G. County not ten miles from here and in Nevada, that even at this late date, we do not seem to be able to get rational outcomes out of private ordering in terms of non-performing mortgages. We can't get the mortgage providers and the servicers to negotiate rational outcomes with homeowners. Now, I believe that this is related to the remnants of non-mark-to-market accounting in banking, that effectively loans that are never going to be worth--the banks are carrying loans that are never going to be worth full value, even though they are capped at high values maybe not at par, but at close to par. And the one thing that would force them to mark them down would be a rational settlement with the homeowner, because then you would have to admit what you actually had. Now, you asked about collateral. You walk through the subdivisions and not all of them are new. In P.G. County, you have got a lot of people who have been effectively exploited and stripped of their homes. That is Prince George's County, for those who are not Washingtonians, here in Maryland. You look at those properties. There may be collateral, but it will never support par value, never. It may return--it may recover value. It may, 10 years from now, if the last very serious real estate collapse is indicative, and I am afraid this is clearly worse, in many areas, it took 10 years to recover from the bust of the late 1980s and early 1990s. But returning to par in 10 years means you are never really worth par present value basis, you are not going to be there. And so I am in favor of sort of--I am kind of in the middle of the road on these issues, but I think we need to recognize that there could be very, very serious broad economic consequences of indulging the fantasy that subprime loans backed up by collapsed residential property are ever going to be worth par. They are just not. And the consequences of that pretense is actually throwing people out of their homes. Senator Bennet. Mr. Chairman, could I ask one more quick question---- " FinancialCrisisReport--196 The joint report of the Treasury and the FDIC Inspectors General specifically identified WaMu’s poor quality loans and poor risk management practices as the real cause of its failure, rather than the liquidity crisis that hit the bank in 2008. 747 During the Subcommittee’s hearing, when asked why WaMu failed, a senior FDIC official put it this way: “Asset quality. Weak asset quality. It brought on the liquidity problems.” 748 He explained: “If you have strong asset quality, you will not have liquidity issues because your assets – you can borrow either against them or you can sell them. If you have weak asset quality, then you are going to have liquidity issues at some point.” 749 (4) OTS Turf War Against the FDIC As WaMu approached the end, tensions between OTS and the FDIC that had built up over two years evolved into a turf war. OTS examination and regional officials began to express distrust of their FDIC counterparts. The conflict was elevated to the top leaders of both agencies, who came to take different views of what to do with WaMu – the FDIC becoming more aggressive and OTS becoming more protective. When the bank’s imminent collapse was no longer a question, the result was a hasty seizure and sale. Had the two government agencies acted in concert, rather than as adversaries, it is likely that WaMu’s problems would have been resolved earlier and with less collateral damage. During an interview, the chairman of the FDIC, Sheila Bair, stated pointedly that WaMu “could have sold themselves in July if they had tried.” 750 The same outcome was not accomplished until two months later in September when no other options remained, and OTS worked with the FDIC to make it happen. As mentioned earlier, OTS was the primary, but not the only, federal bank regulator that oversaw Washington Mutual. Since WaMu was also an insured institution, the FDIC served as a backup examiner responsible for evaluating the risk that the bank posed to the Deposit Insurance Fund. Because WaMu was one of the eight largest insured institutions in the country, the FDIC had assigned a Dedicated Examiner whose full time responsibility was to determine whether the bank was operating in a safe and sound manner. The FDIC Examiner reviewed all OTS ROEs and examination findings, participated on many occasions in OTS examinations, and reviewed bank documents. The FDIC reviewed the CAMELS ratings for the bank, as well as LIDI ratings under its Large Insured Depository Institutions Program. For many years, FDIC examiners worked cooperatively with OTS examiners to conduct oversight of WaMu. But beginning in 2006, OTS management expressed increasing reluctance to allow FDIC examiners to participate in WaMu examinations and review bank documents. Claiming that joint efforts created confusion about which agency was WaMu’s primary 747 IG Report at 8. 748 April 16, 2010 Subcommittee Hearing at 76. John Corston was the Acting Deputy Director of the FDIC’s Division of Supervision and Consumer Protection, Complex Financial Institution Branch. 749 Id. 750 Subcommittee interview of Sheila Bair (4/5/2010). regulator, 751 OTS officials employed a variety of tactics to limit the FDIC oversight of the bank, including restricting its physical access to office space at the bank, its participation in bank examinations, and its access to loan files. In addition, as the FDIC began to express greater concern about the bank’s viability, recommend ratings downgrades, and urge enforcement action, OTS officials displayed increasing resistance to its advice. In the end, OTS not only undermined years of cooperative oversight efforts, but at times actively impeded FDIC oversight of one of the largest insured banks in the country. CHRG-111shrg52619--44 Mr. Tarullo," Thank you, Mr. Chairman. I agree with my colleagues that we should not undermine the dual banking system in the United States, and so you are going to have at least two kinds of charters. It does seem to me, though, that the question is not so much one of can an institution choose, but what constraints are placed upon that choice. So, for example, under current law, with the improvements that were made to the Federal Deposit Insurance Act following the savings and loan crisis, there are now requirements on every federally insured institution that apply whether you are a State or a Federal bank. I think that Chairman Bair was alluding to some areas in which she might like to see more constraints within the capacity to choose, so that a bank cannot escape certain kinds of rules and regulations by moving from one charter to another. " CHRG-111shrg55117--101 Mr. Bernanke," Well, the Federal Reserve has been interested in this area as well. We have a program that allows for the low-cost sending of remittances. I think the Federal Reserve Bank of Atlanta, working with the Mexican central bank, has developed some low-cost methods. I think this is an area where many mainstream institutions--banks and credit unions and the like--can provide cheaper, quicker services to minority communities. And this is an entree, this is a way to get a higher rate of participation by minorities in the mainstream banking system. Since I have talked about this for a number of years, we have seen credit unions in particular, but also banks and others, offer new remittance services which gives them an opportunity to attract minority customers into their other services as well. So I think that is a positive development. Senator Akaka. Well, thank you. Again, I want to express my appreciation to your talented and dedicated staff as well as your work in this area. " CHRG-111hhrg74090--138 Mr. Radanovich," I suggest that you need to convince the banks because they are the ones that are expressing the real concern. If I may, though, Mr. Barr, I do have a second question, and that is that President Obama has stated that a streamlined system will provide better oversight and will be less costly for regulated institutions but the preemption statutes in the bill create a floor rather than a ceiling for State regulation. Doesn't that mean we are looking at 51 different versions of this thing by giving the preemption statutes to the States and does that not conflict with President Obama's statement that we are looking at a streamlined system? " FOMC20080430meeting--215 213,MR. CLOUSE.," Thanks, Steve. As noted on page 25, the Interest on Reserves Workgroup developed a set of options for monetary policy implementation in the United States based on alternative settings for a small set of core structural elements. The first core element--so-called balance targets--is a central feature of many systems. In the United States, Japan, Switzerland, and the euro area, balance targets are established through mandatory reserve requirements. In the United Kingdom, balance targets are established through voluntary contractual arrangements. Other countries, such as Canada and Australia, operate with no formal balance targets. Target bands are a second structural element incorporated in many systems to afford banks some flexibility in meeting their targets. The carryover provisions for required reserves and the clearing band for required clearing balances play this role in the United States. The structure of the maintenance period is another core structural element. As Steve noted, the U.S. system operates with a mixture of one-week and two-week maintenance periods. The United Kingdom and the euro area operate with maintenance periods that correspond to the interval between monetary policy meetings. Central banks like the Bank of Canada and Reserve Bank of Australia that operate without balance targets implicitly operate with a one-day maintenance period. Finally, most systems involve some form of interest rate corridor with the upper bound of the corridor established by a standing lending facility and the lower bound set by the rate of remuneration on excess reserves or a redeposit facility. As noted on page 26, market developments may, at times, impair the efficacy of one or more of these core structural elements. For example, the standing lending facility should, in theory, establish a cap on interbank rates. However, the presence of stigma in using the standing lending facility can impair the effectiveness of the cap. That certainly seems to have been the case in the United States over recent months. We have observed depository institutions regularly bidding for funds in the market at rates above the primary credit rate. The table at the bottom reports some evidence on this score culled from data on Fedwire transactions. Over recent weeks, many of the largest banks in the country have executed numerous trades for sizable amounts at rates well above the primary credit rate. It may be possible to redesign the discount window to mitigate stigma to some extent, but it appears likely that stigma will continue to be an issue for the discount window, especially during periods of financial distress. As a result, systems that rely heavily on a standing lending facility to establish an upper bound on the federal funds rate implicitly disadvantage those institutions that are most wary about using the discount window. As you can see in the table, that set of institutions in the United States includes many that are critical providers of liquidity across a range of markets. It is noteworthy in this regard that Citibank in the past has been willing to provide liquidity in the funds market by borrowing primary credit and relending the proceeds in the funds market. However, in recent weeks, Citi has seemed reluctant to pursue this strategy and has, in fact, executed more than 100 trades from late March through last week in sizable amounts at rates above the primary credit rate. Indeed, the three largest banks in the country-- shown in the first three rows--all appear to be quite wary about using the discount window. As noted on page 27, it is helpful, broadly speaking, to think about the five options discussed in the paper as falling into two basic categories--systems that incorporate a multiple-day maintenance period and systems in which depositories manage their reserves to meet a daily reserve objective. The multiple-day systems-- options 1 and 2 in the paper--rely on arbitrage across days of a maintenance period as an important factor contributing to day-to-day funds rate stability. Single-day systems tend to rely more heavily on standing facilities and the structure of remuneration rate(s) on reserves to stabilize the funds rate. The next few slides focus on multiple-day systems. Option 1. As noted on page 28, option 1 considers a straightforward modification of our current system of monetary policy implementation. Required reserve balances would be remunerated at a rate close to the target funds rate. The primary credit facility, in theory anyway, would establish the upper bound of an interest rate corridor. The lower bound of the corridor would be established by paying interest on excess reserves at a rate appreciably below the target funds rate. The solid line in the picture displays what the demand for reserves might look like on the last day of the reserve maintenance period. The curve would be downward sloping and might entail some precautionary demand for excess reserves. The reserve demand curve on previous days in the maintenance period--the dotted line--would be much flatter at the target rate over a wide range, reflecting the ability of banks to substitute balances across days of the maintenance period in meeting reserve requirements. Eventually, though, at very low levels of balances, the increased risk of an overnight overdraft would push the intraperiod demand curve up to the primary credit rate. At high levels of balances, the intraperiod demand curve would eventually fall to the remuneration rate on excess reserves as banks recognized that they held excess balances that could not be worked off by the end of the maintenance period. The width of the ""flat portion"" of the intraperiod demand curve tends to narrow over the maintenance period as the scope for substitution diminishes across the remaining days of the period. In this structure, the Desk would operate much as it does today, supplying an aggregate quantity of reserve balances each day to address both daily demands and maintenance-period average needs. Option 2. As noted on page 29, option 2 in the paper is a multiple-day system based on voluntary balance targets rather than mandatory reserve requirements. This system would share many of the key structural elements of the system for monetary policy implementation employed in the United Kingdom. Depository institutions would establish a voluntary balance target that they would agree to meet, on average, over a maintenance period. The maintenance period could be set equal to the interval between FOMC meetings. The system could include a target balance ""band"" to afford banks some flexibility in meeting their voluntary target balance. As shown on the right, the demand for reserves on the last day of the period would again be downward sloping, and the Desk would supply an aggregate quantity of reserves equal to the quantity demanded at the target funds rate. Reserve management and the funds market under this option probably would be similar to that for option 1. The longer maintenance period might allow depository institutions more scope for substitution of balances across days of the maintenance period. That could imply less need for daily fine-tuning of balances and greater funds rate stability. A key issue, however, is whether the aggregate quantity of voluntary balance targets would be large enough to provide adequate leeway for effective arbitrage across days of the maintenance period. Many banks might choose not to establish a voluntary balance target in this system, and those that do may not choose to establish a large balance target. In this case, the funds rate could be fairly volatile within the interest rate corridor. Option 3. As noted on page 30, option 3 in the paper--the simple corridor--is similar to the systems employed by the Bank of Canada and the Reserve Bank of Australia. Banks would not need to establish a balance target of any sort and would simply manage their accounts each day to balance the opportunity cost of holding reserves against the risk of overnight overdrafts. The system would involve a fairly narrow symmetric funds rate corridor. As noted in the figure, the Desk would supply reserves each day equal to the quantity demanded along the downward sloping portion of the demand curve. Because the demand curve is likely to be fairly steep, shocks to reserve supply are likely to result in significant volatility in the funds rate within the corridor. As noted earlier, the heavy reliance on the primary credit facility to establish an upper bound on the funds rate may be suspect, especially during periods of financial distress. Option 4. As noted on page 31, option 4 in the paper is a system similar in many respects to that employed by the Reserve Bank of New Zealand. Key structural features of this system include an asymmetric interest rate corridor and a relatively high level of balances to ensure that the funds rate trades near the floor of the interest rate corridor. As in option 3, depositories would not need to establish a balance target of any sort. The reserve demand curve for this system might look like that shown to the right. At low levels of balances, the demand curve would be downward sloping reflecting precautionary demands for balances to avoid overnight overdrafts. But at sufficiently high levels of balances, the risk of overnight overdrafts should become very low, and the demand curve would asymptote near the floor of the funds rate corridor. It is difficult to estimate the level of balances that would be necessary to reach this point, but an aggregate level of balances on the order of $50 billion would probably be sufficient in most cases. In principle, fluctuations in various factors affecting reserves would not have much effect on the funds rate, and the generally high level of balances could reduce daylight overdrafts. Partly because of the experience in New Zealand, there are questions about incentives for strategic behavior in this structure. Option 5. As noted on page 32, option 5 is a hybrid single-day system that would involve a voluntary daily balance target and a relatively wide target band. Depositories would receive full remuneration on balances maintained up to the upper bound of the target band and would be penalized for any shortfall in balances below the lower bound of the target band. With these structural elements, the reserve demand curve should be fairly flat at the target rate over a wide range, but the curve would be downward sloping near the upper and lower bounds of the target balance band. The Desk would presumably operate by targeting a quantity of balances each day near the middle of the target band. As with option 2, a significant issue with option 5 would be whether depositories would choose a high enough level of voluntary balance targets to allow the target band to play the desired role in stabilizing the federal funds rate. As noted on page 33, the paper also identifies a number of general issues that cut across all the options. First, depository institutions will still be subject to statutory limitations on their ability to pay interest on demand deposits. As a result, the Federal Reserve's initiative to pay interest on reserves may be seen by correspondent banks as unfair competition. There are also technical issues associated with the setting of the remuneration rates on reserve balances that appropriately account for the essentially risk-free nature of balances held with the central bank. The Federal Reserve would need to work through governance issues associated with all the options. In particular, the Board is responsible for setting all remuneration rates on balances, and this would need to be closely coordinated with the FOMC's determination of the target federal funds rate. Finally, many if not all the options discussed would likely require some transition period that would need to be carefully managed. Spence will now discuss some of the pros and cons of each option in more detail and how they stack up relative to key objectives. " CHRG-111shrg52619--57 Mr. Smith," I would say that as a State charterer who has good experience with both of our Federal colleagues, we need to say that the current State system involves what we have called constructive or cooperative federalism now, and State-chartered banks are not exempt or are not free from federally enforced standards. " CHRG-111shrg56415--34 Mr. Tarullo," I do. Senator Tester. And there are folks in many of these companies that are up here right now lobbying to make sure t there is no or very, very little regulation on a lot of the incidences that created the economic collapse. Do you find that some--because they are making a ton of dough. Do you find that somewhat ironic, troublesome? " CHRG-111shrg52619--130 Mr. Tarullo," Senator, with respect to payment systems, I think there is a fair consensus at the Fed that some formal legal authority to regulate payment systems is important to have. As you probably know, de facto right now the Fed is able to exercise supervisory authority over payment systems. That is because of the peculiarity of the fact that the entities concerned are member banks of the Federal Reserve System. They have got supervisory authority. If their corporate form were to change, there would be some question about it, and payments, as you know, are historically and importantly related to the operation of the financial system. Now, with respect to the systemic risk regulator, I think there is much less final agreement on either one of the questions that I think are implicit in what you asked. One, what should a systemic risk regulator do precisely? And, two, who should do it? The one thing I would say--and I think this bears repeating, so I will look for occasions to say it again--is however the Congress comes down on this issue, I think that we need all to be clear, you need to be clear in the legislation, whoever you delegate tasks to needs to be clear, not just what exactly the authorities are, which is important, but also the expectations are, because we need to be clear as to what we think can be accomplished. You do not want to give responsibility without authority---- Senator Bunning. Well, sometimes we give the responsibility and the authority---- " fcic_final_report_full--351 Following that call, McDade advised the board that Lehman would be unable to obtain funding without government assistance. The board voted to file for bank- ruptcy. The company filed at : A . M . on Monday morning.  “A CALAMITY ” Fed Chairman Bernanke told the FCIC that government officials understood a Lehman bankruptcy would be catastrophic: We never had any doubt about that. It was going to have huge impacts on funding markets. It would create a huge loss of confidence in other financial firms. It would create pressure on Merrill and Morgan Stanley, if not Goldman, which it eventually did. It would probably bring the short-term money markets into crisis, which we didn’t fully anticipate; but, of course, in the end it did bring the commercial paper market and the money market mutual funds under pressure. So there was never any doubt in our minds that it would be a calamity, catastrophe, and that, you know, we should do everything we could to save it.  “What’s the connection between Lehman Brothers and General Motors? ” he asked rhetorically. “Lehman Brothers’ failure meant that commercial paper that they used to finance went bad.” Bernanke noted that money market funds, in particular one named the Reserve Primary Fund, held Lehman’s paper and suffered losses. He explained that this “meant there was a run in the money market mutual funds, which meant the commercial paper market spiked, which [created] problems for General Motors.”  “As the financial industry came under stress,” Paulson told the FCIC, “investors pulled back from the market, and when Lehman collapsed, even major industrial cor- porations found it difficult to sell their paper. The resulting liquidity crunch showed that firms had overly relied on this short term funding and had failed to anticipate how restricted the commercial paper market could become in times of stress.”  Harvey Miller testified to the FCIC that “the bankruptcy of Lehman was a catalyst for systemic consequences throughout the world. It fostered a negative reaction that endangered the viability of the financial system. As a result of failed expectations of the financial markets and others, a major loss of confidence in the financial system occurred.”  On the day that Lehman filed for bankruptcy, the Dow plummeted more than  points;  billion in value from retirement plans, government pension funds, and other investment portfolios disappeared.  As for Lehman itself, the bankruptcy affected about , subsidiaries and affiliates with  billion in assets and liabilities, the firm’s more than , creditors, and about , employees. Its failure triggered default clauses in derivatives contracts, allowing its counterparties to have the option of seizing its collateral and terminating the contracts. After the parent company filed, about  insolvency proceedings of its subsidiaries in  foreign countries followed. In the main bankruptcy proceeding, about , claims—exceeding  billion—have been filed against Lehman as of September . Miller told the FCIC that Lehman’s bankruptcy “represents the largest, most complex, multi-faceted and far-reaching bankruptcy case ever filed in the United States.” The costs of the bankruptcy administration are approaching  bil- lion; as of this writing, the proceeding is expected to last at least another two years.  In his testimony before the FCIC, Bernanke admitted that the considerations be- hind the government’s decision to allow Lehman to fail were both legal and practical. From a legal standpoint, Bernanke explained, “We are not allowed to lend without a reasonable expectation of repayment. The loan has to be secured to the satisfaction of the Reserve Bank. Remember, this was before TARP. We had no ability to inject capi- tal or to make guarantees.”  A Sunday afternoon email from Bernanke to Fed Gov- ernor Warsh indicated that more than  billion in capital assistance would have been needed to prevent Lehman’s failure. “In case I am asked: How much capital in- jection would have been needed to keep LEH alive as a going concern? I gather B or so from the private guys together with Fed liquidity support was not enough.”  In March, the Fed had provided a loan to facilitate JP Morgan’s purchase of Bear Stearns, invoking its authority under section () of the Federal Reserve Act. But, even with this authority, practical considerations were in play. Bernanke explained that Lehman had insufficient collateral and the Fed, had it acted, would have lent into a run: “On Sunday night of that weekend, what was told to me was that—and I have every reason to believe—was that there was a run proceeding on Lehman, that is people were essentially demanding liquidity from Lehman; that Lehman did not have enough collateral to allow the Fed to lend it enough to meet that run.” Thus, “If we lent the money to Lehman, all that would happen would be that the run [on Lehman] would succeed, because it wouldn’t be able to meet the demands, the firm would fail, and not only would we be unsuccessful but we would [have] saddled the [t]axpayer with tens of billions of dollars of losses.”  The Fed had no choice but to stand by as Lehman went under, Bernanke insisted. CHRG-110shrg38109--171 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM BEN S. BERNANKEQ.1. I have been concerned for some time about the implementation of the Basel II Capital Accord and the impact Basel II may have on the safety and soundness of the U.S. banking system. In particular, I am worried that Basel II may lead to a sharp reduction in the amount of capital banks are required to hold, which would put U.S. taxpayers at risk of having to pay for expensive bank failures. Accordingly, I believe that it is critical that Basel II be implemented with the utmost care and diligence. Would you please update the Committee on the status of the Basel II Capital Accords and the current timeframe for implementing Basel II? I would like you to comment on whether there is enough time for banking regulators to finalize the rules implementing Basel II, so that banks adopting Basel II can start the test run for Basel II presently scheduled to begin next year. What, if any, is the likelihood that the timeframe currently envisioned may need to be adjusted?A.1. First, let me reiterate that the primary goal of the agencies in implementing Basel II in the United States is to enhance the safety and soundness of the U.S. banking system. Accordingly, we will not permit capital levels to decline under the Basel II framework so as to potentially jeopardize safety and soundness. We remain committed to ensuring that regulatory capital levels at all U.S. banking organizations remain robust. It is important to keep in mind that under Pillar II, banking supervisors will be reviewing total capital plans relative to risk at each Basel II bank, not just the minimum capital requirements calculated under Pillar I. We also continue to believe, subject to the receipt of comments on the outstanding Basel II notice of proposed rulemaking (NPR), that it is critical to move forward with Basel II implementation so that our largest and internationally active banking organizations have the most risk reflective regulatory capital framework and can remain competitive with other banking organizations that apply similar risk sensitive frameworks. The Basel II NPR issued in September 2006 remains open for comment through March 26, 2007. As outlined in the NPR, the first opportunity for a bank to be able to begin a parallel run (that is, apply the Basel II framework and report results to the appropriate supervisor, but continue to use Basel I ratios for regulatory purposes) would be January 2008. The first opportunity for a bank to begin applying the Basel II framework subject to the proposed transition floors would be January 2009. We remain committed to this schedule; however, it will be challenging to meet the previously announced June 2007 date for a final rule. We are very interested in public comments submitted on the proposal. We will need to take sufficient time to fully consider comments and to make corresponding modifications to the proposed framework as the agencies deem to be appropriate. Because the comment period is still open, it is difficult to estimate how comprehensive the comments will be. While we already are aware of a number of issues raised by the industry, in complex rulemakings such as this one there are always unanticipated issues as well. The extent and complexity of the comments overall will have an impact on the ultimate timing for issuing a final rule. We continue to believe that it is important to meet the previously stated first live start date of January 2009 and at this time do not anticipate that that start date will need to be adjusted.Q.2. Your testimony noted that the U.S. current account deficit remains large, averaging about 6\1/2\ percent of nominal GDP. You also note that economic growth abroad should support further steady growth in U.S. exports this year. Do you anticipate much improvement in the current account deficit over the next year as a result of export improvement? Do you see any other economic factors changing over the next year that might lead to an improved trade deficit?A.2. In the past year, U.S. exports have grown strongly, reflecting a number of factors, including solid foreign economic growth, increases in investment spending abroad that have boosted sales of capital goods produced in the United States, and the booming market for agricultural goods and other commodities. These developments have played out against the backdrop of continued innovation and productivity growth in the U.S. economy that, along with the decline in the foreign exchange value of the dollar since earlier in this decade, have buoyed the attractiveness of American-made products. As a result of strong export growth, in combination with sharp declines in the price of imported oil, the trade deficit has narrowed from 6 percent of U.S. GDP in the third quarter of last year to about 5\1/4\ percent of GDP in the fourth, and the current account deficit has improved by a broadly similar extent. These movements, coming as they did toward the end of 2006, may well cause the trade and current account deficits for 2007 as a whole, measured as a share of GDP, to be smaller than those for 2006. Focusing on their evolution from the current quarter onwards, however, it is uncertain whether our Nation's external deficits will narrow further over the next few years. On the export side, the extraordinary growth in overseas sales of some U.S. products during 2006 may be difficult to sustain; for example, exports of aircraft grew more than 20 percent last year. On the import side, the price of imported oil has bounced back from recent lows, and futures markets suggest that further increases may be in the offing. Another important determinant of U.S. trade flows, the foreign exchange value of the dollar, is volatile and extremely difficult to predict. Finally, even if the trade balance were to continue to improve, it is not clear that the current account balance--which is equal to the trade balance plus the balance on international income flows and transfers--would follow suit. The need to finance continued trade deficits, even if these deficits are smaller than in the past, puts upward pressure on the Nation's external debt and thus investment income payments to foreigners, thereby tending to expand the current account deficit.Q.3. This Committee continues to have a great degree of interest in the Chinese economy, particularly currency practices. China's foreign exchange reserves now stand at over $1 trillion, creating excess liquidity in their banking system. Some financial experts have stated that the United States should not view China's large stock of foreign currency reserves as a problem. What is your view of this level of reserves? Do you believe China's ratio of reserves to money supply is reasonable? To what extent do you believe that China's reserves are the result of speculation? Could this, in fact, result in an even lower value for the RMB should that currency become more flexible in the future?A.3. For some time now, the monetary authorities in China have been resisting upward pressure on the value of the renminbi in foreign exchange markets by purchasing dollars and perhaps other foreign currencies. Even though these accumulated purchases have reached a value of more than $1 trillion, it is not certain that the accumulation has created excess liquidity in China's banking system. Reserves and liquidity do not move in lockstep in China, because Chinese authorities have policy tools available to drain liquidity, including issuance of official securities (so-called ``sterilization bonds'') and increasing banks' reserve requirements. At present, it does not appear that China has had any substantial difficulty using either of these tools to drain liquidity, although that may change in the future. Because the linkage between reserves and money need not be tight, it would be hard to determine a reasonable range for the ratio of reserves to the money stock appropriate for China's economy. I do not believe China's substantial accumulation of reserves in itself represents a problem for the United States or for United States monetary policy. Official demand in China and other countries for United States assets reflects the dollar's role as preeminent reserve currency, which results in great part from the strength of our economy and the safety and liquidity of the United States financial system. Because foreign holdings of U.S. Treasury securities represent only a small part of total U.S. credit market debt outstanding, U.S. credit markets should be able to absorb without great difficulty any shift in foreign allocations. And even if such a shift were to put undesired upward pressure on U.S. interest rates, the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our domestic economic goals. It is not easy to identify the portion of the upward pressure on the renminbi, and hence on the accumulation of reserves, that might be the result of speculation. It is also difficult to predict where the renminbi would settle were the currency to float freely. However, speculation in the renminbi would not occur if investors did not expect the Chinese currency to appreciate at some point. It seems reasonable to conclude that, at the present exchange rate with the dollar, the renminbi is undervalued. CHRG-111hhrg48867--158 Mr. Castle," Thank you, Mr. Chairman. I will throw up two questions, and then I will just duck and let you try to deal with them. And I think Mr. Bartlett touched on this a little bit in his opening statement, maybe not too definitively. But it is a little bit off systemic risk regulation, but bank regulation in general. We have many entities, both at the Federal level and you have State entities too, who regulate different financial institutions in this country, depending on what they do. And my question is, do you believe that there should be some consolidation in that area? Should there be more of a reaching out in terms of some of the leverage type of circumstances that exist today in hedge funds, etc., in terms of what we are regulating, or are we okay in terms of our basic regulation? So that is one question I have. The other question is more pertinent perhaps to the hearing today. And that is the Federal Reserve in general. I mean, whenever we talk about systemic risk regulation, which I basically believe in, we talk about the Federal Reserve. But I worry about the Federal Reserve in that they have responsibilities in terms of some regulation now and they have other responsibilities that relate to our economy in a great way. First of all, if you have wild objections to the Federal Reserve, I would like to hear that. And secondly, if you feel the Federal Reserve perhaps should give up certain powers if they were to take on a systemic risk regulation component, I would like to hear about that as well. So those are my two areas of concern. I open the floor to whomever is willing to step forward. " CHRG-111shrg56376--193 Mr. Ludwig," If I might, Senator, I would reserve the right to come back to the Committee with a list of suggestions, because I come from a small town myself, and I am a huge believer in community banks. I think it is one of the great benefits here in the United States, one of the great forces for good and innovation, and I think the consolidated supervisor at the end of the day will do more to support community banking than the current system. Senator Warner. And it may even get down to not simply capital requirements, but literally forms and volume of forms they have to---- " CHRG-111shrg52966--2 Mr. Cole," Chairman Reed, Ranking Member Bunning, it is my pleasure today to discuss the state of risk management in the banking industry and the steps taken by supervisors to address risk management shortcomings. The Federal Reserve continues to take vigorous and concerted steps to correct the risk management weaknesses at banking organizations revealed by the current financial crisis. In addition, we are taking actions internally to improve supervisory practices addressing issues identified by our own internal review. The U.S. financial system is experiencing unprecedented disruptions that have emerged with unusual speed. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn. In the period leading up to the crisis, the Federal Reserve and other U.S. banking supervisors took several important steps to improve the safety and soundness of banking organizations and the resilience of the financial system, such as improving banks' business continuity plans and the compliance with the Bank Secrecy Act and anti-money-laundering requirements after the September 11 terrorist attacks. In addition, the Federal Reserve, working with the other U.S. banking agencies, issued several pieces of supervisory guidance before the onset of the crisis such as for nontraditional mortgages, commercial real estate, and subprime lending, and this was to highlight the emerging risks and point bankers to prudential risk management practices they should follow. We are continuing and expanding the supervisory actions mentioned by Vice Chairman Kohn last June before this Subcommittee to improve risk management at banking organizations. While additional work is necessary, supervised institutions are making progress. Where we do not see sufficient progress, we demand corrective action from senior management and boards of directors. Bankers are being required to look not just at risks from the past, but also to have a good understanding of their risks going forward. For instance, we are monitoring the major firms' liquidity positions on a daily basis, discussing key market developments with senior management and requiring strong contingency funding plans. We are conducting similar activities for capital planning and capital adequacy, requiring banking organizations to maintain strong capital buffers over regulatory minimums. Supervised institutions are being required to improve their risk identification practices. Counterparty credit risk is also receiving considerable focus. In all of our areas of review, we are requiring banks to consider the impact of prolonged, stressful environments. The Federal Reserve continues to play a leading role in the work of the Senior Supervisors Group whose report on risk management practices at major U.S. and international firms has provided a tool for benchmarking current progress. Importantly, our evaluation of banks' progress in this regard is being incorporated into the supervisory exam process going forward to make sure that they are complying and are making the improvements we are expecting. In addition to the steps taken to improve banks' practices, we are taking concrete steps to enhance our own supervisory practices. The current crisis has helped us recognize areas in which we can improve. Vice Chairman Kohn is leading a systematic internal process to identify lessons learned and develop recommendations. As you know, we are also meeting with Members of Congress and other Government bodies, including the Government Accountability Office, to consult on lessons learned and to hear additional suggestions for improving supervisory practices. We have already augmented our internal process to disseminate information to examination staff about emerging risks within the industry. Additionally, with the recent Federal Reserve issuance of supervisory guidance on consolidated supervision, we are not only enhancing the examination of large, complex firms with multiple legal entities, but also improving our understanding of markets and counterparties, contributing to our broader financial stability efforts. Looking forward, we see opportunity to improve our communication of supervisory expectations to firms we regulate to ensure those expectations are understood and heeded. We realize now more than ever that when times are good and when bankers are particularly confident, we must have even firmer resolve to hold firms accountable for prudent risk management practices. Finally, despite our good relationship with fellow U.S. regulators, there are gaps and operational challenges in the regulation and supervision of the overall U.S. financial system that should be addressed in an effective manner. I would like to thank you and the Subcommittee for holding this second hearing on risk management, a crucially important issue in understanding the failures that have contributed to the current crisis. Our actions with the support of Congress will help strengthen institutions' risk management practices and the supervisory and regulatory process itself--which should, in turn, greatly strengthen the banking system and the broader economy as we recover from the current difficulties. I look forward to answering your questions. Senator Reed. Mr. Long. STATEMENT OF TIMOTHY W. LONG, SENIOR DEPUTY COMPTROLLER, BANK SUPERVISION POLICY AND CHIEF NATIONAL BANK EXAMINER, OFFICE OF CHRG-111shrg53176--3 Chairman Dodd," Yes, I know. Well, he was a good Governor and he is a good Senator. We welcome him to this Committee. Then I am going to ask my colleagues--we are going to have one round on the first panel. As much as there are many questions, obviously, we have for both of you, but if we end up with too many rounds, we will never get to the second and third panels, and colleagues have busy schedules as well, as do our witnesses. So we will cut it off after one round. Then we will go to the second panel, which I will leave a little more open, given the backgrounds of our witnesses, and the third panel. With that, let me share some opening comments and then turn to Senator Shelby, and then we will go right to our witnesses this morning. Today, the Committee meets, as I said, for our second hearing to examine the securities market regulation, the ninth hearing on this general matter of modernization of Federal regulations. This hearing is to discuss how investors and our entire financial system are protected, or lack of protection, in the future from the kind of activities that led to the current crisis. This hearing is one of a series, as I mentioned, of nine we have already convened to modernize the overall regulatory framework and to rebuild our financial system. And I saw this morning the headlines of our local newspaper here, the direction that the Secretary of the Treasury is heading. I welcome that. This is all within about 60 days of this administration coming to office. We will not have all the time this morning to go over that. This Committee will be meeting at the request of the Treasury tomorrow with Democrats and Republicans to listen to some of these thoughts. It is not a formal hearing. We will have one of those. But given the time constraints and the fact that the administration is heading overseas to the meeting coming up with the G-20, we thought it would be worthwhile to have at least a briefing as to where this thing is heading. So we welcome that and are excited over the fact that they are going to be proposing some thoughts in this area as well. We are also very excited to have two witnesses who are not only former Chairmen of the SEC but also, I might add, residents of my own State as well, having Arthur Levitt and Richard Breeden with us. From the outset, I have argued that our financial system is not really in need of reform but modernization, that truly protecting consumers and investors in the decades to come will require a vast overhaul of our financial architecture that recognizes the extraordinary transformation that has occurred over the last quarter of a century, and it is extraordinary. And nowhere has that transformation been clearer than in the area of securities, which have come to dominate our financial system, now representing 80 percent--80 percent--of all financial assets in the United States. With pension funds, the proliferation of 401(k)s and the like, today half of all households in the United States are invested in some way in the securities markets. As Federal Reserve Governor Dan Tarullo said at our last hearing on this subject matter, ``The source of systemic risk in our financial system has, to some considerable extent, migrated from traditional banking activities to markets over the last 20 or 25 years.'' In essence, as the assets of our financial system have shifted from banking deposits to securities, so too have the dangers posed to our economy as a whole. We need regulators with the expertise, tools, and resources to regulate this new type of financial system. At our last hearing on this subject, this Committee heard about the need to watch for trends that could threaten the safety of our financial system. Our witnesses had different views on what regulatory body should perform that function. Some felt it should be given to a special commission made up of the heads of existing agencies. Others have argued for a new agency or to give that authority to an existing regulator. As I have said, given the regulatory failures we saw in the lead-up to this crisis, I have concerns, and I think many of my colleagues have also expressed, about this authority residing exclusively within one body. And I re-express those views this morning. For instance, we have seen problems with the regulated bank holding companies where they have not been well regulated at the holding company level. And while there are many aspects to our financial system, systemic risk itself has many parts as well. One is the regulation of practices and products which pose systemic risk, from subprime mortgages to credit default swaps, and that is why I remain intrigued by the idea of a council approach to address this aspect of systemic risk. And I know our previous witnesses Paul Stevens with the Investment Company Institute and Damon Silvers with the AFL-CIO have both recommended this type of concept. Of course, systemic risk is only one issue which we are examining. At our last hearing on this subject matter, we heard how we could increase transparency by addressing the risks posed by derivatives. We heard ways to improve the performance of credit rating agencies, who failed the American people terribly, by requiring them to verify the information they used to make those ratings. And, more recently, Secretary of Treasury Geithner has proposed the creation of a resolution mechanism for systemically important nonbank financial institutions, and I will be very interested in hearing from you, Chairman Schapiro, on that subject matter, what your thoughts are and the role the SEC should play. In providing this authority to the FDIC, I am pleased that they have recognized the need to ensure that powerful new tools do not all reside, again, with any single agency. These are all ideas that deserve careful examination, which we will engage in here at this Committee. Today's diverse panel, including representatives from hedge funds, credit rating agencies, retail investors, industry self-regulatory organizations, paints a very vivid picture of the numerous issues facing the securities markets at this moment. The goals of modernization are clear, in my view: consistent regulation across our financial architecture with strong cops on the beat in every neighborhood; checks and balances to ensure our regulators and the institutions that oversee them are held accountable; and transparency so that consumers and investors are never in the dark about the risks they will be taking on. The time has come for a new era of responsibility in financial services. That begins with the rebuilding of our 21st century financial architecture from the bottom up, with the consumer clearly in our minds in the forefront. It begins with the work of this Committee, and, again, this is now almost the tenth hearing on the subject matter. Senator Shelby and I and our colleagues here are determined to play a constructive and positive role as we help shape this debate in the coming weeks. With that, let me turn to Senator Shelby. CHRG-111shrg53822--33 Mr. Stern," I think Chairman Bair covered it thoroughly. And I would prefer not--until the results are out, I would prefer not to go further. Senator Warner. I would like to go back, on my own remaining time, to the notion that the Chairman raised in terms of systemic risk and the idea of a council, which I think has some attractiveness but also some challenges. What guidance/advice would you have if we were to, at least, continue to pursue the possibilities of this option, of how we would make sure that information would actually be forced up and truly shared? Number one. Two, how would we ensure, and what structural advice could you give us to ensure that this council would not end up becoming simply a debating society? And number three, when this council or group reach some conclusion, how could we ensure that it could act with some force? I would love you to comment on all three. Ms. Bair. Well, I think accountability will be key. The statute needs to put accountability for systemic risk with this council. It needs to be given real authority to write rules, to set capital standards, to collect information, and make sure it is shared with the other regulators. If you provide that mandate and that accountability, as well as real legal authority, I think you will get the result that you want. There is nothing perfect about supervision, and this is why we have also suggested a resolution mechanism to enhance market discipline as well as protect taxpayers. In addition, we have suggested an assessment system that the resolution authority would have as well to provide disincentives for higher risk behavior. I think with those three steps in combination, you would dramatically improve the situation. Part of the problem is nobody really has the mandate right now for the entire system. There were problems. For instance, capital arbitrage between investment banks and commercial banks--different capital standards. That is exactly the kind of issue this type of council could have not only identified but also addressed. Senator Warner. But one of the things we need to do is make sure that that information that may currently reside in the day-to-day prudential regulator actually would get pushed up and actually shared, which---- Ms. Bair. That is right. Senator Warner.----seems in the past that some of this information has been out there, but it has not been---- Ms. Bair. That is exactly right. There needs to be clear authority to collect and to force the sharing of the information. We give the SEC our bank data; they give us their trading data. You need a mechanism to do that. Right now, sometimes it eventually happens, but it can be a long process, and it is not a coordinated, systematic process. Establishing a council with the mandate and the legal authority to carry out that mandate would dramatically improve the situation. Senator Warner. Mr. Chairman, I know I have gone beyond my time, but if I could have Mr. Stern answer the question, too, sir? " CHRG-111shrg54533--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. I have said on a number of occasions that reforming our financial regulatory system may be, as Senator Dodd has indicated, the most significant thing many of us will do while serving in the U.S. Senate. We all know how difficult it can be to shepherd even minor bills through the legislative process, let alone anything as significant as financial regulatory reform. We also know equally well that the opportunity to accomplish something of this magnitude can be fleeting, which presents a bit of a conundrum. We certainly want to strike while the iron is hot, but we also want to make the most of the opportunity that has been presented. The philosopher William James once said, ``He who refuses to embrace a unique opportunity loses the prize as surely as if he has failed.'' I hope that we do not collectively refuse to embrace this unique opportunity because here failure I believe is not an option. The President has put forward his plan. It deserves our careful consideration. That consideration will involve not only an evaluation of his proposed reforms but, more importantly, a close examination of the facts upon which he based his recommendations. The administration's factual predicate can then be compared with the Committee's findings as soon as we complete our examination of the crisis. I have said many times this Committee must first clearly identify what went wrong before we even began to consider a response. It is my hope that we can take advantage of some of the work done by the Secretary and others in the administration. It would be helpful if Secretary Geithner could share with Congress any and all documents and information used in their process in their recommendation. As is the case with all legislative efforts, laws are built around consensus, and consensus is achieved when all parties can agree on either facts or principles. There is one fact upon which I believe we have reached a complete agreement. Our financial regulatory system is antiquated and inadequate. I am not as confident, however, that we have reached agreement on what principles should guide our efforts yet. As we begin evaluating the President's plan, I want to highlight the key considerations that I believe should guide our process as we move forward. First, notwithstanding the great difficulties we have recently experienced, private markets still provide the best means for achieving our full economic potential. Risk taking is an essential ingredient in these markets, and while we should improve our ability to manage risk, we cannot simply eliminate risk taking without sacrificing the foundation of our free market system. We must also remember that risk is a two-way street. Those who take risk must be prepared to suffer the losses as well as enjoy the gains. Any reforms we adopt must reduce expectations that some firms are simply too big to fail. Second, we must establish regulatory mandates that are achievable. This is especially true with respect to the regulation of systemic risk. And while there is wide agreement that we have experienced a systemwide event, we have spent very little time discussing the concept of systemic risk, determining how best to regulate it, or even establish whether it can be regulated at all. Third, I believe that regulators should have clear and manageable responsibilities and be subject to oversight and proper accountability. I am concerned that we already have a number of regulators that do not currently meet these criteria, and the administration is contemplating giving them additional responsibilities. For example, the Federal Reserve already handled monetary policy, bank regulation, holding company regulation, payment systems oversight, international banking regulation, consumer protection, and the lender-of-last-resort function. These responsibilities conflict at times, and some receive more attention than others. I do not believe that we can reasonably expect the Fed or any other agency effectively play so many roles. In addition, the Federal Reserve was provided a unique independent status to assure world markets that monetary policy would be insulated from political influence. The structure of the Federal Reserve involves quasi-public reserve banks that are under the control of boards with members selected by banks regulated by the Fed. By design, the board and the reserve banks are not directly accountable to Congress and are not easily subject to congressional oversight. Recent events have clearly demonstrated that the structure is not appropriate for a Federal banking regulator let alone a systemic regulator. Finally, while we have a responsibility to identify and repair the weaknesses of our current regulatory structure, we also have a duty to position our regulatory system for the future. Since World War I, we have been the world's financial market of choice. That is rapidly changing. We must do everything we can to not only ensure the safety and soundness of our financial system, but also its competitive standing in the world. The President has now added his voice to the debate, and it is now up to us to add ours. As we do, I hope that we will not allow the administration's recommendations to limit the debate that we are about to undertake. While we have a very difficult task before us, I also believe we have a unique opportunity to do something significant. I urge my colleagues to focus on creating a regulatory system for the next century, not one that merely seeks to remedy the mistakes of the last few years. Thank you, Mr. Chairman. " CHRG-111hhrg54868--42 Mr. Dugan," It is similar. We also did not have any rulewriting authority in this area. But we did have considerable examination and enforcement responsibilities with respect to the rules that were on the books, and we think we did a decent job with that. I would make one other very fundamental point, though. A number of the problems that caused the crisis, while consumer protection contributed to it, a big chunk of that was pure and simple underwriting problems. A big chunk of that was outside of the banking system. And we did not have any authority over that in terms of examining and supervising it, and even the rules that were adopted didn't apply to them. And so you had this uneven world where you had two different systems applying to the regulated and the unregulated, and that was a fundamental problem. " CHRG-110hhrg46596--367 Mr. Scott," Thank you very much, Mr. Chairman. Mr. Kashkari, first of all, the great concern we have is--the fundamental need right now are two things for us to get out of this doldrum that we have in our economy. One is we have to lend the money--the banks have to lend the money. We have to get consumers to spend the money. As you well know from finance--and you are a man of finance--the banking system is sort of like the heart of our economy. Like our own heart and our own bodies, the primary function is to pump the blood to get throughout the body. That is what the banks are there for. But they are not pumping the blood, the money, out to the system. It is not getting out to the fingers, and out to the toes. It is not getting out there. It is not getting out to the homeowners who are hanging on by their fingernails, and not getting out to those people who need to keep their jobs. That is what we have to break through with. I want to deal with a couple of specific points, and I think that we can give you an example, and I want to get your answers as to how you might be able to help us to do this. For example, here is one example. In Atlanta, Georgia, we have the Hartsfield International Airport which, I am sure, if you have been around, everybody has gone through. It is the world's busiest airport. We have a great need now. We are building a second terminal, the Maynard H. Jackson International Terminal. However, without access to the short-term credit market, construction will stop. We need that access. The question is: Can Treasury make sure that the reserves and money and resources that are going to the banks be directed to unfreeze the market for State and local debt so that projects like this can go forward? That is nearly over 3,000 jobs that will stop. Now, can we do that? " CHRG-111hhrg74090--147 Mr. Barr," Thank you very much for that set of questions. I do think that our proposal does involve sweeping change, a sweeping change that in our judgment is essential to protect consumers. Our old system was fundamentally broken and we do need fundamental reform. With respect to smaller institutions, we don't expect to see, would not expect that small banks and big banks would have different rules of disclosure, but you may see differences in, say, how much examination or supervision there would be. In the bigger institutions as we do today on site there are examiners on site year round. You wouldn't want that for a small bank. So you may see differences like that but not differences in the basic standards affecting consumers. Those would be uniform across the board. So if you walk into a bank or you walk into a credit union, you walk into a big bank or you go to your independent mortgage broker or you go to an independent mortgage company, you get the same simple mortgage disclosure so consumers can understand what they are getting. " FinancialCrisisReport--39 Oversight of Lenders. At the end of 2005, the United States had about 8,800 federally insured banks and thrifts, 73 plus about 8,700 federally insured credit unions, many of which were in the business of issuing home loans. 74 On the federal level, these financial institutions were overseen by five agencies: the Federal Reserve which oversaw state-chartered banks that were part of the Federal Reserve System as well as foreign banks and others; the Office of the Comptroller of the Currency (OCC) which oversaw banks with national charters; the Office of Thrift Supervision (OTS) which oversaw federally-chartered thrifts; the National Credit Union Administration which oversaw federal credit unions; and the Federal Deposit Insurance Corporation (FDIC) which oversaw financial institutions that have federal deposit insurance (hereinafter referred to as “federal bank regulators”). 75 In addition, state banking regulators oversaw the state-chartered institutions and at times took action to require federally-chartered financial institutions to comply with certain state laws. The primary responsibility of the federal bank regulators was to ensure the safety and soundness of the financial institutions they oversaw. One key mechanism they used to carry out that responsibility was to conduct examinations on a periodic basis of the financial institutions within their jurisdiction and provide the results in an annual Report of Examination (ROE) given to the Board of Directors at each entity. The largest U.S. financial institutions typically operated under a “continuous exam” program, which required federal bank examiners to conduct a series of specialized examinations during the year with the results from all of those examinations included in the annual ROE. Federal examination activities were typically led by an Examiner in Charge and were organized around a rating system called CAMELS that was used by all federal bank regulators. The CAMELS rating system evaluated a financial institution’s: (C) capital adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk. CAMELS ratings are on a scale of 1 to 5, in which 1 signifies a safe and secure bank with no cause for supervisory concern, 3 signifies an institution with supervisory concerns in one or more areas, and 5 signifies an unsafe and unsound bank with severe supervisory concerns. In the annual ROE, regulators typically provided a financial institution with a rating for each CAMELS component, as well as an overall composite rating on its safety and soundness. In addition, the FDIC conducted its own examinations of financial institutions with federal deposit insurance. The FDIC reviews relied heavily on the examination findings and ROEs developed by the primary regulator of the financial institution, but the FDIC assigned its own CAMELS ratings to each institution. In addition, for institutions with assets of $10 billion or more, the FDIC established a Large Insured Depository Institutions (LIDI) Program to assess and report on emerging risks that may pose a threat to the federal Deposit Insurance Fund. Under this program, the FDIC performed an ongoing analysis of emerging risks within each 73 See FDIC Quarterly Banking Profile, 1 (Fourth Quarter 2005) (showing that, as of 12/31/2005, the United States had 8,832 federal and state chartered insured banks and thrifts). 74 See 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration (showing that, as of 12/31/2005, the United States had 8,695 federal and state credit unions). 75 The Dodd-Frank Act has since abolished one of these agencies, the Office of Thrift Supervision, and assigned its duties to the OCC. See Chapter IV. insured institution and assigned a quarterly risk rating, using a scale of A to E, with A being the best rating and E the worst. CHRG-111hhrg51591--109 Mr. Harrington," I would say with regard to the insurance sector, if we can get beyond AIG, that the capital requirements have been such that most companies have held vastly more capital than what is required by the requirements, especially on the property/casualty side, so that because of market discipline, many property/casualty companies are really well-capitalized and a lot of life insurance companies have. In principle, if you have moral hazard problems and real systematize risk problems, I think this idea of increasing capital requirements, and increasing them more the more risk you take on, makes some sense. But I am still skeptical about whether it will ever work in practice because if you look at the last 20 years of banking regulation, the name of the game has been the move towards ostensibly sophisticated systems that, in effect, allowed banks to reduce the amount of capital they held. So I am just skeptical that you can actually make that type of system bite. In theory, I think it sounds like a good idea. " CHRG-111shrg54533--9 Chairman Dodd," Well, I appreciate the answer to that. Let me go to the issue--and, again, I want to state--I think all of us have had a chance to talk about this, and obviously the debate about, one, whether or not you want a systemic risk regulator, which I certainly do, and then the question who does it and what authorities do you give them. From my standpoint, I am open on the issue. I have not made up my own mind what is the best alternative. Obviously, you have submitted a plan that gives that authority to the Fed. But let me raise some questions that have been raised by others about the wisdom of that move to the Fed and not looking at the more collegial approach or some other alternative. A fellow by the name of Mark Williams, a professor of finance and economics at Boston University and a former Fed examiner, said the following: ``Giving the Fed more responsibility at this point''--and he had a rather amusing analogy--``is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.'' SEC former Chairman Richard Breeden testified before this Committee, and he said the following: ``The Fed has always worried about systemic risk. I remember in 1982 and 1985 the Fed talking about that it worried about systemic risk. They have been doing that, and still we had a global banking crisis. The problems like the housing bubble, the massive leverage in the banks, the shaky lending practices, and subprime mortgages, those things were not hidden. They were in plain sight.'' And perhaps most significantly, Chairman Volcker in response to a question by Richard Shelby back in February in a hearing we had in this Committee testified that he had concerns about giving the Fed too many responsibilities that would undermine their ability to conduct monetary policy. So the question that many are asking, not just myself but others on this Committee and elsewhere, is: Given the concerns that have been expressed by the former Chairman of the Federal Reserve, the former Chairman of the SEC, and others about the Fed's track record as well as the multiple responsibilities that the Fed already has, why is it your judgment that the Fed should be given this additional extraordinary authority and power? And does it not conflict in many ways or could it not conflict with their fundamental responsibility of conducting monetary policy? " CHRG-111hhrg53244--164 Mr. Bernanke," Well, I don't think I would break firms down to their elementary components; you know, commercial banks can only loan and take deposits, for example. There are lots of benefits to having multiple services provided by one institution, or global services provided by one institution. But I do think we need to take considerable care that we are not creating institutions which are imposing risks on the broad financial system. Ms. Moore of Wisconsin. Okay. So I have just one more question. Many of my Republican colleagues are critical and concerned about the Fed taking on the role of the systemic risk regulator, and then there are people like me who are undecided. And when I looked at the last page of your testimony and you say that you don't want as much auditing of the Fed because it may interfere with your independence, I have to ask you why you think, then, that you should be able to perform the tasks of monetary policy and how that will not compromise your policy independence. I mean, you know-- " CHRG-111shrg382--29 Mr. Tarullo," Well, Senator, the Federal Reserve is certainly not interested in being a receiver or conservator of any institutions. Let me say a couple of things. One, the complexity of the larger institutions is going to be a challenge, and I think we all just have to acknowledge that. The FDIC does a terrific job of winding down institutions, but if we look at the profile of those institutions, they are overwhelmingly fairly straightforward banking institutions. Second, I think that as we approach the resolution issue, as I said to Senator Corker a moment ago, we do have to make sure that we are increasing market discipline, and usually what that means is--forgive me for the vernacular--but guys are going to take some losses. And unless that is pretty clear, then you are going to lose the advantages of market discipline along the way. But the third thing I will say is--and I have said this before in this hearing and other hearings--I am not sanguine that any one tool is going to be adequate to contain systemic risk and, more importantly, in a direct regulatory sense to deal with the moral hazard and too big to fail problems. That is why I think that we should regard a resolution mechanism as one element, necessarily imperfect but I hope positive, along that road. Senator Shelby. We are always going to have in a market system winners and losers, failures and success, and that is the genius of the market in a sense. And you are going to have failures in banks ahead down the road. But do you believe as a regulator that you would have some responsibility to make sure that these banks are well capitalized and that are not into something that you--in other words, you do not let the banks run ahead of you and jeopardize themselves and ultimately the taxpayers in some way? " CHRG-111hhrg53240--4 Mr. Sherman," The Federal Reserve is a very powerful government agency exercising government power. The proposal now is to give them a lot more power. In a constitutional democracy we have one person, one vote. The executive branch is headed by the President and all important executive branch appointees are appointed by the President or appointed by the President's appointees. There is one incredible and offensive exception. That is the Federal Reserve where, at the regional bank, a majority are selected and, ultimately, on the Federal Open Market Committee, perhaps the most important government agency we have, a majority of the power is in the hands of one bank, one vote. Or should I say, ``one big bank, one big vote;'' ``one small bank, one small vote?'' This is an affront to the Constitution which will be exacerbated if we transfer more power to the Federal Reserve without mandating that all its Governors be appointees of those who are elected by the voters. It is a testament to the power of the banks that such incredible governmental power is invested in agencies where the voters don't decide who are the Governors. I realize the Federal Reserve Board of Governors is appointed, but those regional slots and the Open Market Committee are very important centers of government power. Second, the ranking member on this committee has a bill which I have cosponsored to audit the Federal Reserve. It is absurd to have a government agency with this kind of power be the agency immune from such audits. And finally, there is the idea of, where do we put consumer protection? Right now, we have a Federal Reserve where the banks choose the majority of those on the regional boards and on the Federal Open Market Committee, and then we are told that is the agency that will protect consumers from the banks. No other industry has that much power to select its regulators. Finally, if the Fed is going to be the systemic risk regulator, we have to recognize that ripping off consumers is one way to ameliorate systemic risk because if you can double-cycle bill, you can get the banks a little bit more healthy, and maybe they will survive their stress tests. We can't put those responsible for the stress test on the one hand with the responsibility for protecting consumers on the other. And I don't care how healthy you can make the banks with credit card rip-offs, we ought to prevent those credit card rip-offs, we ought to prevent those credit card rip-offs because ripping off the consumer is not the best way to make the banks healthy. I yield back. " CHRG-111shrg52966--73 PREPARED STATEMENT OF TIMOTHY W. LONG Senior Deputy Comptroller, Bank Supervision Policy and Chief National Bank Examiner March 18, 2009Introduction Chairman Reed, Ranking Member Bunning, and members of the Subcommittee, my name is Timothy Long and I am the Senior Deputy Comptroller for Bank Supervision Policy and Chief National Bank Examiner at the Office of the Comptroller of the Currency (OCC). I welcome this opportunity to discuss the OCC's perspective on the recent lessons learned regarding risk management, as well as the steps we have taken to strengthen our supervision and examination processes in this critical area, and how we supervise the risk management activities at the largest national banking companies. Your letter of invitation also requested our response to the findings of the GAO regarding the OCC's oversight of bank risk management. Because we only received the GAO's summary statement of facts on Friday night, we have not had an opportunity to thoroughly review and assess their full report and findings. Therefore, I will only provide some brief observations on their initial findings. We take findings and recommendations from the GAO very seriously and will be happy to provide Subcommittee members a written response to the GAO's findings once we have had the opportunity to carefully review their report.Role of Risk Management The unprecedented disruption that we have seen in the global financial markets over the last eighteen months, and the events and conditions leading up to this disruption, have underscored the critical need for effective and comprehensive risk management processes and systems. As I will discuss in my testimony, these events have revealed a number of weaknesses in banks' risk management processes that we and the industry must address. Because these problems are global in nature, many of the actions we are taking are in coordination with other supervisors around the world. More fundamentally, recent events have served as a dramatic reminder that risk management is, and must be, more than simply a collection of policies, procedures, limits and models. Effective risk management requires a strong corporate culture and corporate risk governance. As noted in the March 2008 Senior Supervisors Group report on ``Observations on Risk Management Practices During the Recent Market Turmoil,'' companies that fostered a strong risk management culture and encouraged firm-wide identification and control of risk, were less vulnerable to significant losses, even when engaged in higher risk activities.\1\--------------------------------------------------------------------------- \1\ See Senior Supervisors Group Report, ``Observations on Risk Management Practices,'' at http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf.--------------------------------------------------------------------------- While current economic conditions have brought renewed attention to risk management, it is during periods of expansionary economic growth when risk management can be most critical and challenging both for bankers and supervisors. Financial innovation and expansion of credit are important drivers of our economy. Banks must be able to respond to customer and investor demand for new and innovative products and services. They must also be able to compete with firms that may be less regulated and with financial service companies across the globe. Failure to allow this competition risks ceding the prominent role that U.S. financial firms have in the global marketplace. Banks are in the business of managing financial risk. Competing in the marketplace and allowing market innovation means that there will be times when banks lose money. There will also be times when, despite a less favorable risk/reward return, a bank will need to maintain a market presence to serve its customers and to retain its role as a key financial intermediary. These are not and should not be viewed as risk management failures. The job of risk management is not to eliminate losses or risk, but rather to ensure that risk exposures are fully identified and understood so that bank management and directors can make informed business decisions about the firm's level of risk. In this regard, 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 mitigation actions are needed. Knowing when and how to strike this balance is one of the most difficult jobs that supervisors and examiners face. Taking action too quickly can constrain economic growth and impede credit to credit worthy borrowers; waiting too long can result in an overhang of risk becoming embedded into banks and the marketplace. Effective risk management systems play a critical role in this process.Risk Management Lessons Learned It is fair to ask what the banking industry and supervisors have learned from the major losses that have occurred over the past 18 months. The losses have been so significant, and the damage to the economy and confidence so great, that we all must take stock of what we missed, and what we should have done differently to make sure that we minimize the possibility that something like this happens again. Below are some of our assessments: Underwriting Standards Matter, Regardless of Whether Loans are Held or Sold--The benign economic environment of the past decade, characterized by low interest rates, strong economic growth and very low rates of borrower defaults led to complacency on the part of many lenders. Competitive pressures drove business line managers to ease underwriting standards for the origination of credit and to assume increasingly complex and concentrated levels of risk. Increased investor appetite for yield and products, fueled by a global abundance of liquidity, led many larger banks to adopt the so-called ``originate-to-distribute'' model for certain commercial and leveraged loan products, whereby they originated a significant volume of loans with the express purpose of packaging and selling them to investors. Many of these institutional investors were willing to accept increasingly liberal repayment terms, reduced financial covenants, and higher borrower leverage on these transactions in return for marginally higher yields. Similar dynamics were occurring in the residential mortgage markets, where lenders, primarily non-bank lenders, were aggressively relaxing their underwriting standards. Given the abundance of liquidity and willing investors for these loans, lenders became complacent about the risks underlying the loans. However, in the fall of 2007 the risk appetite of investors changed dramatically and, at times, for reasons not directly related to the exposures that they held. This abrupt change in risk tolerance left banks with significant pipelines of loans that they needed to fund as the syndicated loan and securitization markets shut down. Bankers and supervisors underestimated the rapidity and depth of the global liquidity freeze. A critical lesson, which the OCC and other Federal banking agencies noted in their 2007 Shared National Credit results, is that banking organizations should ensure that underwriting standards are not compromised by competitive pressures. The agencies warned that ``consistent with safe and sound banking practice, agent banks should underwrite funding commitments in a manner reasonably consistent with internal underwriting standards.''\2\--------------------------------------------------------------------------- \2\ See Joint Release, NR 2007-102 at: http://www.occ.treas.gov/ftp/release/2007-102.htm. Risk Concentrations Can Accumulate Across Products and Business Lines and Must be Controlled--Risk concentrations can arise as banks seek to maximize their expertise or operational efficiencies in a highly competitive business. Community banks can often develop significant concentrations as their lending portfolios tend to be highly concentrated in their local markets. For larger institutions, a key issue has been the ability to aggregate risk exposures across business and product lines and to identify risks that may be highly correlated. For example, many national banks underestimated their exposure to subprime mortgages because they did not originate them. Indeed, some senior bank management thought they had avoided subprime risk exposures by deliberately choosing to not originate such loans in the bank--only to find out after the fact that their investment bank affiliates had purchased subprime loans elsewhere to structure them into collateralized debt obligations. Because of inadequate communication within these firms, those structuring businesses were aggressively expanding activity at the same time that retail lending professionals in the bank were avoiding or exiting the business because of their refusal to meet weak underwriting conditions prevalent in the market. These failures were compounded when products, markets, and geographic regions that previously were looked to as a source of risk diversification became more highly correlated as contagion effects spread across the globe. Additionally, significant corporate acquisitions, especially if they were not consistent with the bank's business strategy and corporate culture, affected the institutions' financial well being, their risk positions and reputations, and placed significant strains --------------------------------------------------------------------------- on their risk management processes. Asset-Based Liquidity Provides a Critical Cushion--There is always a tension of how much of a bank's balance sheet capacity should be used to provide a cushion of liquid assets--assets that can be readily converted to liquid funds should there be a disruption in the bank's normal funding markets or in its ability to access those markets. Because such assets tend to be low risk and, thus, low yielding, many banks have operated with very minimal cushions in recent years. These decisions reflected the abundance of liquidity in the market and the ease with which banks could tap alternative funding sources through various capital and securitization markets. Here again, when these markets became severely constrained, many banks faced significant short-term funding pressures. For some firms, these funding pressures, when combined with high credit exposures and increased leverage, resulted in significant strains and, in some cases, liquidity insolvency. Systemically Important Firms Require State-of-the-Art Infrastructure--As noted in a number of visible cases during this period of market turmoil, a large firm's ability to change its risk profile or react to the changing risk tolerance of others is dependent on an extremely robust supporting infrastructure. The velocity with which information is transmitted across financial markets and the size, volume and complexity of transactions between market participants has been greatly expanded through technology advancements and globalization of markets. Failure to have sufficient infrastructure and backroom operations resulted in failed trades and increased counterparty exposures, increasing both reputation and credit risks. Need for Robust Capital Levels and Capital Planning Processes--Although we are clearly seeing strains, the national banking system, as a whole, has been able to withstand the events of the past 18 months due, in part, to their strong levels of regulatory capital. The strong levels of capital in national banks helped to stabilize the financial system. National banking organizations absorbed many weaker competitors (e.g., Bear Stearns, Countrywide, and WAMU). This relative strength is more apparent when compared to the highly leveraged position of many broker-dealers. Nonetheless, it is clear that both banks' internal capital processes and our own supervisory capital standards need to be strengthened to more fully incorporate potential exposures from both on- and off-balance sheet transactions across the entire firm. In addition, capital planning and estimates of potential credit losses need to be more forward looking and take account of uncertainties associated with models, valuations, concentrations, and correlation risks throughout an economic cycle. These findings are consistent with reports issued by the SSG's report on ``Risk Management Practices,'' the Financial Stability Forum's (FSF) report on ``Enhancing Market and Institutional Resilience,'' the Joint Forum's report on ``Cross- Sectoral Review of Group-wide Identification and Management of Risk Concentrations,'' and the Basel Committee on Banking Supervision's consultative paper on ``Principles for Sound Stress Testing Practices and Supervision.''\3\ Two common themes from these reports and other studies in which the OCC has actively participated are the need to strengthen risk management practices and improve stress testing and firm-wide capital planning processes. The reports also note several areas where banking supervisors need to enhance their oversight regimes. The recommendations generally fall into three broad categories: 1) providing additional guidance to institutions with regard to the risk management practices and monitoring institutions' actions to implement those recommendations; 2) enhancing the various aspects of the Basel II risk-based capital framework; and 3) improving the exchange of supervisory information and sharing of best practices.--------------------------------------------------------------------------- \3\ Senior Supervisors Group Report, ``Observations on Risk Management Practices,'' at http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf; Financial Stability Forum, ``Enhancing Market and Institutional Resilience,'' at http://www.fsforum.org/publications/FSF_ Report_to_G7_11_April.pdf; Joint Forum, ``Cross-sectoral review of group-wide identification and management of risk concentrations'' at http://www.bis.org/publ/joint19.htm; and Basel Committee on Banking Supervision Report, ``Sound principles for stress testing practices and supervision,'' at http://www.bis.org/publ/bcbs147.htm. ---------------------------------------------------------------------------OCC Supervisory Responses The OCC has been actively involved in the various work groups that issued these reports, and we are taking a number of steps, primarily in our large bank supervision program, to ensure that our supervisory process and the risk management practices of our institutions incorporate these recommendations. I will focus on the three key areas identified by the Subcommittee: liquidity risk management, capital requirements, and enterprise-wide risk management.Liquidity Risk Management The sudden and complete shutdown in many traditional funding markets was not contemplated by most contingency funding plans. This period of market disruption has magnified the risks associated with underestimating liquidity risk exposures and improperly planning for periods of significant duress. The SSG report specifically noted that better performing firms carefully monitored their and on- and off-balance sheet risk exposures and actively managed their contingent liquidity needs. In April 2008, the OCC developed a liquidity risk monitoring program to standardize liquidity monitoring information across our large bank population and provide more forward looking assessments. We developed a template for the monthly collection of information about balance sheet exposures, cash-flow sources and uses, and financial market risk indicators. Our resident examiners complete this template each month and then work with our subject matter specialists in the Credit and Market Risk (CMR) division in Washington to produce a monthly report that summarizes the liquidity risk profile, based on levels of risk and quality of risk management, for 15 banking companies in our Large and Mid-size bank programs. These risk profiles provide a forward looking assessment of liquidity maturity mismatches and capacity constraints, both of which are considered early warning signals of potential future problems. In September 2008, the Basel Committee on Banking Supervision (Basel Committee) issued a report on, ``Principles for Sound Liquidity Risk Management and Supervision.''\4\ This report represents critical thinking that was done by supervisors in over 15 jurisdictions on the fundamental principles financial institutions and supervisors must adopt to provide appropriate governance of liquidity risk. OCC subject matter specialists in our CMR division were actively involved in the development of this important paper on risk management expectations, and are now contributing to the second phase of this work which is focused on identifying key liquidity metrics and benchmarks that may be valuable for enhancing transparency about liquidity risk at financial institutions. We are also working with the other U.S. Federal banking agencies to adapt and apply these key principles more broadly to all U.S. banking institutions through an interagency policy statement.--------------------------------------------------------------------------- \4\ See Basel Committee on Banking Supervision, ``Principles for Sound Liquidity Management and Supervision,'' at http://www.bis.org/publ/bcbs144.htm. --------------------------------------------------------------------------- The OCC reviews bank liquidity on an ongoing basis and we have incorporated these valuable lessons into our evaluations. Our strategic bank supervision operating plan for 2009 directs examiners at our largest national banks to focus on banks' firm-wide assessments of their liquidity risk and the adequacy of their liquidity cushions (short-term liquid assets and collateralized borrowing capacity) to meet short and medium term funding needs, as well as on the effectiveness of their liquidity risk management, including management information systems and contingency funding plans.Capital Requirements The market turmoil has highlighted areas where the current Basel II capital framework needs to be strengthened. The OCC, through its membership on the Basel Committee and work with the FSF, has been actively involved in formulating improvements to the capital framework. Among the refinements recommended by the Basel Committee in its January 2009 consultative papers are higher capital requirements for re-securitizations, such as collateralized debt obligations, which are themselves comprised of asset-backed securities.\5\ These structured securities suffered significant losses during the recent market turmoil. Other proposed changes to the Basel II framework would increase the capital requirements for certain liquidity facilities that support asset-backed commercial paper conduits.--------------------------------------------------------------------------- \5\ See: ``Proposed enhancements to the Basel II framework,'' ``Revisions to the Basel II Market Risk Framework,'' and ``Guidelines for computing capital for incremental risk in the trading book,'' January 2009 at http://www.bis.org/press/p090116.htm. --------------------------------------------------------------------------- In addition, the Basel Committee has proposed requirements for certain banks to incorporate default risk and credit migration risk in their value-at-risk models. These proposals are designed to better reflect the risks arising from the more complex, and less liquid, credit products that institutions now hold in their trading portfolios. The intention is also to reduce the extent of regulatory capital arbitrage that currently exists between the banking and trading books. The January consultative paper that proposed enhancements to the Basel II framework would also strengthen supervisory guidance regarding Pillar 2, or the supervisory review process of Basel II. Specifically, the proposed supervisory guidance would address firm-wide governance and risk management; capturing the risk of off-balance sheet exposures and securitization activities; and incentives to manage risk and returns over the long-term. More recently, following its meeting last week, the Basel Committee announced additional initiatives to strengthen capital in the banking system. These include introducing standards to promote the buildup of capital buffers that can be drawn down in periods of stress, as well as a non-risk-based capital measure like our leverage ratio.\6\ Once the Basel Committee finalizes these and other changes to the Basel II framework, the OCC and other Federal banking agencies will jointly consider their adoption in the U.S. through the agencies' notice and comment process.--------------------------------------------------------------------------- \6\ See ``Initiatives on capital announced by the Basel Committee,'' March 12, 2009 at: http://www.bis.org/press/p090312.htm. ---------------------------------------------------------------------------Enterprise Risk Management As previously noted, the recent market turmoil has highlighted the importance of a comprehensive firm-wide risk management program. The SSG report advised that striking the right balance between risk appetite and risk controls was a distinguishing factor among firms surveyed in its study. Additionally, the FSF report noted that, ``Supervisors and regulators need to make sure that the risk management and control framework within financial institutions keeps pace with the changes in instruments, markets and business models, and that firms do not engage in activities without having adequate controls.''\7\--------------------------------------------------------------------------- \7\ See ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 2008 at: http://www.fsforum.org/publications/r_0804.pdf.--------------------------------------------------------------------------- Proper risk governance was a key focus of guidance that the OCC, the SEC, and other Federal banking regulators issued in January 2007 on complex finance activities.\8\ That guidance stressed the need for firms to have robust internal controls and risk management processes for complex structured finance transactions. The guidance emphasized the importance of a strong corporate culture that includes and encourages mechanisms that allow business line and risk managers to elevate concerns to appropriate levels of management and to ensure the timely resolution of those concerns. It also stressed the need to ensure appropriate due diligence at the front-end, before products are offered, to ensure that all risks have been appropriately considered and can be effectively identified, managed and controlled. At the OCC, approval of new or novel banking activities is predicated on the bank having sufficient risk management controls in place.--------------------------------------------------------------------------- \8\ See: OCC Bulletin 2007-1, ``Complex Structured Finance Transactions'' at http://www.occ.gov/ftp/bulletin/2007-1.html. --------------------------------------------------------------------------- Assessing management's ability to effectively identify, measure, monitor, and control risk across the firm and to conduct effective stress testing is a key focus of our examination strategies for large national banks this year. Stress tests are a critical tool for effective enterprise-wide risk assessments. Such tests can help identify concentrations and interconnected risks and determine the adequacy of capital and liquidity. As with most other issues, the success of a stress testing program depends importantly on the support and sponsorship provided by senior management. In banks where risk management functions did not perform well, stress testing typically was a mechanical exercise. Management viewed stress tests as more of a ``requirement'' than an important risk management tool that could lead to internal discussions and debate about whether existing exposures constituted unacceptable risks. In addition, many stress tests failed to fully estimate the potential severity and duration of stress events and to identify and capture risks across the firm. Often, stress tests would focus on a single line of business and/or use only historical statistical relationships. When designing a stress test, particularly after a prolonged period of abundant liquidity, low credit spreads and low interest rates, it is important to probe for weaknesses in the portfolio that may not be evident from historically based stress exercises. Expert judgment can help define scenarios to address the likely breakdown in normal statistical relationships, as well as feedback loops, in a crisis. Such scenario-based stress tests, often dismissed as implausible by business unit personnel, allow firms to shock multiple market factors (e.g., interest rates credit spreads and commodity prices) simultaneously. Such stress tests are an important way to capture risks missed in traditional stress testing exercises, such as market liquidity risk and basis risk.OCC's Supervision of Risk Management at Large National Banks Let me now turn to how we apply and incorporate our perspective on risk management into the supervision of large national banks. The OCC is responsible for supervising over 1,600 banks, including some of the largest in the world that offer a wide array of financial services and are engaged in millions of transactions every day. Pursuant to the provision of the Gramm Leach Bliley Act (GLBA), the OCC serves as the primary Federal banking regulator for activities conducted within the national bank charter and its subsidiaries, except for those activities where jurisdiction has been expressly provided to another functional supervisor, such as the Securities and Exchange Commission (SEC), for certain broker-dealer activities. Nonetheless, we work closely with the Federal Reserve Board, the SEC, and other appropriate regulators to help promote consistent and comprehensive supervision across the company. The foundation of the OCC's supervisory efforts is our continuous, onsite presence of examiners at each of our 14 largest banking companies. These 14 banking companies account for approximately 89 percent of the assets held in all of the national banks under our supervision. The resident examiner teams are supplemented by subject matter specialists in our Policy Division and PhD economists from our Risk Analysis Division trained in quantitative finance. Our Large Bank program is organized with a national perspective. It is highly centralized and headquartered in Washington, and structured to promote consistent uniform coordination across institutions. The onsite teams at each or our 14 largest banks are led by an Examiner-In-Charge (EIC), who reports directly to the Deputy Comptrollers in our Large Bank Supervision Office in Washington, DC. The Large Bank Deputies are in ongoing communication with the EICs, in addition to holding monthly calls and quarterly face-to-face meetings with all EICs. To enhance our ability to identify risks and share best practices across the large bank population, we have established a program of examiner network groups in Large Banks. There are eight main network groups (Commercial Credit, Retail Credit, Mortgage Banking, Capital Markets, Asset Management, Information Technology, Operational Risk and Compliance) and numerous subgroups. These groups facilitate sharing of information, concerns and policy application among examiners with specialized skills in these areas. The EICs and leadership teams of each of the network groups work closely with specialists in our Policy and Risk Analysis Divisions to promote consistent application of supervisory standards and coordinated responses to emerging issues. All of this enables the OCC to maintain an on-going program of risk assessment, monitoring, and communication with bank management and directors. Nonetheless, given the volume and complexity of bank transactions, it is not feasible to review every transaction in each bank, or for that matter, every single product line or bank activity. Accordingly, we focus on those products and services posing the greatest risk to the bank through risk-based supervision. Resident examiners apply risk-based supervision to a broad array of risks, including credit, liquidity, market, compliance and operational risks. Supervisory activities are based upon supervisory strategies that are developed for each institution that are risk-based and focused on the more complex banking activities. Although each strategy is tailored to the risk profile of the individual institution, our strategy development process is governed by supervisory objectives set forth annually in the OCC's bank supervision operating plan. Through this operating plan, the OCC identifies key risks and issues that cut across the industry and promotes consistency in areas of concerns. With the operating plan as a guide, EICs develop detailed strategies that will direct supervisory activities and resources for the coming year. Each strategy is reviewed by the appropriate Large Bank Deputy Comptroller. Our risk-based supervision is flexible, allowing strategies to be revised, as needed, to reflect the changing risk profile of the supervised institutions. We have a Quality Assurance group within our Large Bank program that selects strategies to review as part of a supervisory program review to ensure reasonableness and quality supervision. Our supervisory goal is to ensure banks have sound risk governance processes commensurate with the nature of their risk-taking activities. Risk management systems must be sufficiently comprehensive to enable senior management to identify and effectively manage risk throughout the firm. Therefore, examinations of our largest banks focus on the overall integrity and effectiveness of risk management systems. The first step in risk-based supervision is to identify the most significant risks and then to determine whether a bank has systems and controls to identify and manage those risks. Next, we assess the integrity and effectiveness of risk management systems, with appropriate validation through transaction testing. This is accomplished through our supervisory process which involves a combination of ongoing monitoring and targeted examinations. The purpose of our targeted examinations is to validate that risk management systems and processes are functioning as expected and do not present any significant supervisory concerns. Our supervisory conclusions, including any risk management deficiencies, are communicated directly to bank senior management. Thus, not only is there ongoing evaluation, but there is also a process for timely and effective corrective action when needed. To the extent we identify concerns, we ``drill down'' to test additional transactions. These concerns are then highlighted for management and the Board as ``Matters Requiring Attention'' (``MRAs'') in supervisory communications. Often these MRAs are line of business specific, and can be corrected relatively easily in the normal course of business. However, a few MRAs address more global concerns such as enterprise risk management or company-wide information security. We also have a consolidated electronic system to monitor and report outstanding MRAs. Each MRA is assigned a due date and is followed-up by onsite staff at each bank. If these concerns are not appropriately addressed within a reasonable period, we have a variety of tools with which to respond, ranging from informal supervisory actions directing corrective measures, to formal enforcement actions, to referrals to other regulators or law enforcement. Our supervision program includes targeted and on-going analysis of corporate governance at our large national banks. This area encompasses a wide variety of supervisory activities including: Analysis and critique of materials presented to directors; Review of board activities and organization; Risk management and audit structures within the organization, including the independence of these structures; Reviews of the charters, structure and minutes of significant decisionmaking committees in the bank; Review of the vetting process for new and complex products and the robustness of new product controls; and Analysis of the appropriateness and adequacy of management information packages used to measure and control risk. It is not uncommon to find weaknesses in structure, organization, or management information, which we address through MRAs and other supervisory processes described above. But more significantly, at some of our institutions what appeared to be an appropriate governance structure was made less effective by a weak corporate culture, which discouraged credible challenge from risk managers and did not hold lines of business accountable for inappropriate actions. When the market disruption occurred in mid 2007, it became apparent that in some banks, risk management lacked support from executive management and the board to achieve the necessary stature within the organization, or otherwise did not exercise its authority to constrain business activities. At institutions where these issues occurred, we took strong supervisory actions, and we effected changes in personnel, organization and/or processes. Just as we adjust our strategies for individual banks, we also make adjustments to our overall supervisory processes, as needed. And of course we are adjusting our supervisory processes to incorporate the lessons we have learned during this period of extreme financial distress. For example, recent strategy guidance prepared by our Large Bank network groups and issued by Large Bank senior management increases our focus on: Risk concentrations across the enterprise; Refinancing risk arising from illiquidity in credit markets and changes in underwriting standards that limit the ability of many borrowers to refinance debt as originally intended; Collections, recovery and loss mitigation programs; Decision modeling; Liquidity contingency planning; Allowance for loan and lease loss adequacy; Capital buffers and stress assessments; and Syndication and other distribution processes and warehouse/ pipeline controls. Our supervisory activities at individual banks are often supplemented with horizontal reviews of targeted areas across a group of banks. These horizontal reviews can help us to identify emerging risks that, while not posing a significant threat to any one institution could, if not corrected, pose more system-wide implications for the industry. For example, reviews of certain credit card account management practices several years ago revealed that as a result of competitive pressures, banks were reducing minimum payments required from credit card customers to the point where many consumers could simply continue to increase their outstanding balances over time with no meaningful reduction in principal. We were concerned that these competitive pressures could mask underlying deterioration in a borrower's condition and could also result in consumers becoming over-extended. Because of the highly competitive nature of this business, we recognized that we needed to address this problem on a system-wide basis and as a result, worked with the other Federal banking agencies to issue the 2003 guidance on Credit Card Account Management Practices.\9\--------------------------------------------------------------------------- \9\ See OCC Bulletin 2003-1, ``Credit Card Lending: Account Management and Loss Allowance Guidance,'' at http://www.occ.gov/ftp/bulletin/2003-1.doc.--------------------------------------------------------------------------- In addition to the aforementioned liquidity monitoring data we have begun collecting, we have also initiated loan level data collection from our major banks for residential mortgages, home equity loans, large corporate credits, and credit card loans. This data is being used to enhance our horizontal risk assessments in these key segments and offers a tool for examiners to benchmark their individual institution against the industry. More recently, in early 2008 we began developing a work plan to benchmark our largest national banks against the risk management ``best practices'' raised in various reports issued by the President's Working Group (PWG), SSG, FSF, and Basel Committee. OCC staff developed a template for our examining staff to collect information to conduct this benchmarking exercise and we shared this with our colleagues at the PWG and SSG. In the interest of expanding the pool of firms and expediting the collection of risk management information, agency principals elected to use the SSG as the forum for undertaking the risk management assessment. In December 2008, a self-assessment template was sent to 23 globally active financial firms and the completed self-assessments are now in the process of being collected and shared among the participating agencies. These self-assessments will be supplemented with interviews at selected firms to discuss the status of addressing risk management deficiencies already identified and also probe for further information on emerging issues that may not yet be evident. To summarize, the goal of our supervision is to ensure that banks are managed in a safe and sound manner, to identify problems or weaknesses as early as possible and to obtain corrective action. Through our examinations and reviews, we have directed banks to be more realistic in assessing their credit risks; to improve their valuation techniques for certain complex transactions; to raise capital as market opportunities permit; to aggressively build loan loss reserves; and to correct various risk management weaknesses. As previously noted, we have a staff of specialists who provide on-going technical assistance to our onsite examination teams. Our Risk Analysis Division includes 40 PhD economists and mathematicians who have strong backgrounds in statistical analysis and risk modeling. These individuals frequently participate in our risk management examinations to help evaluate the integrity and empirical soundness of banks' risk models and the assumptions underlying those models. Our policy specialists assist by keeping abreast of emerging trends and issues within the industry and the supervisory community. Staffs from our CMR, Operational Risk, and Capital Policy units have been key participants and contributors to the ongoing work of the SSG, FSF, PWG and Basel Committee. In 2008, we established a Financial Markets Group within the agency and tasked them with the build-out of a market intelligence program. Their mission is to look around corners, to seek out early warning signs of emerging and/or systemic risk issues. This team is comprised of highly experienced bank examiners and subject matter specialists hired from the industry, and they spend considerable time meeting with bank investors, bank counterparties, bank competitors, bank analysts, and other relevant stakeholders. Their work is discussed with members of the OCC's senior management team on a bi-weekly basis, or more frequently when needed, and discussed in detail with the OCC's National Risk Committee members, who represent all lines of bank supervision within the OCC, as well as our legal and economics teams.Coordination with Other Supervisors Successful execution of our supervisory priorities requires an effective working relationship with other supervisors, both domestically and internationally. The events of the past 18 months highlight the global nature of the problems we are facing and the need for global responses. The OCC has taken a significant leadership role in the interagency work underway to address risk management issues raised during this period of market turmoil. Comptroller Dugan is an active member of the PWG and also serves as the Chair of the Joint Forum. In that capacity, he has sponsored critical work streams to address credit risk transfer, off-balance sheet activities and reliance on credit rating agencies. The Joint Forum work not only builds transparency about how large, financial conglomerates manage critical aspects of risk management, but it also serves as a vehicle for identifying risk management ``best practices.'' Close coordination with our supervisory colleagues at the other banking agencies, as well as the securities agencies, has proven beneficial for all parties--firms, supervisors and policymakers. One example where this is evident has been the cooperative work among major market players and key regulators (the New York Federal Reserve Bank, the Federal Reserve Board, the OCC, the SEC, and other key global regulators) to strengthen the operational infrastructure and backroom processes used for various over-the-counter (OTC) derivative transactions. This is another example where a collective effort was needed to address problems where there was not a clear incentive for any individual firm to take corrective action. As a result of these efforts, we have seen material improvements in the reduction of unconfirmed trades across all categories of OTC derivatives, with the most notable reduction in the area of credit derivatives, where the large dealers have reduced by over 90 percent the backlog of credit derivatives confirmations that are outstanding by more than 30 days.GAO Report As I noted in my introduction, we received the GAO's draft statement of findings on Friday night and, as requested, provided them with summary comments on those draft findings on Monday morning. Once we receive the GAO's final report, we will give careful consideration to its findings and any recommendations therein for improvement in our supervisory processes. We will be happy to share our conclusions and responses with the Subcommittee. As I have described in my testimony, the OCC has a strong, centralized program for supervising the largest national banks. But clearly, the unprecedented global disruptions that we have witnessed across the credit and capital markets have revealed risk management weaknesses across banking organizations that need to be fixed and we are taking steps to ensure this happens. In this regard, it is important to recognize that risk management systems are not static. These systems do and must evolve with changes in markets, business lines, and products. For example, improving and validating risk models is an ongoing exercise at our largest institutions. Therefore it should not be surprising that we routinely have outstanding MRAs that direct bank management to make improvements or changes to their risk models and risk management practices. This is an area where we continuously probe to look for areas of improvement and best practices. As I described earlier, we have systems in place to monitor and track these MRAs and, when we determine that the bank is not making sufficient progress to address our concerns, we can and do take more forceful action. However, unless we believe the model deficiency is so severe as to undermine the bank's safety and soundness, we will allow the bank to continue to use the model as it makes necessary refinements or adjustments. Given the iterative process of testing and validating risk models, it simply is not realistic to suggest that a bank suspend its operations or business whenever it needs to make enhancements to those processes. One of the GAO's major findings is that institutions failed to adequately test for the effects of a severe economic downturn scenario. As I have discussed, we agree that the events of the past 18 months have underscored the need for improved and more robust stress testing. Banks' stress tests need to more fully incorporate potential interconnection risks across products, business lines and markets, and evaluate such exposures under extreme tail-events. The OCC was actively involved in developing the January 2009 report issued by the Basel Committee cited by the GAO. Indeed, many of the findings and recommendations in that report were drawn from our findings and work in our large banking institutions. We will be working with these institutions to ensure that they incorporate those recommendations into their stress testing processes.Conclusion The events of the past 18 months have highlighted and reinforced the need for effective risk management programs and revealed areas where improvements are needed. I believe the OCC and the banking industry are taking appropriate steps to implement needed changes. I also believe that these events have demonstrated the strength of the OCC's large bank supervision program. Throughout the recent market turmoil, our resident examination staffs at the largest institutions have had daily contact with the business and risk managers of those institutions' funding, trading, and lending areas to enable close monitoring of market conditions, deal flow and funding availability. Their insights and on-the-ground market intelligence have been critical in helping to assess appropriate policy and supervisory responses as market events have continued to unfold. Indeed, I believe that the OCC's large bank supervision program, with its centralized oversight from Washington D.C., and highly experienced resident teams of bank examiners and risk specialists, is the most effective means of supervising large, globally active financial firms.Statement Required by 12 U.S.C. Sec. 250: The views expressed herein are those of the Office of the Comptroller of the Currency and do not necessarily represent the views of the President. ______ CHRG-110hhrg44900--181 Mr. Bernanke," Well, the issue you're referring to is of course under Gramm-Leach-Bliley. The Treasury and the Fed are in power to allow banks or bank holding companies to enter activities that are incidental to financial activities. The law will require us to make a determination as to whether that's incidental or not. But the Congress, obviously, had some concerns about this; and, therefore, Congress has essentially prevented us from even making that determination. We have not attempted to determine whether it meets the statutory test, nor have we done extensive analysis of the systemic implications of such a move, so, for the time being, it seems to be pretty much a moot question. " CHRG-110shrg50410--136 Chairman Dodd," You are asking us to act expeditiously on something that clearly needs some urgent attention. This is an issue that deserves a lot of thought and consideration. There is a broader question. And I just do not want to have us graft on to a problem we need to address in the next few days with something that is far more far-reaching, that deserves a lot more thought and consultation before we move in that direction. And I am, as I say, relatively sympathetic to the direction you want to move in. I do not think we want to do exactly the models we look at in some other places, but clearly some additional thought on the overall architecture. That is my concern. Yes, Chuck? Senator Schumer. Yes, thanks. I think this is a great discussion and I appreciate your leading it. But the big conundrum we have in our financial system is it has evolved, as the Chairman has said, away from just commercial banks. Systemic risk is far more interrelated to the relationships between these hundreds and thousands of entities. And the responsibility for systemic risk is chopped up in different pieces. I mean, Bear Stearns is a classic. The authority involved for systemic risk was the Fed. But the authority that looked at Bear Stearns was the SEC. And it sort of did not add up. And so I, for one, have been pretty strongly of the view a single regulator, particularly in regards to systemic risk, but in general makes sense. Or at least more unified regulation. And at least to my way of thinking, and I could not agree with you more, Mr. Chairman, to take this aspect, which is looking at the GSEs and then bootstrap it and say we should do it for everybody would be a mistake. On the other hand, when the GSEs present such systemic risk problems, you need somebody to do this. And you know, I do not think OFHEO, for instance, has the ability to look at the systemic problems that the GSEs would cause given their--so I do not--I think if we took your admonition in mind, be careful that this does not bootstrap it to everybody, but did not shy away from doing it--because I think we do have to do it with the problems the GSEs had--I think that may be a way to cut this knot as opposed to just not doing it at all. "